With the evolution in technology over the last 20 years, bank investment portfolios have subsequently experienced their own transformation. Structures that were virtually non-existent at the end of the 1980s, have now become commonplace in the vast world of bank bond portfolios. Given the progression that technology — specifically, computers — has made, the only limitation to the complexity of bond structures seems to be the human mind. A banker does not need to reminisce long to remember the AAA-rated, private label CDOs, CMOs and other MBS products that were ultimately deemed far less than investment grade. This return to reality concerning some formerly investment grade products evidences the many potential pitfalls and traps for community banks and other investors who frequent the fixed-income markets. That being said, with interest rates hovering near all-time lows, are we truly over-thinking community bank investment products right now?
With the wide variety in security structures currently available, the simple concept of riding the yield curve is often mentioned, yet rarely practiced. Looking at the Treasury curve today, a person is easily demoralized with the paltry returns. On first glance, nominal yields across the spectrum are discouraging at best. The thought of a seven-year non-callable bullet agency bond priced to yield 1.50 percent may seem unattractive, yet with fed funds stapled to the floor at 0 to 0.25 percent it remains prudent to stay invested to assist net interest margins. Although that seven-year bullet at 1.50 percent seems difficult to digest, I would argue that there has been no better investment during the past several years.
In May 2011, a Fannie Mae 5-3/8 percent coupon agency bullet was priced at $115.89 to yield 2.54 percent. Of course, hindsight is 20/20 and we all should have loaded the boat at these historically (at the time) low rates. Taking this into consideration, if banks had made a forecast for low rates between 2011 and 2013, they could have realized a profit of $133,769 and a total return of 5.196 percent per $1 million of par value invested. Not too shabby for a boring old bullet agency bond.
As with any investment decision made in community banking today, consider interest rate bias. If you believe that rates will pursue their low trek for the next two years, then there is no better investment decision than riding the steepest area of yield curve with basic agency bullets just as we should have done in 2011.
The graph at the right illustrates the most advantageous area of the agency bullet curve to be between six and seven years of maturity.
Click here for a larger version of the graph.
This is the area of the yield curve where, as an investor, you are receiving the best bang for your buck or the greatest return for a dollar. Investing at the steepest point in the yield curve will provide the maximum total return.
This principal of the seven-year agency bullet can be applied again in today’s market at the current level of 1.50 percent. Although extending seven years to receive 1.50 percent seems like a high risk/low reward tradeoff, think outside the box to help tack added earnings onto the bottom line. Assuming a bias of low interest rates for the next couple of years, you buy that seven-year bullet on a bit of market weakness to yield 1.50 percent. If rates are moderately level by the time 2015 rolls around, this bond will have tumbled down to the five-year area of the curve where similar maturity items are currently priced in the 0.97 percent range. This means you will own that unpleasant 1.50 percent seven-year bullet at a profit of nearly $55,000. That is a total return of 2.71 percent and a holding-period yield of 5.52 percent.
Great returns with highly liquid, predictable instruments can be achieved. Get duration and convexity correct and you will win. If you truly feel rates are not going anywhere for a while, keep it simple and buy an agency bullet. In a world where everything seems more complicated by the day, the investment portfolio is something that does not have to be. Just remember the KISS principal.
Grant LacKamp is assistant vice president in the Capital Markets Group at Country Club Bank, Kansas City, Mo. Contact him at 816-751-9326 or glackamp(at)countryclubbank.com.
Copyright (c) June 2013 by BankNews Media