Bonds That Bounce Floaters Can Be an Answer to Higher-for-longer Rates
Bonds That Bounce
Floaters Can Be an Answer to Higher-for-longer Rates
By Jim Reber, The Baker Group
My experiences in fixed-income investing continuously reinforce the no-free-lunch principle. We brokers are excited to be able to show 5%+ yields in the simplest of securities here in late 2026, but our instincts tell us that there’s trouble at the door. Or at least there’s a consequence in the near term: the current holdings in community bank bond portfolios have taken another hit. According to the bond accounting population of The Baker Group, net unrealized losses jumped more than 2.50% in just the third quarter, to over 9%. This marks the largest aggregate loss in nearly two years. We can’t put too much of this on still-new Fed Chairman Kevin Warsh or the rest of the FOMC, as they’ve been chanting “Inflation is Job One” for several months now, and in fact they hiked rates in mid-September for the first time since 2023.
But there are several things working in the favor of investors currently. The most obvious is rates across the curve, especially five years and out, are at multi-decade highs, so nominal yields are attractive. Another is that there is some modest slope to the curve, so risk-reward dynamics are relatively intact. Still another is that the bond market expects several more hikes in the next year, so perhaps securities that are priced off the short end of the curve, e.g., floaters, will keep pace with the evolving monetary policy for some time to come.
The Most Adjustable
The most rate-sensitive, and therefore price-stable, investments have these standard features:
- Visible, liquid money-market index
- Short reset periods
- High or no interest rate caps, both periodic and life
- Near-term first reset date
Each of these features is built into Small Business Administration (SBA) 7(a) pools. A further sweetener is that SBAs are full faith and credit instruments, so 0% risk-weighted. It’s possible to buy these to effectively yield prime rate minus 2.50% or better, which is the same as saying fed funds plus 0.50%. That may not sound exciting until one considers that it’s conceivable the net yield could approach 5.25% a few quarters from now. Another enticement is that the market values of 7(a)s are remarkably stable. Most pricing models estimate they would be down only about 2% even in a high-rate shock environment.
It must be said that many of these pools can come to market with high premium prices of ten points or more, which absolutely creates prepayment risk to the investor. There are ways to manage this exposure that are beyond the scope of this column, which your brokers can explain. Still, there is a good case to be made for an SBA 7(a) in today’s environment.
Also in the Discussion
Mortgage-backed securities (MBS) come in several different adjustable-rate models. Among the more popular are Collateralized Mortgage Obligation (CMO) floaters. These share some of the characteristics of an SBA loan, including the absence of periodic caps. Their rates float based on money-market indices, such as the Secured Overnight Financing Rate (SOFR). These will have life caps of your choosing, typically in the 6.5% to 8% range. CMO floaters’ cash flows can fluctuate wildly, but most investors don’t mind as their appeal is their quick reaction to rate changes. And, they can be found at discount prices, and current yields in the 5% range.
Commercial MBS, such as Freddie Mac “Ks,” also come in floating rate structures. Their indices are often SOFR, and they also have no periodic caps. Because Freddie Ks are collateralized by multifamily projects, they, too, can see very inconsistent cash flow if some of the larger properties experience prepayments. Again, like CMOs, these usually will come to market with little or no premium, so the early payoffs may not hurt the yields.
Let’s also remember that bond portfolios continue to have higher durations than they used to. We’ve seen four-plus year effective durations since 2022, and prior to 2022 they ran three years or less. Each of the securities discussed in this column will have far less than a one-year duration. All told, the expected path of monetary policy in 2026 and beyond could bode well for money-market alternatives, both for price stability and yield. Portfolio bonds whose prices have recently ebbed could be nicely complemented by short duration instruments. Floaters may just be the answer to provide some bounce to your investment portfolio.
Jim Reber, CPA, CFA (JReber@GoBaker.com) is Managing Director ICBA Relations for The Baker Group, ICBA Securities’ exclusively endorsed broker-dealer.
SBA Secondary Market
A high percentage of guaranteed portions of 7(a) loans are immediately sold into a secondary market by the lenders to a limited number of approved SBA Pool Assemblers. The buyers aggregate the individual loans and issue SBA certificates against them, much like the MBS pooling mechanism. One major difference: 7(a) loans can produce significant gains on sale of 10 points or more to the lenders. The Baker Group has an exclusive arrangement with an approved SBA pooler, StoneX Financial, Inc., for bidding and buying these guarantees. Please contact your Baker representative for more information.