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Five reasons one-time callable bonds might be the right investment strategy right now

By Jeff Duesler, Senior Investment Services Representative

April 22, 2016 -- For investors in the fixed-income market, it feels like Groundhog Day all over again. Why? Let’s recap some recent events:

  • The global economic slowdown has led to continued economic stimulus, including investors paying to hold government debt in the Eurozone and Japan.
  • In the U.S., the Federal Reserve Open Market Committee (FOMC) suspended raising the overnight funds rate, bringing the expected path of “normalizing” rates to a halt before it really gained much momentum.
  • Even after the FOMC raised the target overnight rate to .50% from .25% (basis points) in December 2015, the bull market in bonds roared on.
  • When oil prices plummeted rapidly at the beginning of 2016 (another sign of the global economic slowdown), investors shunned equities in favor of bonds.

Despite what seems like a grim recap of events, investment professionals still need to find a home for excess liquidity, stay the course with their investment strategy, and earn additional income over their cash investments.

One strategy to consider is taking advantage of the value in the callable bond market, specifically government agency bonds with European or 1x calls. Here are five reasons why this strategy might be the right one for you in the near term.

1. You can find maturity months to fit in with your laddered strategy that might not be available in bullets.

Most investors who employ and execute a laddered investment strategy use bullet securities to fill in “term buckets.” However, in the past year, new bullet issuance has been scarce relative to callable issuance. Both Freddie Mac (FHLMC) and Fannie Mae (FNMA) passed several times in the past two years to come to the market with new issue bullets. (These agencies typically file a registration at the beginning of the year to issue a certain amount for the year and predetermine dates they may come to market with a new bullet deal.)

Because of the scarcity of new issuance and the demand for bullet securities (as some institutional investors can only purchase non-callable debt), bullet prices have risen. In some maturity months, it is impossible to find a bullet that fits a rung within a laddered strategy. New issue, callable bond deals come to market much more frequently than bullet deals, and this includes bonds that have one-time calls.

2. You can pick up yield to U.S. treasuries and government agency bullets without additional credit risk.

U.S. Treasury rates are considered “risk-free rates.” All other fixed income securities are going to have a “yield spread” over treasuries. Yield spread is defined as any additional yield one security pays over another security with a similar term. The government agencies have an implied guarantee from the federal government, but presently that guarantee is explicit with both FNMA and FHLMC under conservatorship of the U.S. government.

Of the agency structures, non-callable bullets will have the tightest yield spread to treasuries. Callable bonds traditionally will have a spread over bullet securities for taking on call risk. These spreads are determined by how much an investor is willing to accept in yield for giving the issuer the right to call a bond prior to maturity.

The following chart lists some recent examples in different maturities with a 1x callable bond and the spread picked up vs. bullets and U.S. treasuries. In the recent past, spreads to bullets have been as tight as 3-5 basis points in each term.

Term 1x Call Bullet Spread Treasury Spread
2.0 year 1.00% 0.89% 11bps 0.870% 13bps
2.5 year 1.125% 0.98% 14.5bps 0.930% 19.5bps
2.75 year 1.15% 1.02% 13bps 0.98% 17bps
3.0 year 1.25% 1.10% 15bps 1.01% 24bps
3.75 year 1.375% 1.22% 15.5bps 1.20% 17.5bps
4.0 year 1.45% 1.275% 17.5bps 1.23% 22bps

3. You can limit call risk.

Because agencies with a European call feature are only callable one time, they offer very limited call risk. The investor has a lockout period (a period when the bond cannot be called), and then the bond is callable on, and only on, a specific, stated period. Lockouts differ in length of time, but the most common periods for these types of securities is one year.

Because of the limited call risk, 1x callable bonds will have the tightest yield spread to their non-callable counter-part: bullet securities. Investors in the recent past might have favored bullets over callable securities for two reasons.

  • First, in a falling interest rate environment it is more likely bonds would be called when eligible. This is a negative to a laddered strategy because a called bond typically means investing at a lower rate and takes additional work to find the right investment.
  • Second, yield spread to bullet securities was not enough to take on call risk. However, because of limited call risk and the yield premium currently available, 1x callable bonds offer a good substitute to bullet securities in the current market environment.

4. You can take advantage of the non-typical spread existing between bullets and callable bonds.

When interest rates are expected to rise in the near term, the value of having the ability to call a bond prior to maturity decreases for the issuer. Therefore, the issuer will be unwilling to pay the investor for taking on that call risk, and the spread over non-callable bonds tightens. Currently, we are seeing wider spreads than we have seen in the recent past.

5. You can limit portfolio line items and have additional liquidity over certificates of deposit.

There are two advantages of buying government agency securities vs. CDs.

  • First, you can cut down on line items in your portfolio because you are not limited to the $250,000 in insurance from certificates of deposit.
  • Second, government agencies are much more liquid than certificates of deposits and can be pledged as collateral for lines of credit at liquidity providers.

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Trying to time the market and forecast interest rates is a losing battle for most of us. This article suggests using a different security to execute the laddered strategy, which is a tested method to help insulate a portfolio from changes in interest rates by having a preset plan to reinvest in current market rates, regardless of where you think rates might be going.

However, the laddered approach does not prevent investors from recognizing relative value among asset classes and individual structures. This article has emphasized just one strategy to recognize this additional value. Of course, the value of this strategy itself could change one week, one month or one year from now. Please feel free to contact either your investment rep or me to discuss this strategy or any other investment-related questions.