HIGH PLAINS DRIFTER Floaters Could Be the Answer to a Flat Curve We are suddenly mid-decade of the 2020s, and if there’s a recurring theme, it’s “anomaly.” First, record low yields and rates. (Remember the 10-year treasury note hitting 0.55% in July 2020?) Then, record rate hikes of 525 basis points concentrated in a torturous 16-month window, followed by the longest-ever inverted yield curve of well over two years that finally corrected last September. It’s been the wild, wild West in terms of portfolio management. Now, the Federal Reserve Board projects that the terminal rate for overnight borrowings in this easing cycle will be 3.0%. This would, if it plays out, be the highest floor in over three decades. Hence, this article’s oblique title reference to “drifting” along the “high plains.” Commensurate with this would be the presumption of a chronically flat yield curve, in which there is little incremental benefit to extending the durations of loans or bonds. Stated more positively, there would be less penalty for staying “short.” And the quintessential short bonds are the prime-based floaters guaranteed by the Small Business Administration (SBA) under the 7(a) program. Let’s review this product — and SBA lending in general — to reacquaint ourselves with the opportunities to drift along the high plains, a la Clint Eastwood. First, the Worst Let’s get this over with quickly: Many SBA 7(a) pools have market prices with high premiums, some over 10 points. For those securities, there is certainly built-in prepayment risk, but there are ways to manage that risk. For example, real estate-backed 7(a)s have three years of prepay penalties; while those penalties aren’t passed through to the bondholders, they have the effect of limiting early redemptions initially. In fact, newer pools in general will prepay more slowly. SBA loans are not nearly as fungible as conventional single-family mortgages, so the small business will incur much higher fees to refinance its loans compared with a typical homeowner. On to better news: The reason some pools have such high prices is that the market for guaranteed portions is quite lucrative for lenders/sellers. There’s robust demand from institutional investors for full faith and credit floating-rate securities, and 7(a)s fit the bill. A network of poolers, which include ICBA Securities’ endorsed broker Stifel, are standing bidders for the guaranteed portions of SBA loans, and that creates a stream of fee income immediately (via the premium prices) and later (through servicing revenue). Short Duration Equals Stable Prices Compared with virtually any other bank-suitable securities, 7(a)s will have notably stable market prices. The pools’ yields can change every 90 days if fed funds, and therefore the prime rate, reset. These also have no rate caps, either periodic or lifetime. Thinking back to the hyperactivity of the fed in 2022-23, SBA floaters’ yields went up every bit as much as the overnight index. Hence, the stable prices. PORTFOLIO MANAGEMENT BY JIM REBER, CPA, CFA, PRESIDENT AND CEO, ICBA SECURITIES 6 In Touch
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