Bothersome Bonds in Texas

Government bonds are considered a “safe” investment. Being less risky than stocks and loans, they are often a part of most banks’ portfolios to manage economic risk. By buying a bond, you’re giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date and to pay you periodic interest payments along the way. If the issuer repays the bond early, you lose out on those periodic interest payments, but that is not typically a concern with government bonds. A situation unfolding in Texas, however, showcases that this is not always the case.

Texas bankers are urging the Texas Transportation Commission to rethink a plan to pay off a $300 million bond issued in late 2020, more than nine years ahead of schedule, at a time when that initial investment has some bond buyers losing money on the purchase. If paid off early, potentially at the end of April, the state could save roughly $80 million, but the banks that bought it would absorb that loss. The motivation for the early bond repayment comes from the Texas Department of Transportation’s significant financial uptick due to federal infrastructure funding and higher state revenues. Despite these economic benefits for the state, local banks stand to lose out on the foregone interest income—a situation that could discourage future investment in state projects.

The savings from paying the bonds early comes at a cost for the banks that bought the bonds. Assured of their stability at the time—and given Texas’ long record of paying its debts—the banks grabbed the bonds, thinking they would make a safe and sound long-term investment. Now, that situation has changed. As interest rates have risen sharply since 2020, inflation has meant money doesn’t go as far as it once did, and their long-term profit is eliminated by the state paying the principal sooner. While each bank’s investment loss may seem minuscule when compared to the state’s overall savings, it still economically affects the state by costing local banks capital they would otherwise invest back into their local communities.

This story is not an attempt to dissuade anyone from future bond investments, but it is an important lesson. It is important that the Bank pays attention to trends within their local communities and nationwide as it relates to investment risks. When selecting investments, particularly bond portfolios, the bank needs to be aware of all contractual requirements within the prospectuses and is appropriately stress testing the rate of risk, which includes option risks where the timing of the call on the bond may have a huge impact on the bank. Historically, many banks have not had to consider early repayment and calling of bond risks. Just another part of asset and liability management.