What's Next?

March 2020
By Daniel McIntyre, Vice President Investment Services at Corporate Central Credit Union and QuantyPhi

The last few weeks have had significant impacts on credit union investment portfolios, both positive and negative. Severe decrease in the yield curve has improved price performance for some securities, while spreads to treasuries have caused other securities to underperform.

While much of this change has already happened, we should be vigilant to see what is coming next. One of the next shoes to drop may well be prepayment activity of securities backed by mortgage loans and small business loan administration (SBA) loans.

On the mortgage front, it is a safe bet that the recent dive in rates will accelerate prepayment speeds. For mortgages on your books at a discount, the acceleration will give you a little boost in income. Conversely, the mortgages on your books at a premium will feel some pain from faster prepayment speeds. Looking forward, be aware that the prepayment model used to calculate your returns on mortgage-backed paper may not have adjusted to the rapid rate change. Always look at the yield tables with a bit of skepticism and follow our general rule for mortgage purchases – understand what happens if prepayments come in differently than expected.

Today, we would like to focus on the securities issued by the SBA and backed by loans to small businesses. Many of these were marketed to credit unions using prepayment speeds well below the pace the loans had been experiencing. Since the increased marketing of these instruments, rates indeed dropped, and investors did not experience the rate increase that was hoped for when committing to this structure. Now, investors may experience another prepayment surge in the months ahead. There is no escaping the fact that the current economic shutdown from COVID-19 is a tough environment for all but especially for small businesses. Given the exceptionally high premiums associated with the SBA pools, faster prepayments will prove to be painful for bondholders.

In the immediate term, we strongly suggest that owners of these securities take a close look at their holdings. Review the original purchase analysis for the presumed prepayment speed, compare actual speeds and forecast returns with accelerating prepayment speeds. This will give you some insight into what potential surprises may be in store for your portfolio performance.

Longer term we can review the work and advice previously produced on SBA loan pools in our whitepaper titled, “This Time, Things will be Different.”