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Making a Case for Investing In Your Bond Portfolio
by Darnell Canada, Managing Director
Darling Consulting Group
It’s been nearly seven years since the Fed began cutting rates to historic lows in 2001, and it’s been nearly that long since most bond brokers have been busy with trading volumes. Bond yields in the 3-5% range simply have not been attractive, especially for community financial institution investors who typically employ a buy-and-hold strategy and live on the spread to funding costs. Even as spreads increased and MBS yields approached 6% this past July, bond investing has remained light.
In most local markets, loan growth has been solid, while core deposit growth has been modest at best. As a result, most community financial institutions have been shrinking their bond portfolios to cover ongoing funding shortfalls. Additionally, bond reinvestment yields have been only marginally better than replacement rates for wholesale funding maturities. For institutions that borrow, deleveraging has become a margin enhancement strategy. In summary, it just hasn’t paid to maintain/increase the size of a financial institution’s bond portfolio.
It is true that when the yield curve is steep and spreads are wide, the investment portfolio serves as a useful tool to increase earnings… not so useful when the yield curve is flat and spreads are narrow. However, it is important to remember that while the income generated by the investment portfolio will be looked upon favorably by the marketplace, it will be discounted when estimating franchise value. Core business activity (loan and deposit growth) is what creates real value in your organization. Accordingly, profits should not be the sole purpose for building your investment portfolio. Although the impact on profit margins cannot be ignored, the primary objective behind your investment strategy should be to help alleviate the risks embedded in your core business.
A financial institution’s investment portfolio should be managed to:
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Absorb funds when loan demand is low and infuse funds when cash demands are high.
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Provide liquidity sufficient to support the operational needs of the institution. This includes both cash flow and collateral to satisfy pledging requirements.
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Provide a medium for implementing certain interest-rate-risk management strategies intended to establish and maintain an appropriate balance of sensitivity between interest income and interest expense.
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Provide a degree of high credit quality assets that complement the loan portfolio.
Secondarily, the investment portfolio should be used to:
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Generate a favorable return without unduly compromising balance-sheet-risk management objectives.
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Evaluate and take advantage of opportunities to generate tax-exempt income when it is appropriate given the institution’s tax position.
Liquidity Risks
The shrinkage of bond portfolios coupled with the reluctance to hold one- to four-family mortgage production has limited access to the collateralized funding markets for many institutions. As a result, many have become increasingly reliant on brokered CDs to fill their funding gaps. The increase in credit concerns and the tendency for many institutions to run thin on risk-based capital presents a potentially significant risk, as the ability to draw down new brokered CDs and/or roll existing CDs can be significantly compromised should the institution lose its “well-capitalized” status with the regulators. Keep in mind that given the current credit concerns in the marketplace, access to new capital has become both more difficult and more expensive. Additionally, we have found that some community financial institutions that have grown their balance sheets with commercial real estate collateral are finding it increasingly difficult to access funding at affordable rates. An institution with a balanced mix of assets that includes residential mortgage collateral and marketable securities will have greater flexibility in funding resources and more opportunities to access funding at attractive coupon levels.
Unlike the loan portfolio, where collateral haircuts may be set by credit/default risk parameters, or brokered CDs, where the laws of supply and demand determine both funds availability and cost, bonds backed by the U.S. government or government-sponsored entities (GSEs) provide a “near guaranteed” cash resource. The bond portfolio reduces the opportunity cost of holding excess cash, yet can be easily converted to cash via a collateralized borrowing arrangement. History has demonstrated that Wall Street is likely to lend to an institution, even in troubled times, as long as sufficient collateral exists. A Federal Home Loan Bank is also more likely to extend credit to a troubled institution, if adequate security collateral exists.
The Federal Reserve is a financial institution’s only other reliable funding resource in a time of more extreme duress. However, borrowing at the Fed is expensive, and funding is generally provided only on a short-term basis. Accordingly, your institution should typically reach out to the Fed discount window only when all other alternatives have been exhausted.
Interest Rate Risk
While the level and slope of the yield curve have not been rewarding to community financial institutions, they have been very attractive to borrowers. Competitive pricing pressures and the yield curve have made this a predominately fixed-rate lending environment, and as a result, an increasing majority of financial institution balance sheets exhibit liability-sensitive characteristics, whereby margins are exposed to rising interest rates. With limited ability to shorten the loan portfolio and/or extend deposits to offset this risk, alternatives to reduce interest rate risk reside in the capital markets (through adding shorter-duration investment assets or longer-duration funding structures).
Another significant issue is that most community financial institution balance sheets do not demonstrate a symmetrical interest rate risk posture (e.g., earnings at risk to rising rates are not of the same magnitude as the earnings benefit to falling rates). In the example illustrated in Simulation Graph 1, the interest rate risk model for Bank of Anywhere indicates that 12-month net interest income projections will be $1.8 million lower if interest rates rise 200 basis points. However, if interest rates fall, the expected earnings benefit is only $0.5 million. This presents a dilemma for the ALCO since action taken to reduce exposure to the worst case scenario (i.e., rising rates) can create an equal and opposite impact to the best case scenario (i.e., falling rates). If management is not careful, Bank of Anywhere could find itself expecting margins to decline in both rising and falling rates scenarios.
Simulation Graph 1. Bank of Anywhere – Net Interest Income ($000)
Through collateralized borrowings arrangements, community financial institutions are able to structure funding specifically tailored to fit their risk profile. In the example presented in Simulation Graph 2, Bank of Anywhere used a fixed-rate putable funding structure with embedded caps to not only improve current income, but also reduce risk to rising interest rates, without creating added downside risk to a lower rate cycle. This strategy added $2.75 million of net interest income in the first two years of the rising rate scenario (up 200 basis points) while compromising only $0.5 million in the falling rate scenario (down 200 basis points). The key? Requisite investment collateral was available to support this strategy.
Simulation Graph 2. Bank of Anywhere – Net Interest Income ($000)
($30 million of 90-day funds replaced with structured funding w/embedded caps)
Concluding Comments
Unfortunately, our observations have led us to conclude that, while generally risk averse by nature, many community financial institutions have actually accepted greater risk by forgoing prudent investment opportunities. They have allowed the income component to inordinately determine strategy. In an effort to drive asset growth and mitigate margin pressures, loan activity continues to be concentrated in fixed-rate product (i.e., 5- to 10-year terms) and credit spreads have tightened to uncomfortable levels. As the bond portfolio shrinks to accommodate this loan growth, so too does the ability to manage both liquidity and interest rate risk. It would be wise to revisit or reassess your strategy for the investment portfolio to ensure it is appropriately aligned with your overall balance sheet risk-management objectives.
Darnell Canada is a managing director at Darling Consulting Group who consults with and advises financial institutions across the country in the area of asset/liability management.
Darnell can be contacted at
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