Reduce liability for losses on commercial accounts by adhering to four requirements.
Got Yield? I Wish.
We all face one of the most challenging bond markets in decades and a narrowing interest margin adds to the pressure on earnings for most banks. How are the top bank bond portfolios performing now?
We sorted the top 10 percent of the 500-plus banks that use UMB’s bond accounting service by their total returns. Total return includes both the income yield from your portfolio as well as the current gain or loss in market value so it creates a fair, apple-to-apple comparison tool for analyzing diverse portfolios.
You can see the results of this high-performing group in the pie chart. They currently own $1.3 billion in securities with an income (or book) yield of 4.13 percent and an off-the-chart total return of 9.93 percent. Both numbers obviously look very good now given the extreme bond market conditions.
Let’s review the various performance metrics of this group:
Diversification: This is perhaps the single most important principle in investing. The top performers have eight security classes ranging from 1 percent in bank CDs to 47 percent in municipal bonds, 32 percent with call features. The callable designation provides a hint about the term of these holdings, as most municipal bonds with terms over 20 years possess a call feature. It is interesting to note that the peer group still contains 5 percent in Treasuries and I wonder if some banks are using them as a trading vehicle for extra income.
Average maturity/duration: This peer group has an average maturity of 7.14 years with an average modified duration of 4.24 years. Modified duration is an excellent tool as it quantifies the potential gain/loss in dollars if interest rates move 100 basis points up or down. In other words, these holdings will gain or lose 4.24 percent during a 100-basis-point rate shock. You can multiply this number by two, three over even four to obtain the dollar amount change due to incremental rate shocks.
Duration gap/call risk: If you subtract the portfolio’s duration (4.24 years) from its average maturity (7.14 years), you will create a number I call the duration gap. This is a simple way to measure call risk (also known as optionality) and you can see the 2.74–year gap suggests they are benefitting currently from the longer bonds they own with shorter call dates. At some point the calls may stop occurring so it is important to monitor this gap closely if interest rates start to rise.
Depth of gain/loss: To quantify the depth of the gain presently, divide the total return (9.93 percent) by the modified duration (4.24 years). The result is 2.34 years, which is very good versus the average bank’s depth of gain at 1.77 years. A longer result is better when you have a gain and shorter is better when you have a loss.
The secret of the top performers is that they obviously purchased a high percentage of their portfolios in long-term municipal bonds at the right time. This was a gutsy, contrarian play. The spreads and yields widened significantly after the warning about municipal bonds and declining municipal finance conditions was issued in December 2010. Of course, this strategy is not for everyone.
You can still wish though.
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 (c) November 2012 by BankNews Media