Is the Curve Going to Flatten?
Why it does and what to do about it
By Jim Reber
Before we get too deep into this investment column, I’d like to be on record that I’m not predicting
anything about interest rates. Not that they’re going higher, not that they’ll be range-bound, not that this
so-called curve flattening is about to happen.
Nonetheless, it is probably a good time to talk about the consequences that accompany these what-ifs.
The Fed continues to make noises about removing the “accommodation” when the totality of economic
data justifies it. The data, at least domestically, continues to report at least decent performance.
Moving horizontally
There are numbers that prove the yield curve for government and federal agency bonds flattens as rates
begin to rise. The yield curve, as we recall, is the graphic display of the yields for various maturities of
a given borrower, ranging from very short (e.g., overnight) to very long (10 years or more). When the
difference in “short” and “long” shrinks, we say the curve “flattens.” As it’s been more than a decade
since the Federal Reserve last began a rate hike cycle (in June 2004), we may have forgotten why this
occurs. The answer is really two-pronged.
First, short-term high-quality investments have always had yields that are tied to overnight rates. The
global benchmark overnight rate is Fed Funds, which is what banks domestically charge each other for
short-term loans. The Federal Open Market Committee, a subset of the Federal Reserve Board, sets the
rate. (As an aside, Prime rate in the U.S. is almost always exactly three percent (3.00 percent) higher
than Fed Funds.) The normal difference, or “spread,” between the yield of Fed Funds and the two-year
Treasury note is about 25 basis points, or 0.25 percent.
Secondly, longer-term investors, which include community banks but are primarily non-depositories,
don’t really care what the Fed is doing to manipulate short rates. Since the value of longer investments
can swing wildly with changing rates, those investors are fixated on expected inflation. Ironically, the
more aggressively the Fed tries to stamp out inflation by raising rates, the more likely it is that the longtimers will get their desired real (net of inflation) returns. Over the last 20 years, investors in 10-year
Treasury notes have demanded a yield of about 2.50 percent over inflation.
To complete the thought, the higher short rates go, the more insulated (against inflation) bonds are, so
longer-term buyers don’t demand higher yields. The result is a flatter yield curve.
Values added
Back to the current environment. Many community bank portfolio managers have instinctively held
back some liquidity, in anticipation of better returns soon. Most of them have been disappointed that
rates have been pretty much unchanged over the last 18 months. Some of these same investors are now
wondering if yields are going to only trickle higher, leaving earnings essentially unchanged.
Perhaps a middle ground to ponder is an investment with all these features:
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Acceptable current yield
Monthly cash flow
Moderate premium
Low risk weighting and good liquidity
Ability to rachet higher in yield in near future
Such an investment exists in a hybrid adjustable-rate mortgage (ARM). These instruments have a fixed
rate for a period, and eventually will begin floating annually. The ARMs with the fixed periods which
seem to offer reasonable value are those that begin floating in 48 to 72 months. An example is FNMA
849359.
This bond will have a stated rate of interest (“coupon”) of 2.00 percent until June 2020, when it will
begin to float annually. From then on, it will adjust to the 1-year LIBOR rate plus 1.67 percent, which
today would be 2.38 percent. In other words, this ARM is not fully indexed at this point. Other benefits
are that it has a tolerable premium price (about 102.00), generous annual caps (2.00 percent), and an
attractive loan count of more than 200 loans.
The real tale of the tape is its yield until the reset date of about 1.50 percent, with an effective duration
of only 2.4 years. Most bond analysts would conclude that this has a very attractive risk/reward profile.
And, it has a reasonable chance to perform well when (or if?) the yield curve flattens. As always, be
sure to have your broker demonstrate the pro-forma prices in a variety of future interest rate scenarios.
Curve flattening? I don’t know any better than you. But I know that some well-structured hybrid
ARMs won’t be your biggest problem if that happens.
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Jim Reber is president and CEO of ICBA Securities and can be reached at 800-422-6442 or
jreber@icbasecurities.com.