Before we get too deep into this investment column, I’d like to be on record that I’m not predicting anything about interest rates. Not that they’re going higher, not that they’ll be range-bound, not that this so-called curve flattening is about to happen.
Nonetheless, it is probably a good time to talk about the consequences that accompany these what-ifs. The Fed continues to make noises about removing the “accommodation” when the totality of economic data justifies it. The data, at least domestically, continues to report at least decent performance.
There are numbers that prove the yield curve for government and federal agency bonds flattens as rates begin to rise. The yield curve, as we recall, is the graphic display of the yields for various maturities of a given borrower, ranging from very short (e.g., overnight) to very long (10 years or more). When the difference in “short” and “long” shrinks, we say the curve “flattens.” As it’s been more than a decade since the Federal Reserve last began a rate hike cycle (in June 2004), we may have forgotten why this occurs. The answer is really two-pronged.
First, short-term high-quality investments have always had yields that are tied to overnight rates. The global benchmark overnight rate is Fed Funds, which is what banks domestically charge each other for short-term loans. The Federal Open Market Committee, a subset of the Federal Reserve Board, sets the rate. (As an aside, Prime rate in the U.S. is almost always exactly three percent (3.00 percent) higher than Fed Funds.) The normal difference, or “spread,” between the yield of Fed Funds and the two-year Treasury note is about 25 basis points, or 0.25 percent.
Secondly, longer-term investors, which include community banks but are primarily non-depositories, don’t really care what the Fed is doing to manipulate short rates. Since the value of longer investments can swing wildly with changing rates, those investors are fixated on expected inflation. Ironically, the more aggressively the Fed tries to stamp out inflation by raising rates, the more likely it is that the long-timers will get their desired real (net of inflation) returns. Over the last 20 years, investors in 10-year Treasury notes have demanded a yield of about 2.50 percent over inflation.
To complete the thought, the higher short rates go, the more insulated (against inflation) bonds are, so longer-term buyers don’t demand higher yields. The result is a flatter yield curve.
Back to the current environment. Many community bank portfolio managers have instinctively held back some liquidity, in anticipation of better returns soon. Most of them have been disappointed that rates have been pretty much unchanged over the last 18 months. Some of these same investors are now wondering if yields are going to only trickle higher, leaving earnings essentially unchanged.
Perhaps a middle ground to ponder is an investment with all these features:
- Acceptable current yield
- Monthly cash flow
- Moderate premium
- Low risk weighting and good liquidity
- Ability to rachet higher in yield in near future
Such an investment exists in a hybrid adjustable-rate mortgage (ARM). These instruments have a fixed rate for a period, and eventually will begin floating annually. The ARMs with the fixed periods which seem to offer reasonable value are those that begin floating in 48 to 72 months. An example is FNMA 849359.
This bond will have a stated rate of interest (“coupon”) of 2.00 percent until June 2020, when it will begin to float annually. From then on, it will adjust to the 1-year LIBOR rate plus 1.67 percent, which today would be 2.38 percent. In other words, this ARM is not fully indexed at this point. Other benefits are that it has a tolerable premium price (about 102.00), generous annual caps (2.00 percent), and an attractive loan count of more than 200 loans.
The real tale of the tape is its yield until the reset date of about 1.50 percent, with an effective duration of only 2.4 years. Most bond analysts would conclude that this has a very attractive risk/reward profile. And, it has a reasonable chance to perform well when (or if?) the yield curve flattens. As always, be sure to have your broker demonstrate the pro-forma prices in a variety of future interest rate scenarios.
Curve flattening? I don’t know any better than you. But I know that some well-structured hybrid ARMs won’t be your biggest problem if that happens.