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Bond Swaps: A Tool to Help You Optimize Earnings

By: Jeff Goble

Over the years, we have discussed many times in this column the dilemma bank bond portfolio managers always face: You will always have too much cash to invest when interest rates are low and never enough when rates are high. We call this problem “the bond trap”; and as bankers, it is not completely our fault.

The explanation for why this backwards bond investing cash flow cycle occurs can be tied directly to the loan and economic cycle, as we bankers always make more loans when the economy is good. Excess cash tends to build up when the economy is slow or there is fear in the markets, and we are forced to invest more in bonds.

Our depositors add to the bond trap as they withdraw cash when their business is growing and increase their deposits for income and FDIC protection when times are slow. One other potential contributor to the trap is owning too many callable bonds in your portfolio, as they always favor the issuer and are called when rates are low (to lower their interest costs) and are not called when rates rise.

Most banks have experienced record deposit growth over the past five years. Depositors rushed to banks for safety as the United States recovered from the Great Recession and stock prices fell sharply. Only now are we starting to see these “surge” deposits finally be redeployed in the economy and loan demand pick back up again. It has taken much longer to return to normal than anyone ever expected.

Is there a solution to the bond trap? The answer is “yes,” and it involves both avoiding the urge to reach too far for yield with long-term bonds when rates are really low and also gradually selling your lowest yielding available-for-sale bonds as interest rates return to normal. Banks can write off the loss versus income and then reinvest the sales proceeds into higher yielding bonds. I think it is a good idea to exempt these losses from employee bonus programs.

It is important to note that you will always want to conduct bond swaps in several stages in order to dollar-cost average your new bond purchases as interest rates rise. This is a good time to start the process as new bond purchases you make may yield more than your portfolio’s overall yield, so you are dollar cost averaging up. The Fed has started its exit plan and longer-term rates have risen significantly over the past year as the adrenaline for the economy (which forced rates to record lows) is being withdrawn.

A good way to start a bond swap is to sort your portfolio from top to bottom in yield order in order to identify sale candidates. Since we are early in the year, many losses from securities on the bottom of your list can be recovered in 2014. You can also use sale proceeds to pay down borrowings.

There is computer software available to help you evaluate how bond swaps will affect your income and your entire portfolio on a pro forma basis. In my opinion, the days of simply holding all of your bonds to maturity may be over as the volatility of interest rates and the presence of the bond trap now demand more proactive management of your bond portfolio in order to optimize earnings.

A special thanks to BankNews for the privilege of writing this column. This is my 25th year, and I greatly appreciate the nice comments bankers send me throughout the year. I hope I have helped you sleep a little better at night.


 

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 2014 BankNews Media (March 2014)


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