Reduce liability for losses on commercial accounts by adhering to four requirements.
Memo to Passengers Sailing on the New QE2
The story goes … Federal Reserve Chairman Ben Bernanke took his board of governors and top economists on a research retreat to the Rocky Mountains. On a break day, they took to the hills for inspiration. But after several hours of robust hiking, they became hopelessly lost. Wandering, but never in doubt, the group consulted their maps with the same acute perception they muster in preparation for FOMC meetings. After considerable analysis, the lead analyst reported her findings to Chairman Bernanke.
“Do you see that sheer mountain top on the south horizon?” she asked.
“Yes,” replied the eager chairman, wearily squinting across the sky.
“Well, according to our studies, we’re standing on top of it.”
Moral of the story: In uncharted markets, trust your innate portfolio sense of direction over mined data erroneously applied to models incapable of reasoning for unexpected circumstance.
Interest rates for high-grade taxable bonds less than five years are between 0 percent and 1.50 percent. If the stated goal of quantitative easing is to stimulate economic growth by purchasing mass quantities of bonds, which simultaneously engorges the banking system with excess lending capacity and reduces market yields, it does not appear to have fully succeeded (yet). Rates are low, bond prices are high, but the lending/growth tidal wave has not reached the beach.
Eventually the economic tide will turn and, most agree, the U.S. economy will not resemble Japan’s multi-year economic misery. And with recovery comes rising interest rates. Rapidly rising rates will ravage most banks’ bond portfolios as market values decline in step with ascending yields. For FAS 115 AFS portfolios, this depreciation will be applied directly versus capital (after tax). Thus, liquidity and lending capacity will be dramatically diminished (which suggests poor earnings are in sure pursuit).
So what does an intrepid bank bond portfolio manager do when the headlines say “Don’t Fight the Fed?”
First — Take Profits
Since 2008, bank balance sheets have migrated away from credit risk and morphed into bond repositories as loan balances have been flat to negative. Reverse that trend. Take prudent and surgical bond profits now. Make loans (when you can) or shrink (if you haven’t already). In December 1980, Chairman Paul Volker’s Fed was battling inflation and raising interest rates. The prime rate reached an all-time high of 21.50 percent, and most thought it was headed higher. Untold fortunes were missed by those who “knew” rates were going to 25 percent. Likewise, fortunes were found by those who bought long duration against the crowd.
Today the prime rate is 3.25 percent and the Bernanke Fed is fighting deflation. When higher rates come and bond losses follow, everybody (including you) will dismissively ask, “Why didn’t you harvest gains during the greatest bond bull market of your lifetime?” Begin your sale candidates list with the longest of your lowest book yields and then look for lowest market yields. And don’t forget to include any bond that causes you to sleep less at night — no matter your basis.
Second — Buy Short Duration
Duration is measure of price volatility for a 1 percent shift in market yields. Typically, low duration bonds have shorter maturities — but not always (see ARMs). The curve is steep, and longer duration fixed coupon bonds offer relatively high yields. But they also introduce (possibly) unacceptable price volatility. So be patient and remember the best offense is a good defense. Hit a home run later. Just get on base today. (Bonus — be sure to have a reporting mechanism to reliably stress test.)
Third — Magnificent Munis
Most of what you have probably read in national press regarding the pending crisis in the municipal market is hyperbole. Buyers of plain vanilla, general obligation or essential purpose revenue bonds (rated or not) are most likely to escape the economic downturn unscathed. A vast body of evidence, decades long in the making, suggests these bonds will be the boring, risk averse, income-enhancing assets you want them to be. Buy accordingly and sleep well.
Chris Thompson is an executive vice president in the Capital Markets Group at Country Club Bank, Kansas City. Contact him at cthompson(at)countryclubbank.com.
Copyright © December 2010 BankNews Media