Who Moved My Step-Ups?
Not so long ago, a wildly popular variety of government agency bonds was struggling to get to market fast enough to meet investor demand. Chances are your community bank owned some, or a lot, of these bonds, known as “step-ups.” Lately, the ever-changing dynamics of supply and demand have made the build-out more difficult and the attractiveness less so. Since we’re in the community banking business, and most everything we touch is somehow cyclical in nature, it bears examining why step-ups are at least temporarily on hiatus and what could spark their triumphant return.
But before we do, let us revisit the basic structure. These step-ups are issued by the usual suspects: Fannie Mae, Freddie Mac and the Federal Home Loan Bank. They have good liquidity, are pledgeable and are 20 per risk weighted, so they meet all those safety and soundness criteria. Their maturities can vary from three years to 15. Their “lockouts,” which are the periods from issue until the first call date, can be as short at three months and as long as three years. The one thing they have in common: a stated interest rate, or coupon, that will rise in the future if the bond isn’t called by the issuer.
Beyond the promise of a higher rate in the future (if the bond still exists), step-ups can have very different structures. For one, the steps can be one-time- only (which is comparatively rare), or they can be multi-steps. For another, the height of the steps can be miniscule (as small as 12.5 basis points, or .125 percent, annually) or as large as two percent annually. For still another, most step-ups can be called at any interest payment date, but a few have one only call date. Your broker should show you all the possible outcomes during the pre-purchase phase. In the end, the reason step-ups have appeal to community banks is that they provide protection against rising rates. Portfolio managers realize that they are sacrificing yield today for some potential upside later. The trick is to buy enough yield in the future to make up for the lost revenue today, which involves guesswork, as the following illustrates.
In March 2017, Fannie Mae issued a fixed rate bond that matured 3/29/2021 with a coupon of 2.125 percent. It also issued a step-up that matured 3/29/2022 with a beginning coupon of 1.75 percent. Both bonds were callable in six months, which meant September 2017. In fact, both were called, so the first investor’s holding period yield was 37.5 basis points higher for the same six months. The breakeven date was March 2020, which now will never happen.
With that as a background, let’s examine the difficulty in launching step-ups in today’s market. As short rates rise relative to longer rates, the underwriters struggle to rob enough coupon from the front end of the cash flows to make the back coupons attractive to risk-averse investors. Remember that portfolio managers are comparing fixed rate callables with step-ups, as we saw in our example. In the two years between January 2016 and January 2018, the yield curve between one and 10 years flattened 100 basis points.
To demonstrate, we can refer back to our Fannie Mae step-up from 2017. That bond, which you remember was called in September 2017, would have had a terminal coupon of 4.00 percent had it lasted five years. Today, in a much higher short-term rate environment, a similar step-up would begin with a coupon of about 2.00 percent but would have a terminal coupon of only 3.00 percent. Plenty of portfolio managers are deciding that a fixed rate callable is a better option at the moment.
Proof in the underwriting
Now let’s look at some numbers for evidence. Back in the steep curve days of say, 2011, nearly half of all agency issues had some type of stepped-up coupon structure. Even as late as a year ago, nearly a quarter of the new bonds had built-in yield protection. In December 2017, step-ups accounted for less than five percent of newly hatched bonds. Community banks in general own fewer agencies than before. In the past six years, the sector’s weightings have gone from about 18 percent of the total portfolio to about 11 percent today. I would suspect that given the continued rising demand for well-structured mortgage products and high-quality municipal bonds, and their attendant shrinking spreads, agency bonds can make a comeback among community banks especially when we see the yield curve begin to steepen. The evolution of the agency bond market will continue to respond to investor demand, and that will include step-ups.
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Cutting Edge Bond Accounting
Vining Sparks, ICBA Securities’ exclusive broker, offers full-service bond accounting at attractive prices. Vining Sparks currently performs these services for nearly 500 community banks, and a customized report menu is available. To learn more, contact your Vining Sparks sales rep or visit viningsparks.com.
Jim Reber is president and CEO of ICBA Securities and can be reached at (800) 422-6442 or