The Treasury market continues to move lower today. The 10-year Treasury is up over a point to trade at a 2.12% currently and the Dow Jones has given back all of yesterday’s gain…it is off 434 points right now.
Where to start?
One of the first things to be aware of as we settle in to our new operating environment is that there will be a large spike in the volume of called bonds. In a phone call with FHLB this morning our traders were told that recent called bond volumes over the past few months were around $60 billion but that number is expected to jump up to $90 billion very shortly.
Given the drop in rates and the increase in the number of bonds that are now “in the money” to be called I wanted to highlight a report that we have available to you. We have a Predicted Call Report that we run to show customers the dates on which bonds they hold are likely to be called based on the current yield curve. This has historically been a very accurate and very helpful report for those who manage fixed income portfolios. This is a very good way to get a handle on the amount and timing of cash flows that will be coming out of your portfolio in the form of called bonds. If you would like to receive this report just shoot me your most recent bond accounting data and I’ll run the analytics for you.
Now is a great time to review the structure of your investment portfolio and make sure it’s aligned with your Asset/Liability needs, expectations for interest rates, and cash flow requirements.
The commitment
Yesterday afternoon was a whirlwind. It’s difficult to describe the energy level that existed in the aftermath of the FOMC statement. Now that things are slowing down a bit we can start to really look at what this means. One of the first things to consider is that the Fed just pledged to keep the overnight rate low for at least the next two years. Can they do it?
Keep in mind that the reason the Fed made this pledge is because the economy is transitioning more toward another recession than toward expansion. Given the macro-economic background the Fed not only looks to have the ability to keep rates low for a long time, but it looks like they will have a lot of company on the Treasury curve that will help keep rates low along the length of the curve. Now if you throw the European problems into the mix you have even more pressure on Treasury prices which will force yields lower still. Certainly the Fed can’t keep rates low by themselves…but the global economic picture looks like it will be their partner in keeping rates low for quite a while.
What if they need to tighten?
Can they just go back on their pledge to hold rates low through at least mid-2013? If the macro-economic picture suddenly gets rosy and the Fed feels the need to remove some of the accommodative policy they can certainly do so…and they can do it while staying true to their mid-2013 pledge.
The astute reader might recall that in a Market Update piece a few weeks ago I asked you to print out a list and tape it to your wall...in case you didn’t tape to the wall I’ve included it again below. This is the framework the Fed had outlined for tightening monetary policy when the appropriate time comes. You’ll notice that the step labeled “Raise the Fed Funds Target Rate” is pretty far down the list.
1 – They will stop reinvesting their portfolio cash flows
2 – At the same time (or shortly after) they will change the guidance in the FOMC statement
3 – Initiate temporary reserve draining operations
4 – Raise the Fed Funds target rate
5 – Sometime after they’ve begun raising rates they will begin outright sales from the portfolio
Now there weren’t many people who expected to hear the Fed put a hard timeline of “at least two years” on the prospect of rates going up…but in the event that the economy gets heated up prior to mid-2013 you can see that they have three actions they can take to take that will tighten policy without raising the overnight rate. I don’t want you to hold your breath waiting for this to happen…I just wanted to point out that nothing is written in stone. They Fed acknowledged yesterday that the recovery is in real trouble, and they are likely to be accommodative for a long time. Unless the rest of the world disagrees with this perspective, and/or European sovereign issues suddenly get better, one would expect longer rates to remain low as well.
Thoughts on investments
Below are a few talking points on the investment side…in no particular order.
Callables
You will be getting a lot of cash back from your callable bonds. Your callable bond portfolio just became a lot shorter than you thought it was going to be. Many investors have spent the last three months trying to sell longer bonds they bought last October because they didn’t like the losses they had. In a week’s time they have gone from looking at taking losses on those bonds to wanting to keep them and worrying that their big yields will go away. The point here is that your callable portfolio just became a whole lot shorter than it was last week.
There are a lot of longer maturity bonds out there that will effectively be 1 to 6 month pieces of paper. If you know you have cash coming back on certain dates (ie you sent us your portfolio and we provided you with a very helpful Predicted Call Report) it might make a great deal of sense to buy replacement securities today rather than wait for the actual cash flow date to arrive and be forced to reinvest after the rest of the world has already pushed yields lower.
MBS
Traders are expecting a lot of prepay activity going forward in our new rate environment. If you paid high premiums for MBS paper with 15 year or longer finals you might want to consider your exposure to prepays. Bids are strong on MBS paper right now and there will be cases where it makes sense to unload and reposition into lower coupon paper. Yes…reinvestment rates will be lower…but you also need to consider what is going to happen to the yield on your current MBS if they get hit with a prepay spike. I’ve seen a lot of bonds in the last year or two who have negative yields once the prepay speeds hit 40 to 50 CPR. While reinvestment yields may be low…they aren’t negative…its’ something to consider.
WE HAVE A REPORT that will quickly show you which of your MBS are exposed to a prepay spike. If you shoot me a copy of your bond accounting reports I can run this MBS report and help you identify the bonds that might make sense to sell.
SBA’s
The busiest desk this morning has been our SBA floating rate desk. I’ve not yet received a lot of color yet but Full Faith and Credit floating rate product is in high demand.
What to buy?
As always we need to consider our Asset/Liability, cash flow, yield, and policy constraints when making decisions. Once those are met it will provide more direction…but in the absence of such direction we can make some general observations.
MBS premiums will remain exceptionally high. Moving into lower coupons such as 15 year 2.50% paper begins to make sense.
Fixed to Float structures should come back to the market as investors will begin to adjust to the 2-year time frame the Fed has outlined. These can come in the form of Agency ARMs or straight corporate fixed to float paper. Generally these structures can get you a fixed rate for 2 to 5 years that then begins to float over an index such as Libor, Fed Funds, or Prime. Structures will vary but these will remain popular.
Agency bonds are a mainstay of bank investment portfolios and will remain so. I would expect the main shift in this arena to be toward step-ups and longer final maturities as we settle in for a long wait at these levels.
Final thought
I think the new unit of measurement for the Dow Jones is 400 points. Up or down 400 is no longer news worthy.
If you have any questions or if there is anything I can do for you just let me know.
Steve Scaramastro, SVP
800-311-0707
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