Treasuries kicked off 2018 trading lower with yields rising across the yield curve. Expanding U.S. and global economies, optimistic Fed, and very early signs of increasing inflation have all contributed to the run up. The Federal Reserve is projecting three increases in the Fed Funds rate for 2018 taking the rate to 2.00-2.25% range by year-end. With the expectation of interest rates continuing to rise in the near-term and a meaningfully flatter yield curve, monitoring and managing investment holdings will continue to be a focus. Finding the right mix of sectors in the fixed income market and locating relative value within those sectors will play a large role in the performance of your portfolio.
Bond Market – 2017 in Review
At the end of 2017, the FOMC moved the overnight rate for the fifth time in 24 months, to the 1.25-1.50% range. 2017 began with lofty growth and inflation expectations following the presidential election. Despite legislative setbacks and geopolitical risks, the FOMC was finally able to deliver on its promise of raising interest rates in line with their forecast of three 25 basis point hikes.
Shorter-term Treasury yields fluctuated with the 2 Year Treasury increasing from 1.19% to 1.26% mainly driven by monetary policy. Longer-term bond yields spent three-quarters of 2017 trending lower, reaching their lows of the year in September as the market focused on re-emerging North Korea threats and low inflation. However, starting in mid-September, yields started to move noticeably higher with the 10 Year finishing 2017 at 2.41% and the 2 Year at 1.88%.
The big story of 2017 was significant flattening of the yield curve. The spread between the 2 Year and 10 Year Treasury contracted from 123 bps to 52 bps. Last time yield curve slope was at this level during a tightening cycle was May of 2005, about a year prior to the last Fed hike and nine months preceding an inverted yield curve.
Investing in 2018
As we discuss above, the FOMC is projecting three rate hikes, or 75 basis points, in 2018. The forward curve one year from now shows short term interest rates increasing approximately 85 basis, which means that investors are getting compensated for investing along the short to intermediate part of yield curve. Albeit, the spread between the two indicators is narrowing closer to break-even.
Another challenge investors are facing today is tighter spreads on MBS/CMO/CMBS securities. One word of caution is to avoid stretching for a few extra basis point of spread while compromising cash flow structure and collateral quality. For example, investors should be careful with certain PAC CMOs off Jumbo collateral that may show 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.
A good approach would be to diversify mortgage holdings by focusing on two general sectors. One being shorter cash flow investments with limited optionality, such as seasoned MBS and front-end CMO structures. Having cash flow in a rising rate environment should help as it can be reinvested at higher rates or used elsewhere on the balance sheet, i.e., to fund loans.
The other mortgage sector for the intermediate duration part of the curve includes call-protected investments such as Agency CMBS. Many financial instructions have little call protection in their loan portfolios, as it can be difficult to institute prepayment penalties. Investment managers should avoid compounding this issue by overweighting investment portfolios in agency callables and weaker structure CMOs.
Combining front-end mortgage securities with intermediate locked-out profiles would provide investors regular cash flow while maintaining some duration and call protection.
Also, there are a number of relatively newer products available in the market, many with Agency credit quality that provide good relative value, or incremental return for a given level of risk, e.g., Agency CMBS and Tax-Exempt Mortgage Securities (TEMS and M-TEMS). If spreads continue to remain tight in 2018, having in-house or outsourced investment expertise with knowledge and experience in all available investment options will make a big impact on portfolio performance.
Tax-exempt municipals have been a very good asset class for bond portfolios over various rate cycles due to wider spreads, very low loss rates, call protection, and favorable price performance vs. taxable securities. Not surprisingly, higher-performing portfolios generally have a higher municipal weighting. Going into 2018 with lower tax rates, tax-equivalent yields, assuming all else equal, will be lower. However, even factoring in new tax rates, municipal bond spreads (especially general market) on the intermediate and longer parts of the curve still well-exceed those of taxable alternatives such as Treasuries, Agencies, and MBS/CMO. Institutions with room for municipal securities on their balance sheets should continue to be in the market and opportunistically add to their holdings. We anticipate S-Corp banks becoming more active in the municipal market given estimated Federal Tax rate of around 30% depending on shareholder base.
The continuation of a rising rate environment will present a new set of challenges to portfolio managers. Varying expectations for the pace of rate increases and volatility in interest rates are just a few of the issues portfolio managers are likely to face. Fortunately, financial institutions have more control over the investment portfolio than any other component of the balance sheet. With proper planning, these risks can be managed while maintaining or even improving portfolio returns within the context of the overall balance sheet.