Callable Securities May Be the Biggest Threat to Your Portfolio
Updated: Oct 23, 2019
This paper illustrates the hazards of purchasing callable securities for public funds investors and their taxpayers. Callable securities can accelerate the erosion of portfolio earnings when market rates fall. Callable securities can leave investors trapped at the bottom of interest rate cycles and accentuate fair value declines when market rates increase.
Public fiduciaries, including treasurers, finance directors and investment committees, are faced with the responsibility of assuring that taxpayer resources are prudently invested. Most follow the prioritized guidelines of SLY - safety, liquidity and yield. Public fiduciaries often identify US Treasury and agency securities as risk free and highly liquid. The focus then shifts to the third priority, yield. When comparing securities with equal credit quality and maturity, should the fiduciary’s due diligence stop there, a substantial risk is overlooked.
Public funds investors were reminded during the Financial Crisis and the Great Recession of the importance of maintaining high credit quality and liquidity. But they may have missed an equally important lesson: securities with Aaa/AA+ credit ratings can carry significant risks. Investors reaching for a small increase in yield can expose public funds portfolios to substantial interest rate risk.
Public fiduciaries would be well served to heed the wisdom of John Bogle, the founder of the Vanguard Group who said, “Our financial system is driven by a giant marketing machine in which the interests of the sellers directly conflict with the interests of the buyer. The sellers having (as ever) the information advantage nearly always win.”
Eight Reasons to Avoid Callable Securities
1. favor the interests of issuers over buyers
When an investor buys a callable security, he or she assumes the issuer’s interest rate risk.
FNMA, FHLB, FHLMC and FFCB utilize call features to reduce their borrowing costs when market rates decline. Each time the agency/issuer exercises a call option the investor faces reinvestment at a lower interest rate.
2. generate recurring commissions and highlight the conflict of interest between buyer and seller
Each time a security is called, the reinvestment of the same funds generates an additional commission. The commission incurred by the buyer benefits the seller.
3. offer small incremental yield advantage vs bullet securities
The allure of callable securities has diminished. The additional yield offered the buyer to assume the issuers interest rate risk is near historic lows. Downside risks of callable securities are under appreciated. Examining the effect of repeated investment in callable agency securities brings the asymmetrical risk profile into clear focus.
4. have negative asymmetric risk/reward profiles when compared to bullet securities
Simply put, a callable security carries far greater downside risk than upside reward. Downside risks include lost interest earnings and market value declines. The upside rewards are limited to the small additional yield earned if the security is not called and capital gain limited by the duration of the call feature. When a security has the potential to lose more than it gains given equal and opposite changes in interest rates, bond analysts refer to this asymmetry as “negative convexity”.
5. suffer poor liquidity in volatile markets
Callable securities issued by FNMA, FHLB, FFCB and FHLMC often come to market in small quantities and may lack liquidity during periods of market distress. During the Financial Crisis, small issue callable structures displayed compromised liquidity in the secondary market. Many callable agency securities received “no bid” when investors tried to sell.
6. add uncertainty to budgeting process
Public funds investors face unique challenges when the economy contracts. During a recession local tax revenue falls. The Federal Reserve responds to recession by slashing interest rates. At the confluence of economic weakness and Fed policy response, public funds portfolios with a concentration of callable securities are most at risk. Unexpected declines in portfolio interest earnings coupled with deteriorating revenue and rising social safety net expenses can stress budgets.
It is imperative for public fiduciaries to integrate portfolio cash flows, maturities and interest payments, with changing economic conditions and shifting budgetary considerations. Here too, callable securities undermine sound public funds management.
7. are incompatible with current economic conditions and monetary policy
The US “economic recovery” has lasted almost 10 years, nearing the longest expansion in post-World War II history. But unlike every previous post-war expansion, GDP growth has not exceeded 3% for any calendar year as of 2018. This recovery is long in the tooth, shallow and facing strong global headwinds.
At the onset of the recession in 2007 the Fed’s policy rate stood at 5.25%. Fifteen months later, policy rates were cut to a range between 0% and .25%. Market rates followed in lockstep.
Policy rate reductions of this magnitude have occurred 5 times since 1980, about every 7.5 years. Each series of cuts was in response to weakening economic conditions. The Fed Funds policy rate is currently 2.50%.
The bond market is sending worrisome signals. The yield curve is inverted. The 3 and 6-month T-Bills currently yield more than the 10-Year Treasury. The market yields on US Treasuries maturing from 2 to 10 years are below the Fed Funds policy rate of 2.50%.
When investors increase buying volume in bonds two things happen; prices rise, and yields fall. The question for today is, “Why are investors buying long-dated maturities with yields below Fed Funds and money markets?”
Futures markets are assigning a 30% probability to a policy rate cut by 2020. The next recession could return policy and market rates to near zero for a prolonged period. Public funds investors should act to protect portfolio interest earnings from the risks associated with recession and Fed policy response.
8. increase portfolio interest rate risk
Every fixed income portfolio carries interest rate risk due in part to the inverse relationship of interest rates to bond prices. Longer bonds experience greater price volatility than short maturities, but better protect income in a falling-rate environment. Shorter duration securities provide less price volatility but increase reinvestment risk when market rates decline.
Callable vs. Bullet Security – Scenario Comparison
For illustration purposes this paper will compare interest earnings for two investors purchasing US agency securities with 2-year maturities. The agency securities featured in this example are both issued by Federal Farm Credit and were priced and available for purchase at the time of this writing.
We will examine the interest income generated by both securities in two interest rate scenarios. In the first scenario, the yield curve will remain unchanged from the purchase date through maturity. In the second scenario, market rates will decline in three equal 50-basis-point shifts over 9 months.
Both Investor A and Investor B committed the invested funds to a liability 24 months from purchase date.
Purchases $1 million par amount of a non-callable or bullet agency with a fixed coupon and guaranteed income to maturity
Investor A’s bullet security pays an interest rate of 2.58% fixed for 2 years
Buys $1 million par amount of an agency security that is callable 90 days after settlement and every 5 business days thereafter until maturity
Investor B’s income is only guaranteed for the first 90 days
Investor B’s callable security pays an interest rate of 2.61%, fixed for 3 months
Scenario 1 - Assumptions
The yield curve remains constant
Rates are unchanged over the two-year holding period of the investments
Investor B’s security is not called
Scenario 1 - Results
Investor A earns total interest income of $51,600
Investor B earns total interest income of $52,200
Investor B earns $600 more than Investor A
Scenario 2 - Assumptions
The Federal Reserve cuts policy interest rates 3 times in 9 months, in 50-basis-point increments, totaling 150 basis points
Market interest rates decline along with policy rates
Investor B’s securities are called in full and reinvested at 90 days, 180 days and at 270 days for a total of three calls and three reinvestments
Investor B’s proceeds at each call are reinvested in a security with the same call features
Investor B’s security is not called for the final 15 months prior to maturity
Scenario 2 - Results
Investor A earns total interest income of $51,600
Investor B earns total interest income of $29,700
Investor A earns $21,900 more than Investor B in interest income over the two-year holding period
Public fiduciaries have a unique set of responsibilities. Providing a prudent strategy for optimizing taxpayer financial resources while maintaining safety presents challenges and hidden dangers. The good news is that limiting the risk of accelerated and unpredictable declines in interest income is as simple as reducing or eliminating callable securities from public funds portfolios.
No single example can represent all potential investment outcomes or investor decisions. This comparison is intended to provide general information regarding the characteristics of securities issued with and without imbedded call options.
The opinions presented within this white paper are the viewpoint of Institutional Capital Management, Inc. (ICM) at the time of distribution and are subject to change. The information contained is prepared from data sources generally believed to be reliable and available to the public, but no representation is made as to accuracy or completeness. This white paper is for general information purposes only and is not intended to provide specific advice or recommendation, nor is it an offer to purchase or sell any securities.
ICM is registered with the Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940. ICM clients include city and local governments, hospitals, and similar public funds investors. www.thinkicm.com