By Gregory Zuckerman
U.S. Bancorp is racking up profits with a bond-market maneuver
that is pinching some investors holding high-yielding
investments.
The Minneapolis company, which operates the fifth-largest U.S.
commercial bank by assets, has made paper profits of about $53
million over the past three years forcing insurance companies,
community banks and other investors to sell it Ginnie Mae-insured
mortgage bonds at below-market prices, according to calculations by
Performance Trust Capital Partners, LLC, a Chicago fixed-income
investment firm.
U.S. Bancorp has been buying these bonds at par, or 100 cents on
the dollar, though they had been trading about 15% higher at the
time of the purchases, thanks in part to their above-market yields,
investors say. The bank is entitled to buy the bonds at low prices
because it serves as a trustee for pools of these bonds, which are
sold to investors in the form of collateralized mortgage
obligations, or pools of mortgages sliced into investments with
different maturities, yields and risks.
According to the rules governing these investments, trustees can
call, or redeem, the bonds when 99% of the value of the principal
backing the pools has been paid down by borrowers, something that
has happened with more frequency amid low rates. The maneuver is
called a "1% cleanup call."
MetLife Inc. and TIAA-CREF are among those investors that had
bonds redeemed by U.S. Bancorp, according to securities records.
Representatives of MetLife and TIAA-CREF declined to comment.
Some investors have been surprised by the play, analysts say. A
similar move over a decade ago by Fannie Mae sparked pushback by
unhappy investors and was discontinued.
U.S. Bancorp's purchases come as at least one other trustee for
similar Ginnie Mae bond pools-- Bank of New York Mellon Corp.--has
elected not to pursue a similar buyback strategy, according to
people close to the matter.
"Traders and investors thought the 1% cleanup wouldn't be
called" in part because of the earlier backlash when Fannie Mae
tried to call its own bonds in 2002, said Andrew Pace, vice
president at Performance Trust, which works with institutional
investors.
U.S. Bancorp's gains are a byproduct of the continued
low-interest-rate environment, which can distort financial
markets.
"The fact that they can and are taking advantage of this
provision, even though not everyone else has in the past, makes
investing a bit more challenging," says Anthony Van Daalen, who
runs the $67 million Wright Current Income fund, which has seen
some of its bonds purchased by U.S. Bancorp, forcing the fund to
reinvest the money at lower interest rates. "They're within their
rights, they see an opportunity and I suppose are taking
advantage."
Investors forced to sell debt to U.S. Bancorp suffer because
they no longer enjoy hefty interest payments from the Ginnie Mae
bonds. Many of these bonds were issued in the 1990s with interest
rates of 7% or 8% compared with bonds today issued with yields of
3% or less.
With rates still low, many investors have scoured the market for
high-yielding debt, sometimes overlooking risks along the way, such
as the call features attached to these bonds, traders say. That is
why U.S. Bancorp's moves are attracting attention in some corners
of the market.
It isn't clear if U.S. Bancorp has been profiting by selling the
bonds in the marketplace or by holding them in its own portfolio or
repackaging the repurchased debt in new structures sold to
investors.
More than $355 million of bonds have been called by U.S. Bancorp
since fall of 2012, investors say. In May alone, U.S. Bancorp made
paper profits of about $4 million from these purchases; the bank
could make about $35 million over the rest of 2015 calling bonds
with a face value of about $230 million that are eligible or will
become eligible for redemption, according to calculations by
Performance Trust based on current prices for the bonds and the
prices U.S. Bancorp paid.
Some investors say they were prepared for the potential
redemption of the bonds and had placed a lower internal value on
them, mitigating any losses in market value.
A U.S. Bancorp spokesman said: "The rights of the trustee to
conduct a 1% cleanup call are clearly and fully disclosed in both
the prospectus and the Ginnie Mae program guidelines."
The spokesman noted that U.S. Bancorp provides investors with
30-day notification about the termination of the trust.
John Getchis, senior vice president of the office of capital
markets at Ginnie Mae, said that the cleanup-call provision is
disclosed in the securities' offering materials and the call rights
are part of a trustee's potential compensation for their work.
"Ginnie Mae has no financial interest in the call right nor
control over the decision by the trustee whether to exercise the
call right," Mr. Getchis said in an email.
A trustee for a CMO deal takes payments from the underlying
mortgages and distributes them to investors with claims on various
slices of the deal.
"This is perfectly legal but it's perfectly bitter for already
yield-suffering investors," said Marilyn Cohen, president of
Envision Capital, a bond-advisory firm in Los Angeles. She noted
that retail, or individual, investors often are less capable of
reading the fine print for some bond deals.
Joe Light contributed to this article.
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