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Spring Cleaning … and the Quest for Earnings

By: Josh Kiefer

The current environment of extremely low interest rates continues to allow a relatively painless cleansing of the investment portfolio. Eventually, rates will rise, bond prices will fall and unrealized losses will diminish the overall liquidity of the portfolio. Although the market for government securities will remain liquid, the reality of realizing significant losses will compromise the true liquidity associated with these securities.

The window to clean house may remain open for a much longer period of time, or it may close abruptly. No one knows the future, but we all understand the forgiving nature of unrealized gains. As such, now is a good time to make sure you are prepared to live with each and every security in the portfolio, for better or for worse, till death do you part.

Of course, commercial banks are more concerned with the challenge of making money in this unusually difficult environment. Most bankers have lowered their deposit costs to nearly zero, purged their loan portfolios of the more marginal credits, and turned every stone to find new demand for creditworthy loans. Unfortunately, the options to further improve spread and earnings are limited. As a result, some bankers have been attracted to higher-yielding securities that come with more interest rate risk than meets the eye. While this is a logical response to the pressure for earnings, the degree of risk should be measured and fully understood.
 
The potential threat to liquidity, associated with higher interest rates, should be monitored continuously, but the current environment requires special attention. To appreciate the potential impact of a turn in the market, compare your month-end reports from February to March, which was the last substantial month-to-month move (higher) in rates.

The five-year and 10-year Treasury rates increased 21 basis points in yield (falling in price) during this one-month period. Many portfolio managers were surprised at the extent to which their unrealized gains were reduced in just one month with a relatively small move-up in rates. As an example, the top-performing bank portfolios on our portfolio analytics system recorded an unrealized gain of 3.43 percent in March, down from a gain of 4.24 percent reported in February. This represents a decline of 0.81 percent or $81,000 per $10 million of par value.

This illustration provides an indication of how ugly things could get with a more permanent shift in the market. While no one expects a shift in monetary policy, there are other variables that determine market rates. This cautionary reminder should not be seen as a forecast of imminently higher interest rates ahead. It is intended to be more of a reminder to focus on the math and to know your tolerance.

Regardless of its current position, management should be mindful of the opportunity currently available to re-position the portfolio without penalty. Although there are many reasons to sell, the most difficult aspect of re-positioning the portfolio is always the re-investment of principal from securities that have been liquidated.

Obviously, every bank’s balance sheet is unique and the mental comfort of management varies from one financial institution to another. Nonetheless, most managers would prefer to limit their interest rate risk if they could do so without significantly compromising the overall yield from the investment portfolio. In most situations, laddering the portfolio, or taking a barbell approach with targeted maturities, represents a prudent compromise.

Generally speaking, municipal bonds continue to offer the highest yields available in any given maturity. If longer maturities are appropriate, investors should note that higher-coupon municipal “kickers,” available in the secondary market, will cushion the blow of higher rates, unlike the lower current-coupon bonds from the new issue market. Portfolio managers may be well advised to complement their maturity distribution with the laddered re-pricing of principal from mortgage-backed securities. The better pools are more predictable and provide a reliable stream of cash flow and liquidity. Of course, the devil is in the detail, but the securities that generally fit this profile are the 5-year/1-year hybrid ARMs (with a 5/2/5 CAP structure) and the fully amortizing pools of newly issued 10-year and 15-year mortgages. Seasoned mortgage pools in the secondary market may also be considered, but premium prices require a careful assessment of the potential for an acceleration of prepayments (at par).

The price action in March should remind managers that the unrealized gains within the investment portfolio can evaporate quickly. Confirm the appropriateness of every commitment within the portfolio, as well as the overall interest rate risk and liquidity risk associated with various scenarios. If mental comfort is unattainable for all scenarios, take action while the opportunity exists. Reducing risk without significantly compromising earnings may be more achievable than you realize.

Josh Kiefer is investment officer in the capital markets group of Country Club Bank, Kansas City. Contact him at 816-751-1415 or jkiefer(at)countryclubbank.com.

Copyright (c) August 2012 by BankNews Media

 


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