Twisting the Fed Away

Today, the concern of the Fed for our economy was shown through actions dubbed Operation Twist in the popular press.  Citing “significant downside risks to the economic outlook,” the Federal Reserve Open Market committee today announced they would enter the bond markets and start buying $400 billion of bonds with maturities of between six and thirty years.  To provide the cash to make these purchases, the Fed also announced it would be selling $400 billion of bonds it already owned with maturities of less than three years.  Hmm – selling bonds and buying them back again? What gives?

The Fed is charged with fostering maximum employment (measured by the unemployment rate) along with price stability (measured by inflation).  This is also a good description of what the US Congress wants, but each of these groups comes at the problem with different tools.  The Federal Reserve has at its disposal the amount and price of money in the financial system as its tools, and today it announced that it wasn’t satisfied with the price of money, specifically the price (read: interest rate) of money borrowed for longer than six years.  The mechanics of how this change in longer term interest rates occurs is pretty straight-forward: the next time an investor wants to sell, say, some of his 10 year treasury notes, there will be more competition to buy that note (from the Fed), driving the price of that bond a bit higher. Since the price of a bond moves the opposite way from its yield, this higher price means the interest rate earned on that bond will be lower.  And since the opposite is true, when the Fed sells its short term bonds, the flood of supply will drive prices lower, increasing the effective interest rates earned for those bonds. The movement up of short term rates while long term rates go down is that “twist” you hear about.

The theory is that by lowering the cost of borrowing for longer periods of time, companies will take advantage of this and borrow the funds necessary to invest in their expansion. Additionally, the hope is that mortgage rates will be even lower, encouraging home buyers to step up to the plate at this time.  These may both turn out to be true, but we suspect the real goal of the Fed is to put an end to what is known in the arcane circles of the fixed income world as The Carry Trade.  Most people assume that banks make money by borrowing from depositors and lending those funds to borrowers for longer periods of time, earning a spread between the two.  While that is true generally-speaking, the Carry Trade is what occurs when a bank borrows from depositors at cheap rates and uses those funds to buy treasury notes instead of lending them to commercial borrowers.  For example, at the beginning of this year, banks could borrow money from you and me at cost of somewhere between zero (think your checking account) and 0.25% (1 year CD rate).  The bank could then turn around and buy 10 year treasury notes yielding 3.36% netting a risk free return of better than 3.1%.  If you are a bank that is under increasing regulatory pressure and have a portfolio of questionable commercial loans, the Carry Trade starts to look better and better!  By implementing Operation Twist, the Fed is seeking to take much of the fun out of the Carry Trade.  If we look at the same interest rates today after the Fed announcement, one year funding may cost a bank 0.1% today, but the ability to invest it into 10 year government bonds yields them 1.85% for a net benefit of just 1.75%.  That change may not seem much to you and me, but that’s actually a 43% drop in net interest income, and any bank that showed that for its quarterly report would soon show its CEO to the door.

To be sure, the regulators are still out there ready to pounce and second-guess any number of bank credit officers, but that’s an issue for Congress to tackle.   The Fed has done what it can to encourage both borrowing and lending with the Twist.  Let’s hope it is effective.


Bond Swap

Some of you will be seeing confirmations coming in the mail from your custodian showing we have been busy buying and selling Morgan Stanley bonds recently.  In fact, many of you will see that we sold your Morgan Stanley bonds the same day as we bought you different Morgan Stanley bonds.  What gives you say?  It’s all part of a bond swap we’d
like to explain.

We’ve owned Morgan Stanley 4.75% bonds due in April 2014 for quite a while, having bought most of them at a nice discount during the crisis times of 2008.  These particular bonds are subordinated to most of the other Morgan Stanley bonds, meaning they rank lower in payoff priority.  However, they are still a high-quality bond, with an A3/A- rating from S&P and Moody’s.  We were content to hold this bond until maturity, especially in light of the extraordinarily low rates offered in the market today.

However, Morgan Stanley came to market this week with a new bond that caught our eye.  This bond is known as a fixed-to-floater bond – a bond that has a fixed rate of interest for a period of time followed by a period when the interest paid floats up and down based upon market conditions.  In this particular case, this bond pays a fixed 5% for the first year.  That’s a nice 0.25% bump up from the 4.75% paid on the Morgan Stanley bond we sold. This new bond also ranks higher in priority, so it carries a rating of A2/A – a notch higher than the other bond.  The icing on the cake is that we were able to sell the MS 4.75% bond at a price of $101 and buy the new, higher-rated, higher-paying bond at $100.

How is it possible to get a higher-paying bond from the same issuer with a better rating and pay less for it?  As you might (should!) suspect, there is no free lunch.  As we mentioned above, the new bond is a fixed to floater bond, so the 5% coupon payment is only fixed for the first year.  After that, the bond will pay interest quarterly (most bonds pay semi-annually) based upon what the 3-month LIBOR rate is plus 2% all the way until this bond matures  four years from now.   Today, 3-month LIBOR is just 0.33%, so the rate we receive could drop to just 2.33% if LIBOR stays the same until next year. However, we do get some protection from that happening, as the bond has an interest rate floor of 3%.  Of course, it’s hard to predict interest rates (or stock prices, for that matter) on a short term basis, but we like the idea that this new bond will pay us 3-month LIBOR plus 2%.  Below is a chart of the last 5 years of 3-month LIBOR rates:

As you can see, 3-month LIBOR is as low as it’s been.  That’s been true for just about interest rates of all types, and the press is starting to print stories about the Bond Bubble some believe exists.  Does that mean rates are about to go up significantly? Not necessarily, but the longer we stay in these economic doldrums with startling-low interest rates, the closer we are to resuming reasonable economic growth and, with that, higher interest rates.  All in all, we think the opportunity to profit from the sale of our 4.75% bonds and upgrade the credit quality of our portfolios was worth some uncertainty of future interest payments.  Time will tell.