Chandler Bond Market Review

An Investor’s Perspective On The Contracting Agency Sector

Five years since the historic announcement by the US Treasury in September 2008, Fannie Mae and Freddie Mac remain in conservatorship, essentially a division of the US Treasury. The conservatorship status served to shore up investor concerns about the credit worthiness of both Fannie Mae and Freddie Mac, and yields on their respective securities responded in kind. How to ultimately wind down the aforementioned Agencies has been a controversial topic within the United States government since the financial crisis. Many proposals have been put forth by both the President and Congressional leadership over the past several years, but a clear end-game is not yet evident. The latest bipartisan proposal, titled Housing Finance Reform and Taxpayer Protection Act of 2013, was put forth by Republican Senator Bob Corker and Democratic Senator Mark Warner on June 25 of this year, but little  progress has been made since. Both Fannie Mae and Freddie Mac remain an integral part of the mortgage market despite the impact the conservatorship status has had on each. We do not anticipate any legislation gaining enough bipartisan support to wind down the Agencies over an intermediate time horizon (3-5 years). 

At Chandler, we focus our investment process around three tenets: safety, liquidity, and yield, in that order. Many of our clients have investment mandates that require them to invest in securities that have a final maturity of less than five years. To illustrate the changing market dynamics, particularly in the Agency sector, we  analyzed a time series of three high quality market indices in the 1-to-5 year maturity range to better illustrate how the market has evolved (see chart).

Market Value Percent

 

The Agency sector of the market has decreased materially, currently representing only 8.2% of the respective  market benchmarks (as of 9/30/13) versus 23.0% on 12/31/08. The Credit component of the benchmark has held relatively stable, while the Treasury portion has increased from 51.6% of the benchmark as of 12/31/08 to 67.0% as of 9/30/13. Historically, investors have gravitated to the Agency sector of the market to pick up a modest amount of incremental yield and potential return with a negligible uptick in credit risk. Chandler Asset Management is not beholden to the Agency sector but rather is an advocate of having a diversified portfolio that includes an allocation to the three above mentioned sectors as well as other fixed income assets that meet the tenets of safety, liquidity, and yield. In the past, we have written about the benefits of the Credit sector (see January 2012 article, Investing High Quality Portfolio in a Low Rate Environment and September 2012 article, Considerations for Moving Down in Corporate Credit Quality) and still find the overall yield benefit of the credit sector compelling, however, the focus of this article is concentrated on the Agency sector.

The team at Chandler broke down the components of the Agency 1-5 Year universe into two primary components, non callable (bullet) versus callable issuance (see table below). We theorize that due to the insatiable demand for Agency securities coupled with the decreasing amount of supply, the Agency sector is able to issue securities that investors may be mispricing, particularly in the more complicated callable component of the market. The table does not incorporate all Agency issuance available, but rather the focus is only in the index eligible deals (minimum 250m in par). We acknowledge there is substantial issuance that does not meet the minimum index inclusion criteria however in practice we would also argue the smaller deal sizes negatively impact liquidity from an investor’s perspective.

Agency Indices

As of 9/30/13, the bullet component of the Agency universe was 76.1% versus 23.9% for the callable component, the highest amount of callable securities in the universe since 12/31/08, but below the 25.9% as of 12/31/07. Based on the data set provided, callable issuance has been on a modest upswing as we believe Agency issuers find the callable market attractively priced. In our view the Relative Comparison portion of the table  provides some valuable insight investors need to be cognizant of. In six of the seven periods cited an OAS (Option Adjusted Spread) advantage is evident in the callable  component and in all seven periods the callable component has a higher effective yield versus the bullet universe. Typically, a wider spread and greater yield would over time produce a total return advantage, but based on the index return data this is not the case in all seven periods cited. In all periods, the total return from the bullet universe is greater than the callable universe.

Other data in the table help us confirm that investors need to be especially vigilant in evaluating callable securities so as not to be susceptible to chronic underperformance versus bullet securities. We highlight a few data points of particular interest:

  • 12/31/09 – Despite an OAS advantage of 50 basis points for callable securities the following year the total return of the callable universe was 2.298% below that of the bullet universe.
  • 12/31/10 – Despite an effective yield advantage of 0.31%, the following year the callable universe underperformed the bullet universe by 0.949%.
  • 9/30/13 – The effective duration of the callable universe increased to 2.05 versus 1.37 at year end, highlighting the extension risk of the callable universe and implying investors heavily exposed to the callable sector were likely constrained to buy cheaper fixed income assets when the markets re-priced yields wider in the 3rd quarter of 2013.

Chandler is not advocating that a high quality portfolio have zero exposure to callable  securities. In practice the team has had a difficult time identifying securities that are attractively priced relative to the potential  extension risk embedded in a callable security and we think the data presented above supports that conclusion. Chandler continues to advocate well  diversified portfolios by sector, credit quality, and structure, and we caution investors about the negative implications due to the changing demand and supply dynamics of the Agency sector.

  

– William Dennehy II, CFA
          SVP, Portfolio Manager

 

 

 

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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