By Jim Reber ICBA Securities Availability of Discount Bonds Causes a Rethink of Strategies Over the years, I’ve learned a few things about human nature as it relates to bond portfolio management. Some of these notions or biases in the minds of investors are more logical than others. For example, it seems community bankers take some pride in owning a collection of bonds whose price has risen since purchase. An unrealized gain is much preferred over an unrealized loss in the minds of a lot of seasoned portfolio managers, investment committees and boards. This is in spite of the fact that the gain is the residue of rates falling since purchase. The natural consequence is that the overall portfolio’s yields are on the way down, and I haven’t met many people hoping for lower bond returns. A great paradox is that many of these same bankers prefer to buy bonds whose prices are less than 100 cents on the dollar, rather than at premiums. In some cases, they’ll opt for discount bonds even if they have lower yields to maturity. I think they get satisfaction out of knowing they’re better off than the poor suckers who originally paid par or more for the same investment. In that community banking is a cyclical industry, and its earnings have some correlation to market interest rates, there are periods in which certain strategies are in play and others are not. An environment in which rates are high and rising, such as 2022, will produce bonds whose prices are below par. Like it or not, discounts are the story of the day, so let’s review how discount-priced bonds can be used strategically to improve portfolio performance. Agency options The simplest investment sector to analyze is government agencies. These bonds are issued by some of your favorites, such as Fannie Mae, Freddie Mac and the Federal Home Loan Bank. These do not have periodic principal repayments, so your original investment remains intact until maturity date. That is, unless it has a call feature, which is present in about 88% of outstanding issues. For these bonds, the borrower can decide to “call” or prepay the debt early, and on designated dates. If a given bond is purchased in the secondary market at a price below 100, and the issuer later calls the bond early, the investor’s yield to call is higher than yield to maturity. This yield improvement can be dramatic if the callable is owned at a deep discount. Of course, the investor doesn’t “The natural consequence is that the overall portfolio’s yields are on the way down, and I haven’t met many people hoping for lower bond returns.” Price Pullback Prospects 34 | The Show-Me Banker Magazine
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