Pub. 1 2020 Issue 2

www.cbak.com 6 In Touch NOT ALL BONDS ARE CREATED EQUAL Fierce rally highlights different risk/reward profiles BY JIM REBER A ttention bond portfolio managers: Raise your hand if you were expecting a 50 basis-point bond rally accompanied by a corollary rate cut by the Fed in about a two-week period. Just as I suspected—none of you. You can, for the record, count your correspondent among the crowd. But, since it’s happened, let’s use this as a learning opportunity. There aren’t many cases in which the financial landscape of the global economy has changed so rapidly, and it has thrown us into a harsh belief of how the market values of a community bank’s bonds will change in a decidedly asymmetric pattern when interest rate shocks are applied. Spreads have widened, natch Unless your community bank’s investments consist solely of U.S. Treasury obligations, your price appreciation during the rally was muted compared to a truly riskless portfolio. In shorthand, spreads have widened. This is fully to be expected as rates fall, but you may have forgotten why this occurs. Understandably, the average portfolio manager will chalk it up to increased call (or prepayment) risk, and that’s true enough. Clearly, if a mortgage-backed security (MBS) that is backed with loans bearing an above-market rate is priced at a significant premium of 103 or more, it doesn’t take too much of an increase in prepayments for yields to get hammered. And at the moment, 15-year mortgage rates are hovering right around 3%, so any 15- year MBS pool with loan rates of higher than 3.5% are getting in the refi range. But there is another more fundamental reason for spreads to widen as rates fall that has little to do with call risk, and therefore is more subjective. It has to do with the presumed increase in credit risk, even for high-quality debt securities. This is most easily demonstrated by reviewing spreads on investment-grade corporates, which have no call risk. For the week that ended on Feb. 28, A-rated, five-year corporate notes saw their spreads over the benchmark Treasury balloon by fully 19 basis points. This can be attributed to growing concerns about the global economy and borrowers’ ability to meet their debt obligations. Virtually any security not backed by a government or its agencies can be swept up in the hysteria—or at least the zeitgeist. Cases in point To put a finer point on how community banks’ securities values move generally, but not lock-step, with market rates, let’s examine two securities that are staples of community bank bond portfolios. The first is a five-year agency bond that is callable within six months, and the second is a typical 15-year MBS. Our example agency is a Freddie Mac 1.75% with a maturity date of Feb. 12, 2025. It can be called in six months and every six months thereafter. Between Feb. 4 (pricing date) and Feb. 28, the agency bond appreciated in value by about 0.25%; the benchmark Treasury improved by 2.25%. The only structural difference in the two is the call feature, which has effectively rendered the agency now to be a six-month instrument. Community Bankers Association of Kansas Endorsed Provider