Not all bonds are created equal: Fierce rally highlights different risk/reward profiles

Attention bond portfolio managers: Raise your hand if you were expecting a 100+ basis-point bond rally accompanied by a corollary rate cut by the Fed in about a two-week period. Just as I suspected—none of you. You can, for the record, count your correspondent among the crowd.
 
But, since it’s happened, let’s use this as a learning opportunity. There aren’t many cases in which the financial landscape of the global economy has changed so rapidly, and it has thrown into harsh relief how the market values of a community bank’s bonds will change in a decidedly asymmetric pattern when interest rate shocks are applied.
 
Spreads have widened, natch
Unless your community bank’s investments consist solely of U.S. Treasury obligations, your price appreciation during the rally was muted compared to a truly riskless portfolio. In shorthand, spreads have widened. This is fully to be expected as rates fall, but you may have forgotten why this occurs.
 
Understandably, the average portfolio manager will chalk it up to increased call (or prepayment) risk, and that’s true enough. Clearly, if a mortgage-backed security (MBS) that is backed with loans bearing an above-market rate is priced at a significant premium of 103 or more, it doesn’t take too much of an increase in prepayments for yields to get hammered. And at the moment, 15-year mortgage rates are hovering right around 3%, so any 15-year MBS pool with loan rates of higher than 3.5% are getting in the refi range.
 
But there is another more fundamental reason for spreads to widen as rates fall that has little to do with call risk, and therefore is more subjective. It has to do with the presumed increase in credit risk, even for high-quality debt securities.
 
This is most easily demonstrated by reviewing spreads on investment-grade corporates, which have no call risk. In the two weeks that ended on Mar. 6, A-rated, five-year corporate notes saw their spreads over the benchmark Treasury balloon by fully 30 basis points. This can be attributed to growing concerns about the global economy and borrowers’ ability to meet their debt obligations. Virtually any security not backed by a government or its agencies can be swept up in the hysteria—or at least the zeitgeist.
 
Cases in point
To put a finer point on how community banks’ securities values move generally, but not lock-step, with market rates, let’s examine two securities that are staples of community bank bond portfolios. The first is a five-year agency bond that is callable within six months, and the second is a typical 15-year MBS.
 
Our example agency is a Freddie Mac 1.75% with a maturity date of Feb. 12, 2025. It can be called in six months and every six months thereafter. Between Feb. 4 (pricing date) and Mar. 6, the agency bond appreciated in value by about 0.40%; the benchmark Treasury improved by 3.75%. The only structural difference in the two is the call feature, which has effectively rendered the agency now to be a six-month instrument.
 
The sample MBS is a 15-year Fannie Mae that is seasoned about two years and has a 3% stated rate. It has an average life of about four years, so it is also benchmarked to the five-year Treasury. At the beginning of February, it was worth around 102.50; by Mar. 6, its value had risen, but only to about 103.80. In other words, it appreciated about 40% as much as the benchmark.
 
Win some, lose some
What to take away from all of this? Well, this once again illustrates how bond portfolio management is give-and-take proposition. The bonds your bank currently owns haven’t run up in price as much as you may have liked, but anything you would contemplate buying hasn’t either. On balance, that is a net win for the investor, who typically has a hold-to-maturity mindset and isn’t looking to harvest short-term gains.
 
But maybe the more beneficial lesson to be learned from the sudden and sharp bond market rally of early 2020 is that call protection is your friend. In a rate environment in which all yields are compressed, such insurance can come at affordable rates. The recommendation is to take another, fresh look at your banks’ holdings and assess your exposure to another couple of rate cuts.
 
If you’re a buyer, make note of the handsome spreads available. And if you’re standing pat, do so feeling secure in the likelihood that spread narrowing is likely to take place in a bond market sell-off. Interest rate volatility in the year 2020 could well give community banks a case study in how the securities in their portfolios are the same, only different.