A historic drop in the U.S. Treasury yield: How long will this last?
The last six weeks witnessed a historic drop in U.S. Treasury yields as the 30-year bond eclipsed the previous 10-year low, yields from 3 months to 10 years fell below 1% and the curve remained inverted.
This, of course, is the direct result of the COVID-19 concerns spreading across the globe and the spark of an oil price war among OPEC producers. How long will this last? What investment actions should be taken in light of this drop? There certainly appears to be more questions than answers right now.
Impact of rate changes
When the market peaked in November 2018, it began a process of leading the Fed to lower rates, a pattern that occurred twice between 2000-2010. In both those cases, the 10-year Treasury dropped 500 basis points (bps). Repeatedly during the past 30 years, the Fed demonstrated that their dot plot suggestion matters much less than the market consensus. When the market priced in further easing, consistently the Fed eased.
After three cuts in 2020, the current flight to safety accelerated the drop to lower yields. With the FOMC’s decision over the weekend to cut rates to zero and pump an additional $700 billion of liquidity into the system, we will be in a low interest rate environment for the foreseeable future.
Understanding economic shocks
Is the COVID-19 pandemic similar to a 9/11 or Great Recession economic event? Fair question this morning, given the societal changes and monetary responses. Though the Fed was very accommodating following 9/11, the economic pace did not slow. However, the Great Recession impact was deep, long and only recently did GDP stabilize at the 2% level. This distinction is key. Whether the bottoming of rates is short-lived or not, this fundamentally impacts the duration you should be seeking on both sides of the balance sheet.
Along with the investment yields dropping, funding costs also dropped incredibly quickly. Whether you tap the wholesale funding market for short or longer duration instruments, this will largely be dictated by your cash flow dynamics and your rate anticipation. Even if you are not currently tight, this could be a worthwhile consideration at the historically low levels.
UMB’s approach: credit quality, municipal bonds and mortgage-backed securities
Working in the bond department at UMB provides many opportunities to discuss interest rates. None perhaps more so than the past few weeks. So, what do we buy? How do we invest at the bottom? At UMB, we start with credit quality, and then try to find value on the rate of interest, or given quality. As Benjamin Franklin said, “The bitterness of poor quality remains long after the sweetness of low price is forgotten.” We keep this in mind when recommending securities. BQ bonds, MBS, CMOs, GSAs and CDs all add to the options we offer.
One asset class that is often missed is taxable municipal bonds. They are a muni just like any other you may have in your portfolio with the exception that they are taxable. We have found value in taxable municipal bonds where they are out-yielding their exempt counterparts on a taxable equivalent basis. Yes, you will have to pay taxes, but you are going to make more money above and beyond your tax rate.
If you prefer exempt municipals, then we would look at a high coupon, callable municipal with a long final, perhaps as long as 15 years if the right coupon can be found. When considering a long municipal, we look at credit first and foremost, followed by coupon and structure. A 4% exempt coupon has historically been a good bond to have. The taxable equivalent rate for a par bond at 4%, even at the C-Corp is ~+100 bps above the coupon in the 5% range. The concept behind a high coupon callable with a longer final is to outperform the market and hedge against rising rates. Think of these like you would an old fashioned agency step-up.
MBS products may also prove useful. While prepayment risk remains as we approach the possibility of negative rates and zero rates (NIRP & ZIRP) mortgages, MBS could be a good option with spread to treasuries. Low coupon pools and seasoned pools would be a good conservative option, along with the new issue market, that should in theory be current to market and perhaps less sensitive to rate movements.
As a large financial institution, UMB Bank’s Investment Banking Division can provide access to a comprehensive suite of solutions. From market data and robust technology platforms, to fixed income sales and insightful modeling, your full-service UMB Bank experience provides support that’s relevant to you, with relationships that last for the long-term.
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Craig Sutherland and Stephen Dumont