The good ol’ days?
Remember the good ol’ days? I’m not talking about the 1950’s (I wasn’t around back then but given how long the show Happy Days was on the air I assume they were some good years)…I’m talking about mid-2008 when a gallon of gas and the 10-year Treasury were both at 3.92.
That was a time when the biggest complaint I heard was “OMG I’m paying soooo much for gas.” Times were simpler then. Fed Funds was at 2.00% and the FOMC was worried about inflation. Bernanke and Co. hadn’t started manipulating the Treasury, Agency, and MBS markets yet. Bonds were being called but we could reinvest in MBS at spreads anywhere from +180 to +250 over Treasuries (at a time when Treasury yields still reflected investor sentiment).
Fast forward 2 years. It’s late 2010 and we are nowhere near the end of the troubled road we travel. The Fed has cut the overnight rate to zero. Treasury yields along with Agency and MBS spreads have all been forced artificially low by the Feds actions, and many at the Fed are pushing for an even larger balance sheet expansion to support the recovery and depress yield levels even further.
The yardstick we’ve been given by New York Fed President Dudley is that the Fed can achieve an “equivalent” Fed Funds Rate reduction of 50 to 75 basis points by purchasing $500 Billion worth of Treasury bonds. Remember when $100 Billion was a big number? That’s a Rodney Dangerfield number now-a-days…it gets no respect. The first big number we saw was when Bernanke and Paulson got together in late 2008 and came up with a plan to spend $200 Billion to support the GSE’s…it was a staggering sum at the time…now that seems to be the minimum increment for “fixing” things.
Where are we now?
We are eight days away from the next FOMC meeting. We are also seven days away from mid-term elections. Both of these events are casting a long shadow over the markets right now.
It is widely expected that the Fed will announce a new round of Quantitative Easing at its next meeting. I personally think it’s a terrible idea that will prove to be long on costs and short on benefits but to date nobody from the Fed has called for my opinion…so you have to hear it instead. We’ll know in a few days which direction they’ll decide to go.
It is also widely expected that there will be a big shift in the political balance of power. Almost everyone I speak with is praying for gridlock on Capitol Hill. Everyone knows that neither party has the magical answer to the problems we face. It looks like the business community is just hoping for an environment where neither party has enough power to do anything stupid or more expensive than what has been done to date.
What is everyone doing?
I get this question a lot. With rates at their current levels everyone is looking for ideas. The trading activity lately can be broken down into a few groups.
The first group is taking gains. As we head into the 4th quarter a lot of banks have some holes to plug and they are using gains in the portfolio to bridge the gap. Whether you are trying to offset loan losses or just bump earnings for the year there are a number of swaps that will work. The most common swap is selling higher coupon MBS with large gains and reinvesting in longer final muni’s or Agencies.
The next group of is looking for yield. This group has been buying 10 and 15 year step ups with 2.50% to 3.00% front-end coupons and have big enough steps that if the bond does go to maturity then they can live with the yield.
The floating rate group is concerned about rising rates and has been buying 5 to 7 year corporate fixed-to-float type structures and Agency Hybrid ARMs.
The Full Faith and Credit Group. This is the group that wants zero risk-weighted securities and the vehicles of choice in this arena are SBA fixed and floating rate securities, GNMA MBS (both fixed and hybrid ARM structures), and USDA guaranteed loans. There are other full faith and credit options such as Treasury bonds and FDIC insured corporate paper but the yields on those products are low enough that they don’t have a big following among bank investors.
Why would anyone extend in this environment?
You might be asking “why would anyone extend in this environment?” It’s a valid question. In a world where we only buy one or two bonds I can see how one might question the wisdom of purchasing a long final maturity in this environment. The reality though is that we buy and own portfolios of bonds…not just one or two. It’s how this portfolio of bonds acts in concert with each other that dictates how well it performs over time.
A very short portfolio will do very well if rates rise quickly and it will do poorly if rates remain steady or drop.
A very long portfolio will do very well if rates drop or if they remain constant, and it will do poorly if rates rise.
A balanced portfolio will perform relatively well in all rate scenarios. If rates remain steady or drop, the longer bonds in the portfolio will deliver the yield (and gains) you need for earnings. If rates rise, your longer bonds will be at lower rates and have losses but the short end of your portfolio will all be able to re-price upward and take advantage of current rates. The balanced portfolio tends to outperform other portfolios over time.
What we’ve seen over the last two years is a large migration to very short portfolios. As rates dropped and bonds were called many portfolios shifted toward shorter durations. It was an easy thing to do for a while. Everything the government was doing seemed inflationary, and reinvestment options on the short end were still acceptable. Now however, we’re not seeing any inflation and rates are exceptionally low…this is a much more complicated environment.
Portfolios with durations of 1.5 years or less are essentially laying on a very defensive bet that rates will rise in the very near future. While it’s possible that they could rise, there are many indications that rates will remain low for quite a bit longer.
The first and perhaps strongest indication is that the Fed itself is still maintaining its pledge to keep rates “exceptionally low for an extended period of time”. Furthermore they are aggressively talking up the idea of forcing rates even lower than their current levels via another round of Quantitative Easing (Treasury purchases).
Extremely short or long durations are basically big bets on the direction of rates. Big bets on interest rates are generally not something that community banks do. Historically the high performing institutions maintain a balanced portfolio across interest rate environments.
A more balanced approach is what we tend to gravitate toward. Given the extraordinary duration compression in most portfolios over the last two years you can view the purchase of longer final bonds not as extension…but as more of a rebalancing of portfolio duration. If you historically run a portfolio duration of 3 to 5 years, but you are currently at 1.5 then you may have some room to pick up yield by returning your portfolio duration to your target range without taking undue risk.
That’s all great Steve…but you’re not the one in the hot seat
Having said all of that I also understand that I don’t have to answer to, or explain anything to shareholders, a board of directors, or regulators. These people may not understand (or care) about portfolio management. When rates rise many of these people will look at only one thing…the “unrealized loss” column on a bond-by-bond basis…and they will ask “what were you thinking buying this bond right here?” They won’t care how much better off they were during those low rate years because of your efforts to maintain a properly balanced fixed income portfolio that generated a higher risk adjusted return than your peers. All they will care about is the one number they can understand…the unrealized loss column.
I know that there are times when no amount of reason, logic, or well articulated explanation will be satisfactory for some of these folks. I understand that there are times when you can win the battle but lose the war. So ultimately I understand than many people would like to maintain a balanced portfolio, but the pain of having to explain things at a later date outweighs the benefits associated with taking such actions today.
In closing
If you have any questions on strategies that work in this environment, whether it’s a swap to take gains or a rebalancing of portfolio duration, just let me know. If you shoot me a copy of your current portfolio I can run analytics and bring ideas that might work for you.
Steve Scaramastro, SVP
800-311-0707
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