Investment Guide for a Flat Yield Curve
Treasuries yields started 2018 moving higher across the yield curve. Continued U.S. GDP growth, an optimistic Fed, and very early signs of increasing inflation have all contributed to the run up. Longer-dated Treasuries took a breather during the summer months mostly moving sideways. However, Labor Day kicked off a mini surge in yields with 10 Yr Treasury breaking through 3.20% level by early October. The Federal Reserve is projecting another rate increase in the Fed Funds rate for 2018, taking the rate to 2.25-2.50% range by year-end. With the expectation of short-term interest rates continuing to rise in the near-term and a flatter yield curve, we discuss investment strategy considerations for depository institutions.
Yield Curve Shape
The good news for depositories with investable liquidity is we are in a meaningfully higher yield environment. The 5 Yr Treasury, which is a good proxy for shorter to intermediate investments, is up 104 bps form a year ago and up 206 bps from the 2016 Brexit lows. However, the spread between the 2 Yr and the 10 Yr Treasury, which is often used to describe the slope of the yield curve, is around 30 bps today compared to the average of 145 bps over the last fifteen years as the Fed is in the 7th inning stretch of the tightening cycle. The changing shape of the yield curve is posing an interesting investment dilemma. Is staying short the right strategy given the flatness of the curve? The answer is not that simple, and several key factors need to be considered.
Portfolio’s Role on the Balance Sheet
Depository portfolio management process differs from a mutual fund in a very key aspect: it is not a stand-alone group of assets. Instead, it is an integral part of the balance sheet impacting various overall risk positions such as liquidity, interest rate risk, and capital. Therefore, investment decisions for depository institutions should consider balance sheet needs and implications.
For example, many bank and credit union balance sheets are asset sensitive, meaning when interest rates decline, net interest margins come under pressure from falling asset yields. Many loans have embedded optionality allowing borrowers to refinance at low to no cost. With cost of funds for the industry still largely under 1%, there is not a lot of room to lower funding costs to offset asset yield declines should rates head lower as a result of an economic slowdown and/or a recession. Likely higher credit costs during a falling rate environment would surely add further stress to profitability and capital.
So if your institution falls into the asset-sensitive camp, you should not stay short but instead should be thinking call-protected intermediate duration investments such as Agency CMBS and Municipals. Agency CMBS offer call protection benefits via prepayment penalties of underlying loans. Additionally, certain CMBS deals can provide direct CRA benefit for those needing to improve or maintain their CRA rating. Tax-exempt municipals provide the best relative value on the intermediate to longer parts of the curve, which we will describe further in the article. More basic and likely lower-return options include Treasuries, Agency bullets, and deep discount MBS.
As the old cliché goes – Buyer Beware. There are many types of CMBS and municipal bonds each with different nuances pertaining to structure, underlying collateral, cash flow, credit and pricing. Investors should not only understand all the aspects of these securities but also be able to assess relative value based on pricing. Even a “good” bond can become a “bad” investment at the wrong price.
Product Spread Curve
Executive responsible for the investment portfolio (portfolio managers) should also consider the different product spread curves when evaluating investment options in a flatter Treasury curve environment. Despite lack of slope in Treasuries, there is usually spread pick up for going out on the curve in the various investment types, i.e., CMOs, CMBS, Municipals, etc. Think of each investment type having its own yield curve. For example, a 2 year CMO might be priced at +25 bps to Tsy, and a 4 year CMO is at +60 bps. The Treasury curve slope between the 2 and the 4 year part of the curve is just 13 bps, but the product spread curve pick up is 35 basis points, which increased the total pick up in yield of 48 bps.
This phenomenon is most noticeable in tax-free municipals, especially the general market sector. The 5-15 year slope is 19 bps in Tsy as compared to 71 bps in AAA tax-free municipal benchmark, or 90 bps of tax-equivalent slope assuming 21% Federal tax rate. Absolute levels of high-grade municipals with intermediate duration are currently around 4.50-5.00% TEY assuming 21%, and even higher for S-Corps with an assumed tax rate of 29.6%.
Strategies to Avoid
Another challenge investors are facing today are relatively tighter spreads on MBS/CMO/CMBS securities. One word of caution is to avoid stretching for a few extra basis points of spread while compromising cash flow structure/volatility and collateral quality. For example, investors should be careful with certain mortgage products, including CMOs off Jumbo collateral, which may show a stable cash flow profile utilizing Bloomberg Median static prepayment speeds. However, when analyzed further using vector analysis and other tools, these structures can often exhibit greater extension and prepayment risks and price volatility.
Careful attention should also be paid to the collateral composition. Investors should avoid higher percentages of highly efficient originators, such as Quicken, as borrowers can refinance with a push of a button. This increases optionality and cash flow volatility, which negatively impacts returns. Instead, portfolio managers should look for favorable collateral characteristics, such as lower loan balance and certain geographic stips, which are relatively cheap today but can help reduce optionality and improve returns.
Probably the worst optionality trade today is callable agency bonds priced around par. Agencies are very efficient at exercising call options when market yield move lower. This means the investor loses the higher coupon and is forced to reinvest at a lower rate. However, if rates rise, bonds drop in market value with no cash flow until maturity. Not surprisingly, portfolios with a higher allocation of callable agency bonds tend to underperform over time.
We have also seen an increase in credit risk strategies as a way to increase investment returns in a flatter yield curve environment. These include corporate bonds, private label MBS and ABS, subordinated debt of bank holding companies, Collateralized Loan Obligations, just to name a few. We recommend exercising extreme caution when evaluating these types of trades to make sure they have a fit in the overall balance sheet and credit performance has been evaluated given a variety of economic environment, i.e., stress-testing.
Flat yield curves can be confusing for portfolio managers. Remembering to position the portfolio within the overall context of the balance sheet will help improve balance sheet performance over time. There are many different investment options available with relatively higher market yields today. Decisions made over the next 6-18 months will impact balance sheet performance for many years. Having strong in-house and/or outsourced investment and balance sheet management expertise will help avoid bad strategies and take advantage of opportunities to positively impact your institutions investment portfolio performance. For a comparison of how your institution’s portfolio is performing vs. peer, please Click Here to download our Peer Comparison Tool for Banks.