Independent Banker - June 2020 - 31

Next: An unprecedented grassroots effort on the PPP
reaction was for spreads to widen on anything a community
bank would own. These spreads stayed historically wide for
more than a month, until the Fed was able to buy up enough
of the existing supply to get yields more in line with longer-term
averages.
This, essentially, was a repeat of QE 1 from more than
a decade ago, which lasted from November 2008 through
March 2010. Back then, the Fed bought $100 billion in
agency debt and $1.25 trillion in mortgage-backed securities
(MBS). The reasoning for this action in the previous
crisis was that there was market disruption unrelated to
default risk that needed correcting. All of the Fed's purchases
in QE 1 were investments that were, at a minimum,
conditionally guaranteed by Uncle Sam, but still had yields
The squeeze play being
executed by our central bank
could once again subsidize
borrowers [and] provide a
floor for bond prices.
more in line with bonds containing de facto credit risk.
Just as in 2010, the purchases this time around did get
spreads more normalized. For example, a simple five-year
agency bullet had a spread of 31 basis points (0.31%) as of
April 9. By the end of April, it had shrunk to .25%, which is
still wider than normal but likely to tighten further. However,
there were several other sectors this time that got the
Fed's attention: municipal bonds and commercial MBS.
Retail investors in the municipal bond market were
spooked by the growing pandemic. The week of March 2 was
the first in five years that saw net outflows in muni bond
funds, and that trend continued for six weeks. Only after the
Coronavirus Aid, Relief, and Economic Security (CARES)
Act was signed into law did the bleeding stop. Still, spreads
were enormous for several weeks, even for solid investment-grade
general obligation (GO) paper and remain wider
than normal. On April 9, the Fed announced a Municipal
Liquidity Facility (MLF), which will purchase $500 billion
in short-term notes from eligible issuers in terms of up to
two years. That week, 10-year munis saw their raw yields
fall 43 basis points.
Commercial MBS have recently been featured in this column
several times, and their place in the mortgage market
Education on Tap
Webinar series segment this month
ICBA Securities and its exclusive broker, Vining
Sparks, host the next segment of their 2020
Community Banking Matters webinar series on
June 2 at 10 a.m. CDT. Kevin Smith will present
Mortgage Market Update and Opportunities, which
will discuss in more detail this column's topic. Visit
viningsparks.com to register.
Coronavirus chartbook
Vining Sparks' economists are compiling and
updating a set of slides about the pandemic, its
effect on the domestic economy, and the fiscal and
monetary policies enacted in response. To access
your copy, contact your Vining Sparks sales rep.
continues to grow. That sector also saw dramatic widening
in March until the Fed started gobbling up a lot of the Freddie
K's, Delegated Underwriting and Servicing (DUS) bonds
and Fannie Mae ACES in the secondary market. An element
that affected MBS yields was the near-universal refusal by
mortgage lenders to cut their posted rates, even after the
Fed had cut rates to near zero. There was about a four-week
period after the drastic actions by the Fed before even a
modest drop in mortgage rates.
Relative value can be found
So, we find ourselves here in midyear with several conundrums.
Yes, yields are certainly lower than the start of the
year, but so is your cost of funds. Yes, your portfolio's duration
is probably shorter than ideal, but the curve has some
steepness, so at least there is some reward for strategic
extension. Yes, spreads have narrowed from their yawning
gaps in the spring, but that means some liquidity has
returned to the market.
It says here that past performance is no predictor of future
results. But if we have some slowly improving yields out of
the Treasury market in the second half of 2020, accompanied
by slowly narrowing spreads, then the securities owned
by the typical community bank should see some stability in
their market values. Actually, that's essentially what happened
during the QE phases in the past decade. The squeeze
play being executed by our central bank could once again
subsidize borrowers, while, at the same time, provide a floor
for bond prices.
independentbanker.org Q 31
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Independent Banker - June 2020

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