Whenever the Federal Open Market Committee (FOMC) starts to increase interest rates, many financial institution investors begin exploring what options are available for short-term or variable rate bond investments. One type of investment that has garnered increased attention has been variable-rate SBA pools, or “SBA floater” bonds. Let’s examine these floating-rate securities a little closer and consider their benefits and risks.
What Are SBA Floaters?
SBA floater pools are securities that created using pooled loans from the U.S. Small Business Administration. As a Federal agency, the SBA offers loan guarantees through its 7(a) loan program, which allows small businesses that are unable to otherwise secure financing through normal lending channels to obtain loans.
When a bank originates a qualifying small business loan, they can apply to the SBA for a guarantee. The SBA provides guarantees for between 75% to 90% of the loan balance. It is this guaranteed portion of the loan that the lender can then sell into the secondary market. The loans are incorporated into a pool by an authorized SBA pool assembler (a broker-dealer) and sold to investors. Colson Services, a transfer service agent, is responsible for administering monthly principal and interest payments.
SBA floater pools are generally categorized based on their underlying loan type and original weighted average maturity (WAM):
- Working capital (Less than or equal to 7 years)
- Machinery and equipment (Between 7 and 15 years)
- Real Estate (Greater than 15 years)
Most SBA floater pools have a rate that is tied to Prime. The majority of the pools available have a coupon rate that resets quarterly (Jan 1, Apr 1, Jul 1, Oct 1), though some bonds have a monthly reset. The coupon rate is uncapped, which means there is no limit as to how high it can go in a rising interest rate environment. Payments of principal and interest are received monthly, similar to other mortgage-backed or asset-backed securities.
What Are the Benefits?
SBA floater securities offer several benefits for bank portfolio investors:
1. Government Guarantee — SBA pools are one of the few government securities backed by the full faith and credit of the United States government, like Treasuries. As a result, the bonds carry a zero-percent risk weighting for capital purposes. Simply put, there is no credit risk!
2. Floating Rate — As a variable rate investment, the income an investor receives changes in line with the underlying benchmark. The floating rate provides a source of income that will increase as interest rates rise. Also, because the securities are uncapped, there is no limit to the degree that an SBA pool’s coupon rate can increase when interest rates move higher. The floating rate nature of these bonds also limits the potential interest rate risk exposure for these bonds. For example, a quarterly reset pool carries a maximum effective duration of approximately 0.30 years, while a monthly reset pool’s effective duration would be closer to 0.10 years.
3. Yield — When compared to other short-term investment alternatives, such as Treasury bills or repurchase agreements, the yield and income on SBA pools provide an attractive alternative. Additionally, it can be easier to purchase and maintain a portfolio of SBA pools versus continually reinvesting in short-term instruments.
4. Collateral Eligibility — SBA pools are generally considered eligible collateral for Federal Home Loan Banks; the Federal Reserve; public funds; and Treasury, Tax and Loan (TT&L) accounts.
What Are the Risks?
Like any investment, while SBA floater pools have many benefits, they are not without risks. Among the risks an investor in SBA securities should consider are:
1. Prepayment Risk — Since the vast majority of SBA bonds trade at premium prices (many at prices of 110 or higher), any increase in principal prepayments can produce a negative effect on the investment’s book yield. In general, SBA pools can experience a pickup in prepayment speeds between 15-30 months after issuance before leveling off. Unlike prepayments on mortgage-backed securities, which are primarily driven by changes in the direction of rates, prepayments on SBA pools are influenced more by changes in the slope of the yield curve.
Additionally, while SBA pools do not expose investors to credit risk, loan performance can affect prepayment risk. For example, if a loan were to default, the SBA’s guarantee would result in the return of outstanding principal to investors. This payback is another form of increased prepayment. While these prepayment risks do not make SBA pools a “risky” investment, it is important to understand their prepayment characteristics. Investors also need to be sure to perform proper due diligence on any pools under consideration, as potential prepayment risk can vary based on the loan pool’s composition.
2. Market risk — Because these bonds are variable, you might expect them to experience very little change in price. However, SBA pools can experience price fluctuations. These fluctuations could occur if the underlying Prime rate shifts less than comparable short-term benchmarks, such as LIBOR, otherwise known as basis risk. Prices on SBA pools can also adjust based on a change in market demand for variable rate securities. For example, pricing on SBA pools may increase slightly when expectations for rising interest rates are high; in contrast, a drop in appetite for variable rate bonds could result in a slight price decline.
3. Liquidity risk — SBA pools make up a smaller percentage of the fixed income market, with fewer than a dozen broker-dealers making a market in the securities. While this does not generally present an issue when purchasing SBA pools, investors could experience a wider bid/ask spread if selling a pool becomes necessary due to the potentially lower liquidity.
For financial institutions seeking a short-term, variable rate investment alternative, SBA floaters may be worth consideration. They provide a government-backed, floating-rate source of income that would be beneficial in a rising interest rate environment. However, they are not without their risks. Before investing in them, it is essential to understand their characteristics and perform adequate due diligence.
Important Disclaimer: The information in this post does not constitute a solicitation, offer, or recommendation to acquire or dispose of any investment or to engage in any other transaction. All investments involve risk, including loss of principal. Anyone considering an investment should consult with an investment professional before making any investment decisions, as well as consulting legal and tax advisors when necessary.