F Bonds

Marilyn Cohen, Forbes Magazine, 09.18.00

The bond market is hot because the economy is a bit cool. The yield on the long Treasury has sunk from 6.5% in January to 5.7% now. Are there any bond bargains left? Absolutely. Try the bonds of two politically controversial government agencies: Fannie Mae and Freddie Mac. These quasi-private agencies are stockholder-owned companies but operate under a government charter. They fund mortgage lenders and then securitize those loans. Despite threats from Capitol Hill to renounce the implicit federal guarantee of their debts, these entities get triple-A ratings and deserve them.

What's the difference between a Treasury and a noncallable Fannie or Freddie debt of comparable maturity? Mostly the fact that Treasury interest is exempt from state income tax but Fannie and Freddie interest is not. In a tax-deferred account, that distinction is irrelevant.

Government-bond fund managers love the F paper, meaning you probably have some in your 401(k). Moreover, last year the Federal Reserve began using Fannie Mae and Freddie Mac bonds in its open market operations, since budget surpluses are diminishing the supply of Treasurys. The agencies obliged the Fed by bringing out jumbo issues of up to $9 billion.

The F bonds traded two years ago at a mere 14 basis points over Treasurys of comparable maturities. Not now. You can buy these babies at a yield a full percentage point richer than the yield on Treasurys.

A political imbroglio is responsible for widening these two cousins' spreads. Competing bond issuers are pushing Congress to rein in their growth, making them report to a tougher regulator and canceling their liquidity window at the Treasury. The window allows each of them to borrow up to $2.25 billion in a liquidity crunch.

Other lenders say that amounts to a subsidy. And because the government would probably jump in to save Fannie and Freddie from defaulting, rivals gripe that they can borrow at unfairly lower rates.

The truth is that their Treasury liquidity window looms as large as a flea on an elephant's back. As of June 30 Fannie had $583 billion in outstanding debt; Freddie Mac, $384 billion. The $2.25 billion wouldn't go very far if a meltdown occurs.

For bond bargain hunters, their political distress has produced a buying opportunity. The ten-year agency bullet (that is, noncallable) bond issued in 1998 was a Fannie Mae 5.75%, due Feb. 15, 2008, and it traded at issue 14 basis points over the ten-year Treasury, according to Fidelity Investments. Now comparable ten-year agency bullets trade at a 6.9% yield to maturity, a 114-basis-point spread. The five-year bullet Fannie Mae 5.25%, due Jan. 15, 2003, had an initial spread of 15 basis points. Five-year paper now trades at 75 basis points over.

There are two strategic ways to capitalize on this situation: Buy bonds from a jumbo bullet issue or buy bonds of one of the tiny $10 million to $30 million issues that come to market daily. The latter are callable, and they bear ever-so-enticing teaser rates to pay you for your call risk. Let's evaluate both.

Among bullets, Fannie Mae's 7.25%, due Jan. 15, 2010, is a $9 billion issue, yielding 6.9% to maturity. This is a good deal. If you care to commit funds for only five years, Freddie Mac's 6.87%, due Jan. 15, 2005--an $8 billion issue--yields 6.8% to maturity, 80 basis points over Treasurys.

For those who can tolerate call risk, the teasers dangle even fatter premiums. Fannie's 8%, due July 5, 2007--a $30 million issue callable July 2001 at face value--can be bought just under par, for a 7.9% yield to call. That's 175 basis points over the one-year Treasury and 209 basis points over the seven-year (if they last that long).

Another risk: If you buy, you're just about stuck until the paper matures or gets called in. Callable paper will have little liquidity.

Do I think that Fannie and Freddie deserve a free lunch? No. But I do not think Congress will enact legislation that nukes these issues. At worst we might see a compromise in which these two corporations pay the Treasury a fee for its implicit insurance of their balance sheets. That would hurt earnings a bit but scarcely damage bondholders.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.

Back to Top