Last time, we reviewed the performance results of the top 10 percent of bank bond portfolios in the UMB Peer Group.
The conclusion from studying the top performers was that a combination of shorter term investments (67 percent) and longer-term, high-quality municipal bonds (33 percent) appears to be the optimum total return bond strategy now … or in other words, the old-fashioned barbell approach.
The barbell strategy is certainly not new and has been a classic bank bond strategy taught at banking schools for many years. Always popular because of its simplicity, one of its unique features is that it can be adapted to any bank’s balance sheet easily. For example, if bonds are a small part of your balance sheet’s earning power, you may wish to have a much larger short-term component for liquidity and either underweight the long-term component, or skip it altogether. Your bank earnings are powered much more by loans than bonds.
The more challenging balance sheet combination is when you must rely more heavily on securities for income due to soft loan demand, your lending philosophy, market conditions or local competition. Your choices on security mix and market timing become critical, as you will always have too much cash at the wrong time and too little when yields look really good.
The barbell investment strategy is basically a plan to hedge your bond portfolio’s risk against changing interest rates and volatile cash flows and thus reduce the volatility of your bond income. When rates are rising, you count on the short-term component for liquidity. When rates are falling, you rely more on the longer-term component for income. You will always wish you had more of the long-term yield component during falling interest rate markets (like now) and more of the short-term barbell when rates are rising. Like in most things, balance is the key.
When rates rise, the short-term component provides liquidity to fund loans, match up assets and liabilities and also opportunities to reinvest your bond maturities in better yields. The best time to add longer-term bonds to your barbell plan is during the high-rate phase of the cycle … when you are most tempted to stay short due to rising yields and low liquidity.
At present, banks are generally very liquid with large bond gains, the yield curve is setting all-time records for steepness, and any new purchases you make are generally lower than your portfolio’s overall yield. These market conditions certainly make long-term bonds tempting from a yield standpoint, but the historic low point in bond yields and caution-signal bond conditions listed above remind us that there could be a lot of risk in buying large amounts of long-term bonds at the bottom of an interest rate cycle.
How do you know if your portfolio is too long or too short? A helpful tool for measuring your balance sheet’s exposure to interest rate changes is the economic value of equity measurement. I like this tool as a crosscheck as it looks at the bank in total and not just the bond portfolio. The EVE test will tell you if your bond portfolio is too long relative to your overall balance sheet’s composition, or if you have room for longer-term, higher-yielding issues when the timing is right.
Since 1979, when long-term bond yields were 15 percent, interest rates have been in a dramatic secular decline with interest rate peaks and valleys occurring about every 3.5 years due to the economic cycle. The current low interest rate trough has been much more protracted … lower for longer than anyone expected due to the depth of the recession, which forced the Fed to intervene in the market in historic fashion with QE1 and QE2. Is QE3 possibly ahead? I do not think so.
In my opinion, all of these clues suggest that this is not a good time to start the barbell strategy, especially the long-term component. However, it may be a good time to start planning for how this strategy might help you remove some of the emotion from the market and hopefully improve your future bond income.
After all, the rear view mirror is always clear.
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.
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