Robert Segal

Federal Reserve policy makers lowered their benchmark interest rate for a second time this year to a range of 1.75 percent to 2 percent “in light of the implications of global developments for the economic outlook as well as muted inflation pressures.’’ According to the official statement, the Federal Open Markets Committee continued to characterize the labor market as strong with solid job gains, but added, “although household spending has been rising at a strong pace, business fixed investment and exports have weakened.”  

In a press conference following the announcement, Fed Chair Jerome Powell said although the U.S. economy has performed well, business spending has softened amid slowing growth abroad and trade developments. Powell said the Federal Reserve expects the job market to remain strong, with the unemployment rate projected to be below 4 percent over the next few years. He added, however, that policy is not on a preset course, and if the economy does turn down, then a more extensive series of rate cuts could be appropriate. 

Many bond market participants expect more rate cuts coming in the near term. According to fed funds futures, traders are placing a 50 percent chance of a rate reduction at the Oct. 30 FOMC meeting.  After that gathering, there are even odds for two more moves by March 2020, which would bring the range to 1.25 to 1.50 percent. 

Fund Managers Will Chase Returns 

Financial institutions have been living with a flat yield curve for some time. As an example, the Treasury yield spread as measured by the difference between two-and 10–year maturities was just two basis points during mid-August. That compares with a slightly-higher 25 basis points for the same period in 2018.  

As bond prices have increased, investors have continued to chase performance. Money has been pouring into bond funds globally this year, with net buying on pace to reach a record $455 billion in 2019, according to Barron’s. Over the past decade, global bond funds received $1.7 trillion of inflows. 

At the same time, the funds are getting riskier as managers try to squeeze out better returns in a low-yield world. A recent Morningstar analysis found that even straightforward funds have increased their holdings of lower-rated bonds and emerging-market debt to juice returns. As interest rates continue to fall, bond investors are increasingly “reaching for yield.”  

Treasury officers should remember that a main objective of the investment portfolio is to enhance profitability while balancing the institution’s sensitivity to interest rate changes. Accordingly, management should establish a target level of duration which considers the institution’s balance sheet, income requirements and risk tolerance.   

Maintaining duration is an essential factor in supporting margin and maximizing net interest income. As portfolios age, duration can shrink unless cash flows are reinvested back out on the curve; this “opportunity cost” limits earnings potential. When interest rates decline, for example, portfolios comprised of mortgage securities usually shorten as prepayments ramp up. Investment officers should closely monitor their portfolio and take steps to ensure target durations are preserved to protect net interest income.  

Be Cautious in Certain Cases 

Especially in this environment, caution is advised with regard to investment types that may underperform over a cycle. These include certain collateralized mortgage obligations (CMOs) and callable agency bonds in falling rate scenarios and low-coupon tax-exempt municipals with rising rates. 

CMOs: In a base case scenario, many “plain vanilla” CMOs are projected to have an intermediate-term average life, such as four to five years. However, CMOs are often highly sensitive to movements in interest rates. Changes in the rate at which homeowners sell their properties, refinance, or otherwise pre-pay their loans could result in large swings in cash flow. In a falling rate scenario, the securities could shorten dramatically, to one year or less, causing the investor to reinvest cash flows at appreciably lower yields. Investors in these securities may not only be subjected to this prepayment risk, but also to heightened market and liquidity risks. 

Callable Agency Bonds: Callable bonds expose investors to the same type of reinvestment risk. Issuers tend to call the bonds when interest rates fall, so they can refinance at lower costs. A typical agency issue carries a first call period of three to twelve months, which may not be enough protection. As bonds are redeemed, the investor receives the original proceeds though is unable to match the original return. Moreover, callable agency bonds cannot appreciate much above par due to the call feature, and this limits any lift to the institution’s capital from unrealized securities gains. 

Municipal Bonds: Tax rules describe a price threshold for determining whether a discount bond should be taxed as capital gain or ordinary income. If a municipal bond is purchased at a large discount, the security’s price appreciation can be taxable, which reduces realized investment income. For this reason, many financial institutions prefer to purchase municipal bonds at a premium, since a larger portion of the expected return is comprised of coupon income. Investment officers may wish to tread carefully with low-coupon municipal bonds, as these issues could depreciate rapidly in a rising rate environment. 

Of course, the institution should consider their asset-liability position when making investment decisions. With the market at a potential turning point, investment officers should pay extra attention to performance in multiple rate scenarios, to protect the balance sheet from undesired outcomes. 

Robert B. Segal is president of Bedford-based investment advisers Atlantic Capital Strategies Inc. He can be reached at bob@atlanticcapitalstrategies.com.