by Jim Reber
As yields continue to set cyclical highs during 2018, many community bankers have asked us questions about what to invest their next purchases. Some of them have been surprised to hear an answer that I’ve been giving for the better part of this decade, even though absolute yields and the shape of the curve look nothing like the 2010s.
As yields continue to set cyclical highs during 2018, many community bankers have asked us questions about what to invest their next purchases. Some of them have been surprised to hear an answer that I’ve been giving for the better part of this decade, even though absolute yields and the shape of the curve look nothing like the 2010s.
This answer is rooted in history and in forecasts. While the difference in yields between short maturities and longer ones is the smallest in 11 years (i.e. the curve has flattened), most bond analysts, economists and the Federal Reserve itself are predicting that we’ll see more of the same. And when it’s expected that yields will continue to converge into what looks like a straight line, the type of portfolio structure that performs the best is a “barbell.” This month, we review the structure and the advantages of such an exercise for your investment portfolio.
Repetition and resistance
By being disciplined and deliberate about your investments’ structure, you can take advantage of today’s yields and simultaneously hedge your risk against what looks to be on the cards for the next couple of years. The barbell is simple to build and easy to evaluate later. It just requires an investor to define what it considers to be suitable short-term and long-term investments. To be sure, community bankers have differing opinions on what counts as a long-term investment, but generally speaking, those with durations of five years and greater are considered as being on the high end of the price-risk scale.
Once we’ve identified the target investments, the portfolio manager will simply purchase roughly similar amounts of both and keep the weightings balanced through ongoing monitoring. By having a collection of bonds that are heavy on both ends of the maturity spectrum, you’ve successfully built a barbell.
Classic structure
Among the bonds that meet community banks’ criteria of liquidity and credit quality are those issued by the Small Business Administration (SBA). They are direct obligations of Uncle Sam, and new issue volumes continue to set records, so the SBA market continues to broaden and deepen. Two of the more visible products are 7(a) pools, which are true floating rate instruments, and Development Company Participation Certificates (DCPCs), which are fixed rate pools with long average lives.
It makes logistical sense to consider them together for a barbell. For one thing, credit quality is unsurpassed. For another, one would be hard-pressed to find two bonds with more disparate price-risk profiles. For still another, we can address premium risk that attaches to the 7(a)s by pairing them with a DCPC that is available at a price below par. Finally, at this point in the rate cycle, both ends of the barbell yield much more than they would have a year ago, so an investor today has a big head start over 2017.
End of cycle projections
We created a hypothetical barbell portfolio by modeling equal amounts of 7(a)s and 20-year DCPCs. (The latter generally are issued with 10- or 20-year maturities.) We made note of their market values and yields as of April 30, 2018, and in a 75-basis point (0.75%) higher environment over the next year. This rate-hike assumption was driven by both the fed funds futures market and by the Fed’s most recent projections.
Here are the more important weights and measures:
Current Mid-2019
Yield 2.72% 3.05%
Effective Duration 3.18 years 3.34 years
Market Value 105.27 102.78
These results are probably conservative in that we are assuming a parallel shift upward in the yield curve. What’s more likely to happen is further flattening, by virtue of short rates reacting more in step with continued Fed tightening, and longer rates moving very little in comparison. A flattening would help preserve the market value of the DCPC, resulting in the price declining less than is displayed.
Stretch before you lift
As always, a word of advice from your trainer. These securities will probably produce very little cash flow in the early stages, especially if the pools are new. In fact, the fixed rate securities have prepayment penalties for the first 10 years. As they season, it’s more likely the floaters will have faster prepayments, so you’ll need to monitor your positions to keep the fixed/floating balance in place.
So, if your bond portfolio is suffering from a lack of recent energy or isn’t built to run with the tailwinds from the Fed’s monetary policy, take a trip to your favorite broker’s financial fitness center. A session in barbell lifting can help flex your community bank’s economic muscle.
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Barbell Demo
ICBA Securities’ exclusive broker Vining Sparks can develop a specific portfolio strategy using selected investments for any community bank. This modeling will display the current and projected returns and market prices for all investments in the strategy over a range of interest rate horizons. Visit viningsparks.com or contact your Vining Sparks sales rep for more details.
Jim Reber is president and CEO of ICBA Securities and can be reached at (800) 422-6442 or jreber@icbasecurities.com.