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Three reasons to consider deep-discounted callable securities

By: Jeff Duesler, Senior Investment Services Representative

While things have calmed down in the treasury market since the Federal Open Market Committee’s (FOMC’s) rate decision on Wednesday, March 15, there was quite a bit of volatility leading up to it. This volatility was mostly due to economic data, which caused the opinions of traders, surveyed economists, and other market participants to not only favor a March hike but also continue to speculate on what might be in store for the rest of the year.

During times of volatility, valuable investment opportunities sometimes present themselves. One such recent opportunity is deep-discounted callable agency securities. Today we will define these securities, review their value and risks, and offer steps you can take to determine if these securities are right for you. While we generally favor sticking to a disciplined investment strategy, like keeping a laddered portfolio over market timing or “bond-of-the-day investing,” your credit union can still take advantage of new opportunities like these and pick up some value along the way.

What are deep-discounted callable securities?

A deep-discounted security is a bond that sells at significant discount from par value and has a coupon rate significantly less than the prevailing rates of fixed-income securities (in this case, government agency bonds) with a similar risk profile and term. These bonds are also referred to as “busted” or “out-of-the-money calls.”

The government agency market is one that reprices itself on an almost daily basis. Since the market for government agencies relies heavily on a robust new issue calendar, market bonds available in the secondary market or new issues still on the shelves of dealers can always be compared to the latest new issue. This makes for a pretty transparent market; new issues are usually at par, and secondary bond prices will have to adjust to be competitive with the new-issue market.

Let’s use the following scenario as an example:

  • Paul has a bond in inventory with a three-year maturity that is callable in six months. The coupon rate is 1.50%. Paul wonders at what price he should offer the bond within the context of the market. Lisa runs the new-issue desk and is speaking with the Federal Home Loan Bank about underwriting a three-year maturity that is callable in six months at 1.75%.
    • Question: At what type of yield should Paul consider offering his bond? Will his price be a premium or a discount?
    • Answer: Paul will need to offer his bond at yield of 1.75% or higher, and the price is a discount. (Remember, bonds are at a discount when the coupon is lower than the prevailing market rate, and bonds are at a premium when the coupon is higher than the prevailing market rate.)

Will deep-discounted callable securities work for my credit union?

Deep-discounted callable securities will work for you if the following three things are true:

  • You primarily look at bullet securities, and you need an alternative.
    • These bonds have a coupon rate far enough away from the current market rate that they are priced at a substantial discount.
    • For bullet investors, this creates a twofold opportunity:
      • First, agency bullet securities are scarce in some maturity dates (making it difficult to find securities that fit a particular need on a ladder), which opens up another place to look when trying to fill a need.
      • Second, the discounted price and lower coupon also make it unlikely that the bond will be called prior to maturity, making it a surrogate for bullet maturities.
  • You are looking for yield and can handle the price volatility.
    • Increasing yields will continue to result in downward price movement. This is one of the reasons these bonds should be priced at a yield premium compared to other bullet securities.
  • You buy bonds and plan to hold them to maturity.
    • Most credit union investors have a “buy and hold” philosophy. In order to mimic the characteristics of a bullet security, the bond should be held to maturity.
    • Deal size, call structure, and investor/dealer appetite will drive the bid-offer spread for these and all callable agency securities.

What are the risks of these securities?

When considering whether or not to take advantage of new strategies/opportunities, it is always beneficial to weigh the risks. For these types of securities, take into account the following:

  • Call risk. Although the nature of these discounts make it unlikely these bonds will be called prior to maturity, they are still callable. Because of the discount, the yield to call is usually quite substantial. It might be substantial enough that the call risk is worth taking on.
  • Price volatility. Lower coupon bonds will have more duration risk; therefore, prices are more sensitive to interest rate changes. It’s like watching an airplane fly: When one wing dips up, the other dips down. Bond prices and yields have this same relationship; as yields rise, prices fall.
  • Liquidity risk. In general, with government and agency bonds, judging from bid/offer spreads), U.S. Treasuries will have the most liquidity, global agency bullets will have the next best liquidity, and callable agencies will have the least liquidity.
    • Please note this doesn’t mean callable agencies can’t be sold in the secondary market; it simply means these securities will have a wider bid offer spread because they garner interest from fewer investors.

Let’s briefly summarize some key points:

  • Times of market strife or volatility often present valuable, strategic investment opportunities. (The most recent example of volatility was the precipitous rise in interest rates.)
  • The government agency market is highly efficient in that the new-issue market reprices the secondary market on a daily basis. When rates move up bond prices move down. When the price of a callable bond moves below par, it becomes less and less likely that it will be called based on the movement of interest rates.
  • Investors can find higher yields and an alternative to bullet securities with deep-discounted callable bonds that are purchased at a discount.

Finding these securities is as easy as contacting your Corporate One senior investment services representative! We are happy to look through our own and various dealer inventories to find the right bond for you. Give us a call at 800/366-2677.

It is important to compare the kind of yield pickup you will have to bonds with similar maturity dates. This chart shows a recent snapshot of bonds trading in the marketplace:

  • The callable bond (7.50 YR N/C 6 MO) can be called continuously after six months. The bond is at a discounted price because the coupon is much lower than the market rate. “The market rate” will give the agency an indication of what it will cost to issue new debt. This bond likely won’t be called in the near term because it presently costs the issuer more to issue new debt with a similar maturity. (The market rate is higher than the bond’s coupon rate.)
  • The same callable bond has a yield to maturity (YTM) premium of 13 basis points over a bullet agency (7.50 YR NC) and a 24 basis point yield premium over the U.S. Treasury. All three of these issues have similar terms.
  • The price volatility is measured using the Total Return Analysis (TRA) screen on Bloomberg using the “shock option” with a horizon date equal to 3/29/17. The bullet and U.S. Treasury will have more upside in a down-rate environment (-100 basis points), mainly because at -100 basis points it becomes more likely the callable bond will be called; therefore, the upside is capped at a price at or around par.
  • The callable bond priced at 96.20 will also have more price volatility if rates move up 100 basis points.

*Please note this chart does not indicate a specific offering of securities; it is for educational purposes only. For specific offerings and/or questions about this analysis, please consult your senior investment services representative.