The unrelenting flight-to-safety trade took a breather yesterday, but it in no way represents a turning of the tide for this morning the risk-off trade is with us once again. The impetus for the move this morning stems from the uncertain fiscal stimulus that is still being hashed out in D.C.. While some of the countries first impacted by the virus, namely China, are starting to see significant slowing in new cases, the uncertainty that hangs over Europe (particularly Italy) and the U.S. will continue to keep investors nervous. Those with an optimistic view will point to the coming spring and the experience in China and Korea that the virus appears to have a definite timeline. Those less optimistic will point to the gathering U.S. outbreaks, and the halting, confused government response as reasons to remain cautious about the outlook, both from a health and economic perspective.
The Fed cut rates 50bps two weeks ago, and the market continues to believe more rate cuts are soon upon us. While the Fed surprised with an inter-meeting cut then, for the first time since 2008, they have resisted the urge to cut inter-meeting again despite the nauseating decline in equities. That, however, hasn’t stopped the futures market from pricing in expectations that the Fed will cut policy rates to the zero lower bound by the June meeting. In fact, the futures market has the Fed cutting 75bp at the upcoming March 18 FOMC meeting followed by a final 25bp cut by June. These expectations are mirrored in the Treasury market with the 2yr note yielding 0.42%. As the coronavirus spreads, and its economic impact deepens, the lower for longer trajectory of yields seems more certain.
While longer-end Treasuries have moved decisively to all-time low yields, and short-term yields are pricing for a continued Fed rate-cutting campaign, investors are left wondering where are there any opportunities for investments. One area that we’ve had some success in recent days remains lower coupon 15yr and 20yr mortgage-backed securities. The graph below shows that the 15yr MBS yield spread to a 3yr/5yr Treasury blend (mimicking the 15yr MBS duration) is at a four year high. So, while nominal yield levels are challenging, to say the least, the yield spread to Treasuries reflects a more compelling picture.
A Whole New World of Yields
With the move to all-time low long-end Treasury yields, and short-end rates pricing a return to the zero lower bound, we thought it timely to consider a few investment ideas in this new world. First, the flight-to-safety trade has been fast and furious leading us to believe some correction in current yields is likely in the coming days to weeks. That being said, we envision some degree of lasting damage to economic potential and confidence such that much of the yield moves will be with us for the foreseeable future. Also, we think the Fed cuts rates to the 0.0%-0.25% range by mid-year, at the latest. From an investment perspective that means getting used to these yield levels and making the best of it in that environment. For perspective, we offer some typical bank investment yields in the graph below. To that we have a few immediate investment suggestions:
- Given the dramatic move lower in the long bond yield, duration doesn’t pay like it did just a month ago. Instead, consider lower coupon (2.5%-3.0%)15yr and 20yr MBS pools that project decent yield performance (i.e., limited prepays) in a down 100bp scenario. Lower coupons limit the dollar price as well as prepayment expectations, both are positive attributes in the projected lower-for-longer yield environment.
- Also, lower coupon (2.5%) 10yr MBS are an even safer haven from the likely prepayment surge with acceptable yields, modest duration and limited cash flow volatility. Given the shorter 10yr amortization, and lower coupon, prepayment risk is minimized versus almost all other mortgage products.
- Cushioned callable securities are another acceptable alternative. These are agency callable securities that given the move lower in yields trade at premiums to their next call date. Amortizing the purchase price to the call date allows for a pop in yield if rates do surprise and rise and the bond remains outstanding beyond the call date.
- Don’t forget the liability-side of the balance sheet. These ultra-low yields provide some ultra-attractive funding options whether it is brokered CDs or FHLB advances. Locking in long-term cheap funding should be a top consideration for every community bank.
If you haven’t already it may pay to discuss with your CenterState representative some of the above investment alternatives and/or consider funding options that are available in this new world of yields.
Agency Indications — FNMA / FHLMC Callable Rates
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