The challenges of this rate environment for portfolio managers are well known at this point. With rates being near record lows for so long, most holdings were booked near record-low yields. In addition, because of the unusual steps taken by the Fed, rates are near zero until beyond four years (see yield curves below). The result is that portfolio managers have had to reach well beyond their comfort zones, in terms of duration and optionality to find yields sufficient to cover funding costs, much less overhead costs. As was the intent of the central bank, investors have the alternatives of either earning near-zero yields or adding meaningful risk. Given these alternatives, there is little to do but add the incremental risk.
While reducing the risk strictly within the investment portfolio is objectionable due to the reduction of yields, it is possible to manage the risk by making adjustments to the rest of the balance sheet. Ideally, a longer bond portfolio would be offset by some combination of longer funding or shorter loans. Unfortunately, most banks have reduced their longer-term wholesale funding to minimize funding costs (and due to drowning in liquidity), while at the same time lengthening their loan portfolios with an increased reliance on long-term fixed-rate lending. With all three components headed in the wrong direction at the bottom of the rate cycle, many banks could be in for a rude awakening when the rate cycle turns, as may have already started at the end of June.
One answer often overlooked by community banks is the use of plain vanilla interest rate swaps. Interest rate swaps are perfect for reducing risk without unnecessarily ballooning the balance sheet, especially given the new capital constraints under Basel III. If used properly, swaps are easy to analyze and manage, and the hedge accounting has little to no impact on the financial statements.
In the loan portfolio, an amortizing swap at the loan level can be used to convert individual loans from fixed to floating. These swaps are generally used on larger commercial loans, which are the most likely to be bid competitively between multiple banks. The swap allows the customer to obtain a competitive rate on nearly any structure, including those with long fixed-rate terms and long amortization schedules. The borrowers simply get a fixed-rate loan, and the bank handles the hedging. The swap qualifies as a fair value hedge under FAS 133 (ASC 815) and as long as the terms match very closely (maturities, amortization schedules, payment dates), the two fair value changes will offset exactly. The only impact on the income statement will be the change from a fixed rate to a floating rate. These can be funded with short-term funding, or used to help offset some of the longer-term investments in the bond portfolio.
On the liability side, swaps can be used to convert variable-rate funding to fixed-rate funding to better match the asset base. The liabilities can be advances, brokered deposits, accounts tied to indexes or even blocks of short CDs in some cases. The swap in this case qualifies as a cash flow hedge under FAS 133, with the value of the swap being carried in other comprehensive income and not being marked through the income statement. In addition, because most banks are not concerned with rates rising in the near term, these swaps can be executed with a forward start date. This allows the bank to pay a lower variable rate for funding in the near term, and then convert to a fixed rate later at a cost that was locked in during a lower rate environment. It functions as cheap protection against rising rates.
Even small community banks should at least consider the use of swaps as a way to manage and mitigate risk. Doing so will allow the portfolio manager to continue investing in the areas of the yield curve where value can be found instead of simply settling for near-zero yields in order to reduce the growing interest rate risk.
Dallas Wells is vice president in the Asset Management Group at Country Club Bank, Kansas City.
Copyright (c) August 2013 by BankNews Media