1% for 15 years?

We have been grappling with low rates for quite some time, and the prospect for higher rates seems to be postoned further with each passing news story. So, what’s a bond investor to do?  Short term interest rates are near zero (the 1yr US Treasury pays just 0.18%), and extending maturity for another 9 years gets you a 10 year investment that yields just 1.8% – not exactly what you’d want to do if you think higher rates are possible within that timeframe.

Enter the 1% 15-year bond (or FNMA 1% 8/13/27, CUSIP 3136G0UF6, to be exact).  The trade confirm you receive will have this simple, but inadequate, description listed, and that can raise an eyebrow or two.  What the typical trade confirm won’t tell you is that this bond has an interest rate that increases over time.  The graph below shows how the coupon rate (blue line) steps-up: a modest amount every 6 months, but eventually a larger jump every year followed by a stable rate of 6% for the last 5 years of its stated maturity.

 

 

 

 

 

 

 

 

 

 

 

Of course, the bond market giveth and the bond market taketh away, so the other wrinkle in this bond is the ability of the issuer to buy the bond away from the owner each quarter at par value.  That can make planning a bit challenging, because the bond you thought you’d own for years could be gone in just 90 days.  To take a closer look at how that effects this bond, the green line shows what your yield would be along the way for the next 15 years at each point that the bond could be called away.  If we look out 15 years, we see that the yield on this bond would be a bit better than 4% – not too bad when compared to a 15-year US Treasury investment yielding 2.3% (purple line).  If we look at dates a bit closer in, we see that the yield is at its lowest point – 1.5% – about a year from now.  In other words, if the issuer elected to repurchase our bond at $100 in October 2013, we would, in effect, have owned a one year bond yielding 1.5%.  Again, that’s not too shabby considering a one year Treasury today yields just 0.18%.

To be sure, there is no free lunch, so it is instructive to think about what could go wrong with this picture.  First off, this bond, while having the same rating as a US Treasury note, is issued by the Federal National Mortgage Association (Fannie Mae).  You’d expect to get paid a bit more for something that is a step removed from a US Treasury, even if the ratings are identical.  Second, a bond that takes some explaining to understand, like this one, typically pays a bit more to its holder.  And then there is the matter of how interest rates behave over the next 15 years.  Does the blue line in our graph above represent the way interest rates will actually move over time? Almost certainly not.  If rates increase much more quickly than the blue line above does, then the price of this bond will be hurt, indicating you might have done better investing in a bond with a different structure.  But if rates remain low, then the issuer is likely to repurchase the bond (“call” the bond) in the next year so Fannie Mae doesn’t have to pay you the higher rates shown by blue line.  If that happens, then you owned a one year bond yielding 1.5%, and there are plenty of things out there that are worse than that.

August Conerly Charts

View the latest charts and comments on the U.S., Oregon, and Washington economies from Dr. Conerly of Conerly Consulting.

We are pleased to re-post Dr. Conerly’s August charts for our clients. Please see his site for more data and comments: www.conerlyconsulting.com. Click the images below for larger versions.