On February 1, during its first meeting of 2023, the Federal Open Market Committee raised its target range for the federal funds rate another 0.25%, to 4.5% to 4.75%. At the beginning of 2022, this benchmark hovered around zero percent. The latest announcement had something for everyone.
Inflation hawks saw it as a signal that the Fed is serious about fighting inflation and will continue to hike interest rates … at least for the near-term. Meanwhile, doves saw it as a signal that the worst of the increases is behind us, and future increases will be more measured. Specifically, the FOMC noted, “Inflation has eased somewhat but remains elevated …The Committee is highly attentive to inflation risks … Ongoing increases … will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.”
Most observers believe the Fed will announce another hike at its March 22 meeting, when it may remind us that future increases will be “data dependent.”
So what does this mean for bond portfolios?
It has shifted our thinking somewhat and made us more bullish on government sponsored enterprise (GSE) debt.
In recent columns, I have highlighted the relative value that can be achieved from investing in individual bonds, especially intermediate-term corporate bonds. I also pointed out that we are staying on the shorter end of the intermediate range, focusing new money in the two- to six-year maturity range. While we still find this range attractive, we have seen a major dislocation in the fixed-income markets that we believe was caused (at least in part) by the Fed’s efforts to wind-down its $9 trillion balance sheet.
These efforts have pushed spreads on many GSE issues to rival — and sometimes exceed — spreads on investment-grade corporate bonds. As a reminder, GSEs are private entities created by Congress to increase the flow of credit in certain areas of the U.S. economy. While they are not explicitly backed by the full faith and credit of the U.S. government, senior GSE debt shares the U.S. Government’s credit rating. This is currently Aaa (according to Moody’s) and AA+ (Standard & Poor’s). The rating agencies currently rate GSE subordinated debt as Aa-/AA-.
Investors can choose from a number of GSEs including:
- The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) provide assistance to the secondary market for residential mortgages.
- Federal Home Loan Banks (FHLB) help thrift institutions, banks, insurance companies and credit unions provide financing for housing and community development.
- Farm Credit System institutions, which include the Agricultural Credit Bank and Federal Farm Credit Banks (FFCB), provide financing to agriculture and are regulated by the Farm Credit Administration.
- The Federal Agricultural Mortgage Corporation (Farmer Mac), a subset of the Farm Credit System, provides a secondary market for agricultural real estate, loans for rural housing and utilities, and loans guaranteed by the U.S. Department of Agriculture.
Each of these issuers can be considered separate and distinct for diversification (or concentration) purposes. Here we will focus on the agency bullets (defined maturities), not the mortgage pass-throughs (collateralized mortgage obligations, or CMOs).
Here are some other factors to consider regarding GSEs:
Liquidity
U.S. Treasury debt is the most actively traded security in the world. Generally, multiple dealers will have active quotes going at the same time. Outstanding GSE debt is collectively estimated at $5 trillion, compared with about $31 trillion for the U.S. Treasury market.
But although GSE debt is widely held and frequently issued, it isn’t as liquid as Treasury debt. Therefore, as with most corporate debt, advisors should plan to hold these bonds to maturity, and may want to keep an allocation to money markets or short-term bond funds to meet liquidity needs.
Risk of Loss
Although GSE securities are highly rated, they do not carry an explicit guarantee from the U.S. government and have greater credit risk than treasuries. Fannie Mae and Freddie Mack suffered significant losses on their mortgage holdings during the Great Recession and were placed into receivership by the government, but the bonds paid off. As a result of the market stress caused by the sub-prime and other questionable lending practices at that time, a number of steps have been taken to improve the underlying credit quality. This includes higher lending standards, a reduction in loan-to-value ratios, and tougher controls on the appraisal process.
Taxation
All GSEs are taxable at the federal level. However, a number of them [including FHLB, FFCB, Tennessee Valley Authority (TVA), Financial Corporation (FICO), and Resolution Funding Corporation bonds] are exempt from state and local taxes. Fannie Mae, Freddie Mac, and Government National Mortgage Association (Ginnie Mae) bonds are taxable at the state and local level.
This can be another (often overlooked) client benefit — especially for those clients that reside in high tax states.
Positioning
Generally, we tend to favor individual bonds rather than investing in a bond mutual fund for most clients. This is especially true in a rising rate environment. While we believe most of the Fed’s interest rate hikes are behind us, we could see the Treasury yield curve flatten as investors come to realize the Fed will likely not be lowering anytime soon. This flattening could be bearish for intermediate term fixed income regardless of whether it’s held directly or through a fund or ETF.
However, by owning the actual bond, investors have the security of a firm maturity date and can potentially reinvest those proceeds at higher interest rates in a rising-rate environment. Plus, the current spread between GSEs and Treasuries is wide by historical standards. It may be possible to get a similar yield to corporates while increasing the credit rating of the portfolio.
Finally, adding GSE debt to your client portfolios can help diversify them beyond corporate equities and/or corporate bonds. In many cases, clients are exposed to the same issuers and industries on both the equity and fixed-income sides of their asset allocation.
Final Thoughts
Most of the new issues we have seen — corporate and GSE — are coming to the market with calls in the one-year-or-less range. We recently purchased a 5-year new issue bond at 6%. It was called three months later, and the same issuer has come out with a similar offering at 5.5%.
The takeaways: Pay attention to the yield to worst (YTW) and make sure you are comfortable with it, as well as with the yield to maturity (YTM). Keep a close eye on your client accounts for maturities and calls. We believe interest rates will likely be volatile for the foreseeable future.
As a result, fixed income could be a much more active vs. the buy-and-hold days of the past. But fixed income is where advisors can possibly add value to their client accounts. If you have a question about bond management, feel free to reach out to me.
Christopher Baccella, CFA, a wealth advisor with Mariner Wealth Advisors, develops personalized wealth management solutions for clients to help them achieve their goals and to grow and protect their wealth, and provides investment management services to institutional clients. Chris has over 16 years of experience in the wealth management industry. He can be reached at chis.baccella@marinerwealthadvisors.com.
