High-End Investing

Article excerpt

Steepness of the curve, high quality make DCPCs attractive

Small Business Administration (SBA) floating rate pools have grown in popularity among community bank portfolio managers since the world began changing in 2007. In the past three-plus years, many portfolio managers have not just dipped their toes into the SBA waters; they've gone cannonball into the deep end. And thus far these floating rate pools have performed very well.

For one, SBA loan prices, which took a dive in the first half of 2009 as poolers nationally were unable to finance their inventories, have recovered handsomely-even though many bankers regard these instruments as cash alternatives. Also integral to the rise in prices is the continued good behavior of the borrowers behind the pools. Stated another way, prepayments have slowed every year since 2007, and 2011 started out with a continuation of this trend.

So it appears that these investments, which float quarterly or monthly based on the prime rate and have full faith and credit backing by Uncle Sam, have some appeal. Something else they have is premium risk. It's beyond the range of this column to discuss prepayment implications, but bankers know intuitively that paying 108 to 112 cents on the dollar for an amortizing instrument has its perils. One way to control the premiums paid on SBA pools is to purchase these floaters' fixedrate brethren, Development Company Participation Certificates, or DCPCs.

Why buy? DCPCs are zero percent risk-weighted and generally amortize to 20-year maturity schedules. They are collateralized by a collection of loans, which can number in the hundreds for a given pool. The loans are guaranteed by the U.S. government and are used to finance machinery, equipment and real estate.

Since DCPCs have a fixed rate, the premiums that result from recently issued pools are often modest. This may be a welcome respite for SBA 7(a) buyers. Another nicety is that most pools have prepayment penalties for the first half of their lives, and these pass through to the investor. This can enhance your yield substantially, although in practice it usually simply limits prepayment activity.

The limited ability to prepay commercial real estate loans is another plus for DCPCs. Many investors see these as alternatives to Planned Amortization Class (PAC) CMOs. Or, with some portfolio managers uncomfortable with the short-term prospects of the municipal bond market, these pools have become their go-to choice for the long end of the portfolio barbell. Which, incidentally, is a structure ICBA Securities is recommending.

What to protect against. When you invest in SBA floaters, you accept a low yield today (around 1 percent) in return for the ability to rise in the future. …