Banks make spread income—the difference between assets, loans and securities and the cost of deposits—by taking three risks: duration, convexity and credit. These risks apply to both the loan and investment portfolios, and you must decide which and how much of these risks to take when making your investments.

In a flat or inverted yield curve environment, adding duration can be a beneficial strategy. As the yield curve steepens from continued fed rate reductions, you could be locking in yields today and avoiding a reinvestment at future lower rates. The key is to add duration in bonds with low prepay or call risk (negative convexity), or at least have lockouts for considerable periods. And, while banks typically prefer to take risk in their loan portfolio, there can be a role for some credit risk in the bond portfolio if enough value exists.

Below are 10 ideas that may help balance duration, convexity, and credit in today’s tough bond market.

Options in non-mortgage-backed securities

  1. Long-tenor municipals, cushion and non-cushion

For banks that can add duration, longer-tenor (time-to-maturity) municipals still represent value. While tenors five years and shorter are very expensive, longer-tenor general obligation (GO) municipal bonds (for instance, those with finals of 10 years or longer) still offer relatively high yields and cashflow lockout. Given the almost zero historical default risk in A underlying or better rated GO municipal bonds, and a 20% risk weight, municipals offer real value. This is particularly true for banks that can buy non-bank-qualified municipal bonds by placing them in an investment subsidiary. Noncallable bonds have positive convexity and the ability to roll down the curve.

You may think buying a 20-year final maturity or longer municipal bond is too aggressive if rates end up moving higher in the future rather than the forecast downward trend. If you want to limit that risk, you can buy cushion municipal bonds—bonds at high premiums—which almost ensures the bonds will be called. While you will give up quite a bit of yield between a 20-year, 10-year call, non-cushion municipal bond versus a cushion municipal bond, the cushion option still offers relative value.

  1. Municipal gains inside of 5 years

If you are borrowing or need liquidity, you can also look to sell shorter-tenor municipal bonds into the strength of that part of the municipal market (inside of 5 years). If you don’t need liquidity, you could do a swap generating gains, extend out the curve and buy back an even higher book yield than you sold. This is effectively a hedge against a lower-for-longer environment.

  1. Corporates: 5-year and BBB

For those banks that have sufficient risk-based capital and may not want to take on as much duration, corporates have value and positive convexity, especially when compared to MBS alternatives. If you are willing to dip down to the BBB rating space, you can get MBS-comparable yields with positive convexity and no extension risk. While many corporate bonds have call features, they are typically what are known as make-whole calls, which are callable any time using a formula that almost always makes it prohibitive for the issuer to call the bonds.

You may question buying corporates if we are going into a recession, which is why you have to underwrite each issuer and stay within 5 years in tenor to limit event risk, which also keeps their durations relatively short.

Options in mortgage-backed securities

  1. Lower-loan balance MBS

Agency MBS securities provide spread versus non-MBS agency bonds, and cash flow for reinvestment if our rate view is wrong and rates start rising. They are also pledgable, and, while they have negative convexity, the borrowers are less sophisticated about prepaying than the Federal Home Loan Bank (FHLB) would be in calling a bond from you. Ways to manage that prepayment risk include buying MBS with lower loan balance loans comprising the underlying collateral. Bonds with maximum balances of $110,000 to $150,000 should pay more consistently and be less likely to prepay than larger loan balance MBS bonds.

  1. New York MBS

One particularly good example is bonds backed with New York mortgages. This is because there is a mortgage recording tax which averages 1.25% of the loan balance, but can be much higher, that is assessed each time a borrower refinances. This gives bonds backed with these loans steadier prepayment profiles making them act like pools with low loan balance collateral.

  1. Bank loan servicers versus non-bank servicers

Another way to manage prepayments is to target MBS bonds with bank servicers versus non-bank servicers. History indicates that bank-serviced loans are slower to prepay compared to non-bank serviced loans, because the latter is more aggressive in contacting customers to refinance.

  1. Lower-coupon MBS

Target lower coupon bonds to limit the amount of premium paid. These bonds will underperform if rates rise, but they will have less yield exposure should prepay speeds be faster than you anticipated at purchase. While you would have the negative of increased cashflow to reinvest in a lower rate environment, at least your holding yield wouldn’t suffer as much as with higher coupon bonds. This way you can avoid one of the two negatives that MBS bonds have as rates fall.

  1. Delegated underwriting and servicing (DUS)

DUS bonds are agency-backed bonds, typically with a single apartment complex as the underlying collateral. They are excellent at providing protection from prepayment, have positive convexity, and ability to roll down the curve. The negatives are they have longer durations because they have a 10-year balloon, and yields have compressed greatly over the past few months.

  1. Government National Mortgage Association (GNMA) project loan collateralized mortgage obligations (CMO)

GNMA project loan CMOs are backed by multiple apartment projects typically, offer more yield and zero risk-weight, but they have longer tenors. Notably, you need to be able to model the different tranches and accept their profile if they pay much slower than conventionally traded.

  1. Lastly, review your current holdings for MBS bonds with weighted average coupons (WACs) at risk of paying fast.

What happens to those prepay speeds and projected yields at down 50 basis points (bp) or down 100 bp, and/or when your WACs become 50-100+ bp in the money? You might be able to sell the poor performers at gains and reinvest in a lower coupon, more yield-stable bonds.

These can be starting ideas for you and your institution as you look ahead at portfolio management in a lower-for-longer rate environment. Carefully consider duration, convexity and credit risks when selecting your investment strategy. For more details, watch the recording of our recent webinar on this topic.

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Important disclosures

This communication is provided for informational purposes only. UMB Bank, n.a. and UMB Financial Corporation are not liable for any errors, omissions, or misstatements. The investments mentioned here may not be suitable for all investors. This is not an offer or solicitation for the purchase or sale of any financial instrument, nor a solicitation to participate in any trading strategy, nor an official confirmation of any transaction. The information is believed to be reliable, but we do not warrant its completeness or accuracy. All opinions represent our judgments as of the date of this material and are subject to change at any time without notice. Past performance is no indication of future results. The numbers cited are for illustrative purposes only.  The opinions expressed herein are those of the author and do not necessarily represent the opinions of UMB or UMB Financial Corporation. Products offered through UMB Bank, n.a. Investment Banking Division are:  Not FDIC Insured |  May Lose Value | Not Bank Guaranteed.