Endorsed Partner UP WITH COUPONS LARGER INTEREST PAYMENTS CAN BUILD A FLOOR UNDER YOUR BOND PRICES Up with People, which readers of a certain age may remember, was an organization that had a run of popularity in the 1970s and ‘80s by promoting wholesome values and positive thinking. Its delivery channel was through song and dance performances, often in large arenas and stadiums. Up with People provided the halftime entertainment for five Super Bowls between 1971 and 1986, though in recent decades, it has been relegated to the dustbin of a bygone era. Today’s attitudes toward pop culture, it seems, have little room for this squeaky-clean message; The Simpsons had several episodes featuring a snarky knockoff, “Hooray for Everything.” More salient to the current environment, at least pertaining to community banking, is a simple-to-execute investment strategy: Up with Coupons. This tactic can be employed at any time and in any interest rate scenario. We’re talking about it today because it could well be utilized to limit the price volatility and normalize the cash flows of your bond portfolio. As we’ve seen, market values have been on a one-way trip in 2022, and putting a floor under your investments may strike some as a good idea. Moving target Looking back just a year, we see a totally different rate landscape. It was nearly impossible to buy a bond, particularly an amortizing security, which had a price as low as $100, much less at a discount. So, going “up in coupon” would seemingly have heaped an additional pile of prepayment risk onto the portfolio at a time when mortgage refinancing was setting its own world records. For example, in June 2021, a 15-year agency mortgage-backed security (MBS) with a 1.0% coupon would have cost about $100.00, so if your bank purchased that security back then, your book yield would forevermore be 1%. A similar bond with a higher coupon, say 2.5%, would have cost about $104.50. Its resultant yield would have been totally a residual of the prepayments, over which an investor has little control. Many portfolio managers opted for the lower coupon, given the need to stabilize the shrinking net interest margins. MBS shakeout Today, of course, we have a completely different set of dynamics; foremost is the lower prices for all things in the bond world. The 15-year 1.0%’s are now worth around 86 cents on the dollar, for a decline of about 14%. The 15-year 2.5%’s are down in price “only” about 10%. This demonstrates how premium (up-incoupon) pools will experience price compression in low-rate environments, like the bond market of a year ago. When a market sell-off occurs, the price declines will be less acute for the higher coupon cohorts. Another factor is that average lives and effective durations will remain shorter for the higher coupon securities. Using very recent speeds of our two model pools as examples, the 1.0% So, going “up in coupon” would seemingly have heaped an additional pile of prepayment risk onto the portfolio at a time when mortgage refinancing was setting its own world records. cbak.com 8 In Touch
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