Credit Alternatives in government-backed debt

By Carl W. Pappo, CFA, Head of Core Fixed Income and Garritt Conover, Analyst

The U.S. financial markets have undergone a strong recovery over the past several years, with returns to risk assets and credit spreads reaching impressive levels unseen since 2007. In environments like this, it is common for fixed-income investors to “reach for yield,” as opportunities dry up and they are forced to assume additional credit risk to reach performance targets or maintain income levels. As credit spreads have been driven in, however, risk premiums paid to investors have reached a historically low level.

One way investors may boost yields without taking on undue credit risk is through government agency debt, which fills a niche in the market between high-quality spread product and low-risk Treasury securities. Through explicit or implicit guarantees, timely principal and/or interest on agency debt ultimately may be backed by the U.S. government. Many investors associate U.S. agency debt with very low yields; indeed, the U.S. agency sector in the Barclays Aggregate Index — made up largely of Fannie Mae, Freddie Mac and Federal Home Loan Banks debt — only out-yields Treasuries by 12 basis points. However, there are other types of agency debt that can offer significant spreads to Treasuries with a modest decline in liquidity. At Columbia Management, we have been increasing our allocation to the agency market in core portfolios as a way to reduce credit risk while maintaining competitive yields. In this Global Perspectives piece, we introduce a number of the individual agency programs/structures, discuss how our core team analyzes these securities, and assess current valuations.

U.S. Small Business Administration

Established in 1953, the U.S. Small Business Administration (SBA) was formed to support — financially and through other assistance — small businesses. Key programs of the SBA include the 7(a), CDC (Certified Development Company)/504, and SBIC (Small Business Investment Company) programs.

The SBA CDC/504 program provides secured financing for the purchase or improvement of real estate and long-term equipment through 10- or 20-year loans. Assets financed through the program require three parts: up to 50% from a senior bank loan, a maximum of 40% through a junior loan from the SBA, and at least 10% equity contribution from borrower. The SBA loan not only provides a cheap source of capital, but also assists the borrower in securing attractive bank financing due to its junior position. From the investor’s perspective, the SBA portion of the loan is guaranteed by the full faith and credit of the U.S. government and, thus, has minimal credit risk. The risk to the investor is of prepayment, as the loans have a prepayment option by the borrower. However, investors are paid a declining premium during the first half of the loan term, partially mitigating this risk. Loans are pooled into debentures and issued to the public market on a monthly basis.

CDC/504 debentures offer an attractive alternative to non-agency CMBS. They make up a $25 billion market and can offer spreads of up to 70 basis points (bps) under our proprietary default and prepayment model. The 20-year debentures have amortizing structures with an average life of seven years. AAA-rated collateralized mortgage-backed securities (CMBS), by comparison, offers spreads of 70–75 bps for a security with similar average life.

Resolution Funding Corporation

The Resolution Funding Corporation (or REFCORP), established in 1989, was created to finance the bailout of savings and loan associations during the S&L crisis of the 1980s and 1990s. S&Ls accept savings deposits and use the proceeds to offer mortgages, auto loans, and other personal loans to their members. During the crisis, nearly a third of the 3,234 S&L associations in the United States failed. REFCORP provided liquidity to S&Ls through the issuance of bonds.

While there is no explicit principal guarantee on REFCORP bonds, Treasury strips must be held to defease the liability on each maturity date. At maturity, REFCORP bonds are repaid with the proceeds from the maturing Treasuries. Interest payments are backed by the full faith and credit of the U.S. Treasury.

REFCORP securities offer an attractive alternative to high-quality financials. REFCORP currently has $30 billion outstanding, with bonds stripped into their principal and coupon components. Five-year zero coupon REFCORP bonds currently offer spreads of 30–35 bps over Treasuries, while higher quality financial institutions trade around 50 bps.

Export-Import Bank of the United States

The Export-Import Bank of the United States, established in 1934, assists in financing the export of U.S. goods to international markets when private lenders are unable or unwilling to accept the risk. The Ex-Im Bank provides working capital guarantees, export credit insurance, loan guarantees and direct loans. Over its history, the Ex-Im Bank has supported over $550bn exports, covering industries such as aircraft, energy, construction, mining and medical equipment.

Principal and interest on the Ex-Im notes are guaranteed by the Ex-Im Bank, which is backed by the full faith and credit of the U.S. government. Notes are subject to prepayment risk from optional calls or termination of underlying lease agreements (for example, loss or seizure of an asset). In the case of optional calls, a make-whole premium is paid to the investor, but the premium is not guaranteed by the U.S. government. Additionally, the Ex-Im Bank has been subject to controversy about its impact on competition between foreign and U.S. businesses. Regardless of the outcome, however, the Ex-Im Bank guarantee is backed by the full faith and credit of the United States, and it is unlikely the government would not honor these existing obligations.

Ex-Im Bank guaranteed notes may offer an attractive alternative to corporate debt. They make up a $15bn market and can offer spreads of 50–60 bps for an average life of 5–7 years. High-quality industrial corporates, which lack the government guarantee, are currently offering similar spreads for securities with a comparable duration.

With credit spreads approaching pre-crisis tight levels, the risk-reward for credit risk has become less compelling. The Columbia Management Core Team has taken advantage of this relationship by swapping from 5-year high-quality corporates into REFCORP securities, and from 10-year corporates and senior CMBS into SBA securities. In the current tight spread environment, government agency debt such as these may offer an attractive alternative for investors seeking to maintain yield without adding undue credit risk.

government-backed debt

Source: Barclays, as of 6/2014

government-backed debt

Source: Bloomberg, as of 6/2014

 

Any guarantee by the U.S. Government, its agencies or instrumentalities applies only to the payment of principal and interest on the guaranteed security and does not guarantee the yield or value of that security.