Reduce liability for losses on commercial accounts by adhering to four requirements.
Bond Strategy: Extra Patience?
We have discussed many times in this column how a slow economy often channels cash to a bank’s bond portfolio at the worst possible time to invest. Conversely, when the economy and loan demand are strong, the loan portfolio becomes the optimum vehicle for maximizing earnings … and bonds take a back seat. This dilemma is not our fault but is simply a fact of banking. We call it the bond trap.
We now face a period of time where bond yields may remain exceptionally low because of the Fed’s historic response to the consumer debt deleveraging process under way in the United States. In my opinion, the current combination of low rates, a steep yield curve and record amounts of excess liquidity may prove to be a dangerous combination for future bank earnings.
If you review the past 30-plus years of interest rate history, a protracted period of low interest rates (like we face now) has never happened before. Since 1979, interest rates have basically been falling due to lower inflation expectations (which peaked at 13.25 percent in 1979) and globalization. The world is interconnected now and U.S. bonds are still the safe haven.
When rates have bottomed in the past due to recessions or market shocks (1983, 1986, 1993, 1998, 2001, 2003 and 2008), they have generally recovered, usually very sharply, within two years. Another troubling fact from history is that the sharpest rebounds in rates (1994–1995, 1998–2000 and 2004–2006) have followed the deepest drops. You can see an approximate four-to-five-year pattern here, I think.
Low interest rate markets can be frustrating for bank bond portfolio managers. Because we have basically reached a floor on what we pay for deposits and loan demand is soft, the only solution to maintain or improve the margin other than increasing fee income and cutting expenses is through the bond portfolio.
Below I have listed several friendly suggestions you may wish to consider now:
If you choose to stay relatively short with the term of your bond purchases and ride out the troubled economic waters, I think high-quality municipal bonds make good sense as they work on either a pretax or after-tax basis when compared to agencies and treasuries. Municipal bond spreads are very good now from a historical perspective, and their scarcity helps support their market values.
Insured CDs from other banks still create spread versus agencies, and well-structured mortgage securities, while in scarce supply, are good places to park until the economy recovers. Make sure any premium you pay on mortgage-backed issues makes good economic sense.
You may never see security gains in your portfolio this large again so review your security holdings to see if harvesting gains makes sense. If you can build capital or loan-loss reserves and upgrade quality at the same time, you can maximize many benefits from just one move. Reinvest shorter to be positioned for better bond yields and loan demand down the road.
I have always liked the Wall Street adage that states, “Where you are rewarded the least … you will eventually benefit the most.” Although the “eventually” part may take a little longer this time, be extra patient now, and you will look back at this historic low-rate period in a few years and realize how extreme conditions are now.
This is America. We will work our way out of this.
Friendly Suggestions When Interest Rates Are at Historic Lows
- Focus on quality.
- Avoid trying new things or lengthening maturities significantly for extra yield.
- Review current security holdings for potential credit quality upgrades.
- Review portfolio for overpriced issues to consider taking gains.
- Rate shock your balance sheet and bond portfolio to quantify your exposure to changing interest rates.
- Think long term.
Jeff Goble is executive vice president and senior investment officer, investment banking, at UMB Bank, n.a., Kansas City. His email address is Jeffrey.Goble(at)umb.com.
Copyright (c) November 2011 by BankNews Media.