One of the most interesting characteristics of top-performing banks is that they often also possess top-performing bond portfolios. I guess success loves company.
If you read my column regularly (thank you, by the way), you already know that I am a total-return advocate as it provides the best overall measurement of your portfolio’s health. We sorted the top 10 percent of the 600 banks nationwide that use UMB’s bond accounting service using total return, a metric, which factors in the gain or loss position with a portfolio’s current yield.
The chart below illustrates the current mix and maturity of securities held in those top-performing portfolios. At present, this group consists of 36 banks that own $1.85 billion in securities, has a current yield of 4.60 percent and a total return of 7.54 percent. The difference between these two numbers means that they have a market value gain of 2.94 percent. Given the significant increase recently in long-term bond yields, the size of the gain remaining after that rate increase is eye-catching. You may wish to compare these numbers with those of your portfolio.
How do they do it? I think the answer is that they focus on quality, follow a few basic investment rules, keep things pretty simple and really work on the timing of their purchases. After all, the timing of your purchases is perhaps the most powerful driver of your performance. We, as bankers, by definition always have too much cash to invest when rates are low and too little when rates are high.
Let’s review the metrics. The average maturity of these high-performing portfolios is 4.47 years with a duration of 3.16 years. Duration measures the price sensitivity of your portfolio as interest rates rise and fall; you may wish to add this metric to your monthly analysis if you are not using it already. You will like it, and I think a really good duration target for bank portfolios is approximately three years.
Drilling down a little further, the difference between your average maturity and your duration is what I call the duration gap, and it measures the amount of “callability” (also known as optionality) in your portfolio. I always recommend that banks try to keep this gap less than 18 months in order to increase the certainty of your future bond earnings.
Another interesting combination of metrics is revealed when you divide your total return by your duration. The resulting number measures your holding power, or the number of years that it would take your gain or loss to disappear through attrition. If you do the math, the result for the top performers will be 2.39 years, which is excellent. If you have a net loss in your portfolio now, you may wish to explore a little further.
The key driver in these portfolios is longer-term municipal bonds (7.2 years in average maturity) as they contribute an overall yield of 5.69 percent (7.59 percent total return) to the mix. Also note the lower percentages of callable bonds overall in the mix, as they always favor the issuer. There is good balance between shorter-term issues for liquidity and longer-term municipal bonds for yield.
It looks like the old-fashioned barbell still works.
Jeff Goble is executive vice president and managing director, investment banking, at UMB Bank, n.a., Kansas City. His email address is Jeffrey.Goble(at)umb.com.
Copyright © April 2011 BankNews Media