The current appeal of treasuries and agencies is due to the nominal yields, which investors sense may be short-lived. percentage of bonds purchased by community banks have been treasury and non-callable (“bullet”) agencies. This may be the first year in a generation for high-performing portfolios to hold more treasuries than municipal bonds. The current appeal of treasuries and agencies is due to the nominal yields, which investors sense may be short-lived. Add to this the lock-in benefits of a bond that cannot be redeemed early, and you’ve got a winner. Many portfolio managers are building in some future ability to swap out of these highly liquid instruments for others with better market yields once the yield curve assumes its normal shape. Also, munis continue to be prohibitively expensive for C Corporations. Investment grade tax-frees trade at levels that are “through the curve” (i.e., lower than treasuries) for most maturities out to 10 years. BORN TO RUN Mortgage-backed securities (MBS) continue to play a significant role for community bank balance sheets. In aggregate, MBS still comprise the majority of all positions in bond portfolios. The runup in their sector weightings took place between 2019 and 2021, and as a group their unrealized losses are well over 10%. Those positions are paying down at a torturously slow pace as new mortgage rates remain elevated. Still, their appeal in the current market stems from the ready supply of product at prices deeply discounted to par. One day, there could be an acceleration of refinance activity, and MBS with purchase prices in the mid-to-low 90s will show a big bump in book yields if mortgage rates drop 200 basis points (2%). A popular example is the “Hybrid ARM.” Hybrids are issued by your favorite government-sponsored enterprises (GSE), namely Fannie Mae, Freddie Mac and Ginnie Mae. They have 30-year amortization periods, and a fixed rate period between three and 10 years that you can pick. After the “roll date,” the remaining face value will float annually. And this: they’re available at well over 5% yields, and no premium risk. BEST NEWS YET We have established that the highestyielding bond portfolios have a healthy dose of the most simplistic bonds. What else is a departure from convention is that the shorter the collection of investments, the better the performance. According to Stifel, as of June 30, the top quartile portfolios have an effective duration of only 3.5 years. The bottom quartile’s duration is a full year longer and has tax-equivalent yields that are exactly one-half of the top 25%’s: 3.87% versus 1.94%. There will be a day when investment fundamentals will normalize. Positively sloped curves, for example, will force managers onto a different branch of the decision tree. However, for the time being, less is more, and simple delivers relative value. Jim Reber (jreber@icbasecurities.com) is president and CEO of ICBA Securities, ICBA’s institutional, fixed-income broker-dealer for community banks. CURRENCY | 11
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