Portfolios & The Rising rate Dilemma

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Interest rates have fallen sharply since the beginning of the year. The primary reason for this has been sluggish growth in jobs. Despite the drop in rates, the overwhelming consensus on Wall Street remains that rates will eventually rise this year.

Most on Wall Street, including Alan Greenspan, expect jobs will eventually start to grow, which will lead to an increase in rates. Most pundits agree the Fed will not raise rates until very late in 2004 or perhaps early 2005, but the bond market will not be as patient as the Fed. Credit union investment managers who agree with this outlook will be in for a dilemma. How do I protect my portfolio against rising rates in the future without penalizing current earnings by remaining in 1% overnights while waiting for higher rates?

Many managers will simply hold more cash when expectations are high that rates will rise, but this strategy has been a failure for the last couple of years. Bond rates have stubbornly refused to rise significantly, and the rate on cash equivalent investments has fallen steadily. The penalty for the strategy has proven to be high.

Another popular strategy often used when rates are expected to rise is to buy floaters. Floaters tied to T-bills, LIBOR, or fed funds provide some incremental yield over the underlying index. But this strategy is also doomed to fail if short-term rates stay long for "a considerable period of time," as the Fed is terming the outlook. The other problem with floaters is the time commitment. In order to get that incremental yield over the index, buyers must commit for a term period of usually two to five years.

Bond Prices Could Rise

It is entirely conceivable that bond rates, over which the Fed has no control, could rise based on market expectations during that time period. Meanwhile, rates on T-bills, LIBOR, and Fed funds could remain very low as the Fed does have control over short-term rates. If this happens, the buyers of the term floaters would be stuck in the low-yielding instruments and unable to take immediate advantage of the higher bond rates. Floaters are most valuable to hold at the beginning of a certain cycle of Fed tightening and that is not the current condition.

One product that does help with the dilemma of current earnings vs. interest rate expectations is the step-up. These securities have initial coupons that periodically increase, and so the name step-up. The bonds can be structured with agencies or with, for example, WesCorp certificates. They usually can produce a yield between 10 and 20 basis points more than a comparable agency.

An example of a step-up structure is the one-time call/one-time step up. With this in mind, let's use a five-year final maturity having a two-year, one-time call/step up structure. This has a 3% initial coupon that will step up to a 5% in two years, if not called, and be a bullet for the remaining term. Compare the yields to the call date and the maturity to comparable bullet maturities.

Initial Coupon - 3%

Final Maturity - 5-years

Call/step Date - 2-years

Step-ups to (if not called) - 5%

Yield to Maturity - 4.15%

Current 2-year agency bullet = 2.11%

(pick up 89 bps)

Current 5-year agency bullet = 3.65%

(pick up 50 bps YTM)

There is a host of other step-up structures, including those using multi-steps. In these structures, the coupon of the bond usually increases every year after an initial one- to two-year period. This bond is usually callable on interest dates, which means you are sacrificing call protection. Additionally, the initial coupon on a multi-step bond is usually lower than a bond with a single step-up.

The Drawbacks To Step-Ups

Step-ups seem to satisfy the need for current earnings in an uncertain environment while still offering some protection against rising rates. Are there any drawbacks to step-ups? Absolutely. The first and most obvious drawback is the callable nature of the structure. If rates fall instead of rise, the investment manager will again be investing in a declining interest rate environment, once that bond is called. The other drawback is that while the initial coupon is significantly above the overnight rate, the rate of return for that initial coupon period will be lower than a bond with a comparable final maturity. In our example above, the step-up will earn 3% for the first two years, while the five-year bullet will return 3.65% for the first two years.

Another defensive investment structure that should be considered is the indexed amortizing structures. These are fixed rate investments that the principal will pay down based upon certain predetermined events. Agencies and corporate credit unions have issued indexed amortizing notes that are tied to the performance of specific pools of mortgages. They incorporate and reward the acceptance of mortgage prepayment risk but, importantly, have a defined maturity date-typically three to five years. This eliminates the tail risk or extension risk associated with the performance of mortgage-backed securities in rising rate environments.

Another variation would be to structure an investment where the principal will pay-down based upon reference to current interest rates-for example three-months LIBOR. As interest rates rise, the principal will pay-down providing the opportunity to re-deploy those funds in the now higher interest rate environment.

There is no perfect security for every environment. Wall Street would make a fortune (make that another fortune) if they could devise a security that floats when it needs to, and stays fixed when the time is right. But, we don't see that in the cards.

That leaves us with having to examine investment products on the basis of risk/reward and trade-offs. The step-up is not the complete answer to all portfolio woes, but it is one tool than can be an effective addition to defensive portfolio management.

Dwight Johnston is Vice President of Economic and Market Research for WesCorp.

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