Jim Reber: Tighten up

Back in 1968, rhythm and blues artists Archie Bell & the Drells rode to the top of the charts with their smash hit “Tighten Up.” They probably weren’t making any keen observations about the government agency debt market at that point. But since I don’t know Mr. Bell or his Drells, and I didn’t know there was a bond market in 1968, that’s mere speculation. Nevertheless, they may have hit on something currently affecting your bond portfolio.

Agency bullet spreads, which represent the difference in yield between a risk-free asset (i.e., a Treasury obligation) and a bond issued by Fannie Mae, Freddie Mac or the Federal Home Loan Banks (FHLB), are at historic lows right now. They’ve shrunk in the past several years to the point that there is precious little incremental yield at all. What’s a portfolio manager to do?

One year ago

If you had asked your broker to show you a five-year agency bullet—a bond with no call options embedded—in June 2020, you would have been offered one with a stated interest rate, or “coupon,” of about 0.53%. That yield would, in fact, have been made up of two components. The first would be the yield on the benchmark five-year Treasury note, which at the time was about 0.33%, plus the spread that you’re entitled to for the additional risk you assumed, which was about 20 basis points (0.20%).

Today, that same five-year bullet yields about 0.83%. While the nominal yield has improved, the spread has tightened dramatically, and an investor is only getting one basis point (0.01%) of spread. Even 10-year bullets produce only about five basis points of additional yield. What’s causing this trend?

Supplies compromised

One primary reason is that the agencies simply aren’t issuing as much debt as they have in the past. Both Fannie Mae and Freddie Mac have been shrinking their balance sheets to boost their capital ratios and lessen taxpayer exposure. Their combined outstanding debt has declined by $1.2 trillion, or 67%, since 2008.

The FHLB systemwide balance sheet had grown in recent years but dramatically declined in 2020, as members simply didn’t need to take down advances to fund their operations. In just the 2020 calendar year, FHLB borrowings dropped $279 billion, or 27%.

So, while government-sponsored enterprise (GSE) reform looks to be a later-than-sooner proposition— temporarily leaving Fannie and Freddie intact with their nearly explicit government backing—and the FHLB debt collectively is only about 60% of its size in 2008, demand has overwhelmed supply, pushing down yield spreads. They have gotten so low that some community bank investors have begun employing other alternatives.

Inside scoop

Many institutional investors have actually swapped out of agencies and into treasuries. In fact, Vining Sparks, ICBA Securities’ endorsed broker-dealer, estimates that 25% of the government debt purchased by community banks in 2021 has been treasuries, which is an enormous sector change.

Some of these buyers may be anticipating—or hoping—that spreads widen out in the future and that the ultra-liquid treasury securities can be swapped back into other “spread” products.

Another strategy is to buy bonds that have maturities or call features that are slightly longer than benchmarks. For example, instead of buying true five-year maturity, some investors will stretch out to five and a half years and pick up maybe eight more basis points. Certain institutional buyers are mandated to stay specifically within five-year windows, which is why fractional-year maturities have somewhat higher yields.

Still another strategy is to buy a bond with one-only call date at a price below par at a yield to maturity higher than a bullet. The general rise in yields for maturities beyond three years so far in 2021 actually makes this possible.

If the bond misses its one call date, which is the expectation the day of purchase, spreads will narrow to that of a bullet, and your bond’s total return will be enhanced.

Sector flipping

There are also some agency bullet surrogates available in other investment sectors. Some multifamily mortgage-backed securities (MBS) have short maturities and tight payment windows so that cash flows will mimic a bullet’s cash flow. High-quality corporates will always offer higher yields than comparable agency paper, and it’s up to the buyer to perform the suitable due diligence. It’s fair to say that yield spreads on all these options are far less than long-term averages, so as you do your shopping, keep that in mind.

The best news is that for the bonds currently in your community bank’s investment portfolio, their market prices have already benefited from the “tighten up” of yield spreads.

Regardless, that incremental yield over treasuries will be hard to come by for the time being. The best news is that for the bonds currently in your community bank’s investment portfolio, their market prices have already benefited from the “tighten up” of yield spreads. Archie Bell & the Drells should be so proud.