By Jeff Goble
This is my 151st investments column for BankNews and it occurred to me recently that I should be starting to figure out this bank investing game. Please read on.
A basic rule I have learned over the years is that the deck is stacked against us as bankers for several reasons when we invest money in bonds.
First, loan balance growth (strong economy) and bond balance growth (weak economy) are due to opposite economic forces that rarely occur simultaneously. Secondly, bank customers borrow and spend more money for their business when the economy is good, and tend to accumulate surplus cash in our deposit accounts when the economy is soft.
Consequently, we always have too much to invest in bonds when interest rates are low (a.k.a. the bond trap) and loan demand and the economy are soft, and never enough to invest when bond yields are high.
This is not our fault, and fighting the inherent cash-flow cycle requires investing discipline: You must avoid stretching for extra yield in bonds when rates are low, and be willing to systematically take bond losses in stages and buy longer-term, noncallable bonds when interest rises above your portfolio’s overall average yield. It is a very simple, yet proven formula for long-term success.
There is a formula or blueprint to follow for this inherent cash flow problem and I call it the Stoplight Strategy. You can see the elements in the chart below and the recommended action under each scenario. Currently, reinvestment yields are generally below bond portfolio average yields, so the Stoplight Strategy (red light) cautions one about buying longer-term bonds exclusively now, although it is has probably never been more tempting.
If you follow this strategy consistently, your portfolio’s yield should never be too far away from the yields in the current bond market and your bond income should be very consistent each year.
Jeff Goble is chief market strategist in the Capital Markets Group at Country Club Bank in Kansas City.