Call Protection at Rock-Bottom Prices

In times like these, it’s necessary to talk about relative value.

It can be difficult to discern what securities are of value these days. Even though we seem on the precipice of rate hikes, short-term yields (in particular) remain mired in cyclical lows. The two-year Treasury yield, for example, hasn’t been over 1 percent in over five years. The five-year note hasn’t seen 2 percent for over four years. Where can an investor go for value?

Eye of the Beholder
In times like these, it’s necessary to talk about relative value. Maybe before our careers are over we’ll be able to buy bonds at 7 percent yields, with maturities and credit qualities that are acceptable, but a lot of unusual circumstances will have to occur in concert before that happens.

One variable that is certain to change if rates rise is the cost of carry for community banks. At last look, the 300+ institutions that use Vining Sparks Risk Manager for its interest-rate risk management report an all-in cost of funds of 39 basis points. What this means is that some relatively paltry yields on assets can actually create some respectable net margins.

Another way to quantify value is to study the spread history on certain popular community bank investments. One sector that is large and liquid is federal agency bonds. These are debt instruments issued by your favorite Government-Sponsored Enterprise (GSE), e.g., Fannie Mae, Freddie Mac and the Federal Home Loan Bank. They comprise about 15 percent of a typical investment portfolio, and they are widely seen as fungible, which makes spread analysis very straightforward.

Why So Narrow?
Today, a community bank can purchase a five-year agency bond that is non-callable at a spread of about 12 basis points (0.12 percent) over a comparable Treasury. If you, as an informed investor, are willing to buy a callable bond, which can be refunded to you as early as 90 days from now if the agency/issuer so chooses, you can eek out another 10 basis points on top of that.

That additional 0.10 percent to take on call risk for most of the life of the bond is miniscule. Just a year ago, the incremental yield was more than twice that. There have been times in the last five years in which incremental spreads were over 40 basis points. We can therefore state that callables have outperformed bullets lately.

The question is, why? The answer is logical, and twofold. Supply/demand has helped to make spreads collapse. There are fewer true callable agencies, as the GSEs have collectively been shrinking their balance sheets pursuant to congressional mandate. At the same time, investors have been more willing to take on call risk at the advent of a rate-hike cycle, theorizing that if nothing gets called, they at least have more yield than a bullet, regardless of how puny.

Spreads as Rates Rise
I hasten to remind community bank investment managers what typically happens to yields as rates rise: Spreads tighten. Yes, tighten. The reason is related to the fundamentals of lending. If general interest rates are rising, it is in response to an expanding, and probably inflationary, economy.

As the economy improves, the chances of borrowers meeting their obligations to lenders also improve. As the credit quality, in fact or presumed, increases, a lender will accept a smaller relative return. This plays out in the yields and spreads in your community bank’s own investments and loan portfolio every day.

However, as I write from a trough in the rate cycle, and also a nadir in the history of spreads, something is going to give. I would suggest that spreads will remain very tight, given the restriction on supplies for the near future. What this means from a relative value proposition is that bullet agencies are inexpensive, and should be carefully considered when buying this sector. If, and when, widening occurs, bullets can be very good swap candidates for layering in additional callable debt.

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