Jim Reber: The search for 1%


Photo by Michela Ravasio/Stocksy

Investors are on the hunt for securities that yield a full 1%.

By Jim Reber, ICBA Securities

As we wind down this year, it dawns on me that there has been an unintended theme of this column in 2020. I’ve been able to talk about products, strategies and investment performance metrics that have never before existed. So, we might as well complete the cycle by highlighting one more peculiarity: The fact that bond investors are struggling to find securities that yield even 1%.

Actually, there is, in fact, some precedent. From 2009 through 2015, when fed funds was anchored at 0.25%, many short-term investments had yields between 50 and 100 basis points (0.5% and 1%). However, the vast majority of the securities purchased by community banks in that era were long enough to yield more than the coveted 1%. That highlights another similarity to today’s bond portfolios: Then, like now, durations were shorter than desired, giving community bankers some leeway to buy some longer-term investments.

First sighting

What is unlike the previous era, however, is that the rest of the curve’s yields are also compressed. The benchmark 10-year Treasury note, which is highly correlated with mortgage rates, for the first time ever crashed through the 1% barrier in March and has averaged just 82 basis points in 2020.

Even the 20-year note, which reappeared in May of this year for the first time since 1986, has been trading at historically low levels. This note is helping you and me finance our federal deficit at what sounds like a bargain, by averaging a yield of just 1.22% since its triumphant return.

With the benchmarks trading at record lows, some instruments that are more familiar to portfolio managers have also been recalibrated. For example, in June, July and August respectively, we first saw the first-ever mortgage-backed securities (MBS) with 1.5% coupons in 15-, 20- and 30-year maturities. All of these have been trading at premium prices since their inception, I might add.

Shopping list

So, just what does it take to buy a bond with a 1% yield to maturity? That seems like a pretty straightforward question. In 2020, however, the answer begins with “it depends.”

Since very few debt securities are trading at 100 cents on the dollar, your return will depend on the amount of optionality that is embedded. MBS priced at 104 or more can have wildly volatile returns based on how quickly the loans that back them prepay.

Still, here is an attempt to frame up an answer. As of this writing, the following should have yields of about 1%:

  • Treasury note with a maturity of 12 years
  • Callable agency with a maturity of eight years and two years of call protection (“8/2 callable”)
  • Corporate note “6/2 callable” with a AA rating
  • Small Business Administration fixed-rate pool (“DCPC”) with a 20-year maturity
  • MBS with a 2% coupon and a 20-year maturity
  • Taxable municipal bond with a six-year maturity

Anything that’s shorter, lower coupon or higher quality yields less than 1%. That is an issue for banks that are probably sitting on a cost of funds of 40 basis points (0.4%).

No free lunch

One will notice from the list above that, with the exception of the Treasury note, there is some “structure” embedded. That’s bond speak for sophistication, optionality or illiquidity. The callable agency, for example, may appear simple in construct, but a bond with call protection on only about one-fourth of its potential life will have a high degree of negative convexity. (And that’s another story for another day.)

Similarly, the 20-year MBS will have a price in the 104s. That means the yield to maturity will be highly dependent on the prepayment activity the pool experiences. The investor will want to dive into the demographics of the borrowers by considering the average loan balance, the geographics, and even the servicer to understand the range of outcomes. Your broker should be able to provide this information while offering the security.

Of course, any corporate or municipal offering will need to be vetted both before and after for credit quality. In October, I mentioned the dynamics surrounding the municipal bond market in 2020. Many of the same concerns can be applied to corporate bonds, as neither sector carries any implied or expressed guarantee by the federal government or its agencies.

My December 2019 column declared that banks were maintaining a collection of bonds that would produce a yield spread more than their cost of funds of around 2%, which was in keeping with long-term averages. As we close the book on 2020, those spreads are no longer in play.

Themes for this rate environment? Stay invested, diversify and manage the portfolio to what you define as a suitable duration.

For your community bank’s portfolio to outperform its peers, you’ll need to acquaint yourself with the one-percenters.

Webinar series for 2021

ICBA Securities’ exclusive broker Vining Sparks has concluded its 2020 Community Banking Matters webinar series. These events have proven very popular among community bankers, and we are planning the 2021 series. If you have topics that you would like to see covered, please contact me or your Vining Sparks sales rep.

Jim Reber, CPA, CFA (jreber@icbasecurities.com), is president and CEO of ICBA Securities, ICBA’s institutional, fixed-income broker-dealer for community banks