Long duration GSEs. Worth a look?

Investing Strategies Bonds & Fixed Income Investments
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Hello All,

I was watching CNBC last evening. Between the rehashed analyses of the Fed rate decision, they had a bond investment analyst on. After the normal questions, they got around to asking him what he’d be buying. He replied that mortgage backed long duration bonds were so beat up that they provided a rare buying opportunity. There’s a rare amount of inordinately low coupon mortgage debt out there floating around at a big discount to par.

All the fixed income I own right now is primarily short duration (mostly Treasuries and money market). But I’ve wondered about trying to assemble some long duration, below par positions. Overall, I haven’t been very interested in any of my broker’s offerings outside of Treasuries. Prices look terrible relative to where the bonds trade on Trace; especially for corporates. A lot of offerings are really overpriced. (Is this typical? I use TD Ameritrade and like it but I’m a stock investor. I know they aren’t great for fixed income.)

I did find a Federal Farm Credit bank bond of interest, but I’m not completely certain of some things. I’d like to fact check my understanding with ppl more experienced. The bond (CUSIP 3133ELR22) is extremely long duration, Aaa rated and pretty badly beaten up by rate movement. It’s offered at 66, in line with where it trades on Trace. YTM/YTW is 4.977%, 2.02% coupon (about a 3% current yield), matures in July 2040 and is “continuously” callable according to FINRA. That sounds to me like this is mortgage backed. But I don’t know for sure whether this is mortgage backed or not. Is all GSE debt mortgage backed and subject to call on refinance?

As I see it, buying at this much of a discount to par, any portion of it that’s called down the road is a good thing (you’re getting par on your 66). They’re also a recession hedge as bond prices will rise with falling yields when we enter a recession. Anybody think nibbling on long duration assets isn’t worth consideration? I’m not a bond investor, so I don’t know what I don’t know…

Thx,

Peter

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It depends on what type of credit the specific GSE is facilitating. GSEs are “Government Sponsored Enterprises” that are set up to facilitate the flow of credit to the private sector by guaranteeing loans and/or purchasing loans on the secondary market. Fannie Mae, Freddie Mac and Farmer Mac generally focus on mortgages, while Sallie Mae focuses on student loans. Yes, all bonds sold by GSEs are likely callable at any time if pre-payments on the underlying loans reach a particular threshold.

Prior to the financial crisis, the average duration for a 30-year mortgage was only about 10 years, generally because of refinancing or sale of the underlying property. With the extremely low-rate mortgage loans that were issued since the financial crisis, there is less incentive to refinance, so the average age of loans has been increasing, making calls of mortgage-backed bonds less likely.

AJ

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Peter,

What’s the standard advice given when someone asks whether to invest in something or not? “Don’t buy what you don’t understand.” That should be enough to tell you to walk away.

But let’s dig a bit deeper. GSE bonds carry an implied backing by the US gov’t. But it isn’t a guaranteed backing. Hence, unless one pulls the financials and does proper credit analysis, it should be assumed that the triple-AAA rating is a rubber-stamped guess that won’t hold up if the issuer does run into trouble, which is highly likely given that plenty of loan defaults and bankruptcy filings are still ahead of us.

Why is the bond being discounted? The low coupon in a rising interest-rate environment is part of the reason, but probably not the whole reason. It has to be assumed that the bond isn’t being bid, because it isn’t attractive. What’s its YTM? 4.9% for a bond that’s 17 years away from maturity. What’s the 17-week T-Bill offering? About the same. So why would anyone want to accept duration risk? Next question. How likely is a call and an opportunity for cap-gains? Not very likely compared to debt with higher coupons.

Disclaimer: I own some of their debt, just as I own a lot of other long maturity debt, all of which I could hold until maturity. But in most cases, I’ll be long dead by the time it matures. Meanwhile, most of it kicks out coupons that beat stock divs. So I’m content to sit on it. But I’m not willing buy more.

Arindam

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This is so true. Of course duration risk means different things to different people. The people (like you) who manage to find good bond deals even in near-zero rate environments, you almost definitely don’t want to lock in 27 years of it. BUT, for those who are less skilled, they may look at it differently. They may say, well, I could buy the 17-week and get 4.96% now, and then maybe another 17 weeks at 4.9%, and maybe another 17 weeks at 4.5%, but after that it could be 3.5% or 3% or even less. Or they may say, I can get a 27 year bond that’ll give me 4.9% for all 27 years, no muss, no fuss, and about 2.9% ahed of inflation. Why take the duration risk with short dated bills that are sure to have lower rates pretty soon.

At the moment, I don’t own any GSE bonds at all, only short dated treasuries. I do however recall getting some very nice YTMs with SLM inflation adjusted bonds a decade or two ago.

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Mark,

Bond shopping isn’t a matter of “skill”. It’s a matter of applying to bonds the same common sense and grammar school arithmetic that one uses to shop for bell peppers or baskets of strawberries. “Are they cheap right now, or expensive? If cheap, buy more. If expensive, buy less or none.” Right now, long-dated bonds aren’t cheap. (If they were, the yield-curve wouldn’t be inverted.) Nor do any of them offer a real rate of return after taxes and inflation, not when even the lie that is the CPI is saying that inflation is north of 6%.

So, let’s do some math. If you buy a bond with a 2.5% coupon at a 33% discount to par, your current yield (CY) is 3.75%, right? But that $25 coupon is taxed at ordinary income rates, which drops its effective CY to 2.81%. Meanwhile, your personally-experienced rate of inflation --at the grocery store and gas pump-- is running at least 3x that. Opps. You’re losing money (aka, purchasing power) instead of gaining it. Not smart.

YTM (Yield to Maturity) is made up from two components: the coupon payment and the diff between par and the price paid. If a bond is bought at a discount to par, then cap gains is achieved. So buy the bond at 66 and get 100 at par. That’s an attractive 52% gain. But that gain has to be prorated over one’s holding period, which --in the case of that Farm Bank bond-- would be roughly 17 years, or a cap gain of 3% year for accepting a lot of risk, the chief of which is this. In 17 years, when your principal is returned to you, by how much will the $US dollar have depreciated? Let’s assume that Powell does succeed in his quest to get inflation back down to 2%. Do the math. 17 years from now, when your principal is returned, you will receive $1000 per bond whose purchasing power has been degraded to $714.16. If that isn’t trading elephants for rabbits, then give me another name for it.

Aside: Here’s one way to estimate the decline in purchasing power over any holding period, given a guess about the inflation rate. Add ‘1’ to your estimate of an average inflation rate over your holding period and convert it back to a decimal number. (E.g., 1 + 2% = 1.02) Raise that number to a power equal to your holding period. (Thus, 1.02^17). Use a scientific calculator to do the calculation, whose answer is 1.400241419. Take the reciprocal of that. (1/1.40) The answer is 0.714162562. Multiply that number times the nominal money received at maturity. The result is the purchasing power returned to you.

OTOH, if you’re a “show me” sort of guy, it is easy to use a spreadsheet to show each year how your purchasing power would decline for any inflation rate over any holding period. The results offered by each method differ slightly, but not materially, and the math is faster.

Here’s my take on them who want to get into the bond market at this last stage of the game. DON’T. You’re going to lose money, a lot of it, because the game has gotten so tough. Yeah, for sure, stocks --for the most part-- are still so overpriced as to be unattractive, never mind that declines of (-30%) or more are ahead of us. But the situation in the bond market is far worse due to present uncertainties about almost everything. (IMHO, 'natch.)

PS. SLM issued stepped-coupon bonds, not inflation-adjusted bonds. Only our dear gov’t issues the latter, which you should be buying instead of Farm Bank bonds. (Again, IMHO.)

PPS. I don’t know which bond “expert” you were getting advice from on CNBC. But my bet they were of the same caliber as Jim Cramer --whom I like a lot-- but whose calls are often enough so awful that he’s a tell on What Not To Do. Instead, turn off the TV and start reading at Lew Rockwell and Zero Hedge, plus listen to Jim Rickards and Danielle DiMaritino Boothe.

Meanwhile get hold of Sharon Saltsgiver Wright’s intro to bonds (any edition) and work your way through it, pencil in hand, calculator at your side, then head on over to E*Trade whose bond search engine is the best on the web, but execute through IB or Fido, who have the best commish schedules, although Schwab is excellent for Treasuries bought in the secondary market.

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