What does “spread” mean to you? In Las Vegas, it’s an indication of how many points a sports team is favored to win by. For foodies, it could be a tasty schmear across a Ritz cracker. Sticking with the food theme, it’s sometimes an obtuse reference to one’s midsection, especially post-holidays. As a verb, it indicates a dispersion over an increasingly wide area (think: viral). And in fixed-income investing, it means the additional yield over and above that of a risk-free instrument of the same duration. 

For community bank portfolio managers, yield spread is one of the most important indicators of value. The good news is that there are mountains of documentation regarding historical spreads for virtually any bond sector that is suitable for community banks, as well as for current offerings. This column will look back at several months, which take us through some swings in market rates, to arrive at suggestions about what holds relative value as we get going in 2025. 

Recent past

If we can travel back to the third quarter of 2024, here’s how the bond market was situated. The Federal Open Market Committee met on Sept. 17 and 18 and pulled the trigger on a 50-basis point (0.50%) rate cut, the first since the opening days of the COVID pandemic in 2020. 

Since the Fed had clearly telegraphed its intentions using forward guidance, the bond market barely moved on announcement day. However, within two weeks, there began a steady barrage of better-than-expected economic releases, including a blowout non-farm payroll number on Oct. 4. 

Treasury rates then began a steady climb, and even though the Fed pushed through another 50 basis points in rate cuts by the end of 2024, rates remained closer to where they were in June and July than in September, as expectations for aggressive Fed action in 2025 eroded. Why this matters to community banks is that often, yield spreads run in the opposite direction of Treasury rates. Did this happen late last year?

The big three sectors

We’ll examine the spread action on three separate bond types that are popular with community bankers: callable agencies, mortgage-backed securities (MBS) and tax-free municipal bonds. Collectively, they comprise about 60% of bank portfolios and have done so for many years. The reasons for their appeal are obvious: plenty of market depth, high degrees of liquidity and price discovery, and diversification from the loan portfolio. 

Prior to Sept. 18, the five-year treasury note was trading around 3.50%. At the same time, a five-year agency with two years of “lockout” that can then be called away periodically (in the vernacular, a “5-2 Bermudan”) yielded about 3.90%, for a yield spread of 40 basis points. Fast forward to the end of the year, and the relative numbers were 4.36%/4.66%, for a spread of 30 basis points.

In MBS land, I’ve selected a FNMA 15-year 4.5% pool. In mid-September, they were priced around 101.00, which produced a yield to maturity (YTM) of about 4.15% and a yield spread of .71%. By year end, the price had fallen to about 98.5, and the YTM had risen to 4.82% at a spread of .54%. 

In the same vein, the tax-exempt market had some volatility late in 2024 thanks to the general election. As has been the case recently, a lot of muni issuers rushed to the market in October to get their proceeds before any potentially adverse yield action in the election aftermath. This caused November and December supply to shrink and yield spreads to constrict even further. 

It’s fair to remind readers that the tax-free muni sector really hasn’t had much relative value for C Corps since the tax cuts that went into effect in 2018 and may be extended further this year. For the record, in mid-September, a 10-year municipal bond produced a tax-equivalent yield of about 3.70%, which was .14% less than a comparable treasury. By year end, the available muni yields had not changed much, so their “negative spread” had grown to -.50%. This sector clearly is the domain for individuals and S Corps. Alternatively, they may be ideal candidates for sources of liquidity. 

Rational expectations?

What to make of all of this? First, taxable securities are easily more attractive than nontaxables for most community banks. Second, yield spreads have tightened in the past several months on agencies and MBS, even though general market yields have risen, which is normal. Third, and as a refresher, if yields are going to trend lower this year, you can expect incremental yields to widen. This will compensate investors for increased exposure to bonds being called away. 

And finally, keep in touch with your favorite brokers to identify where pockets of “spread” may be found. No surprise that another definition of the term is “a bountiful feast.”