By Josh KieferThe longer we marinate in this lower-interest rate environment, the greater the concern for higher rates ahead. The need for liquidity to fund long-awaited loan growth is an increasing concern for many banks across the country. The task at hand is to position enough balance sheet liquidity, in the form of consistent cash flows and saleable securities, to help fund the loan pipeline and, at the same time, to structure the portfolio so that a satisfactory level of assets will be re-priced at the appropriate time. For the purpose of this discussion, we are defining liquidity as the degree to which an asset can be readily bought or sold without a substantial widening between the bid price and the offering price. More specifically, when rates begin to rise, will there be a sufficient number of buyers that will allow market makers to competitively bid bonds without a significant widening of the bid/ask spread or discounting of the bid price?
Pictured to the right is a ladder of the liquidity for various fixed-income securities. Please understand this is an oversimplification of a complicated matter, as there are variations within each asset category. Several of these asset sectors, particularly in the middle of the ladder, could be ordered differently, depending on overall structure and maturity. The categories toward the top and bottom of the ladder, however, are fairly predictable in terms of liquidity (or lack thereof). The important takeaway here is that management should have an identifiable and sufficient portion of the portfolio invested in the more liquid assets, which should allow for stable cash flow and ease of liquidation if and when rates begin to trend higher. Because interest rates have declined to such extraordinarily low levels (negative real rates in many cases) and remained at such low levels in recent years, many bank portfolios have drifted into a longer duration with increased optionality. This shift in the dynamics of the portfolio contributed to the severe deterioration in unrealized losses when rates jumped in 2013. In a matter of five months, the yield of the 5YR USTN tripled and the 10YR yield nearly doubled. Virtually all portfolios experienced gains being erased, and many recorded losses for the first time in years.
The catalyst that caused the spike in rates was the initial discussion within the FOMC of tapering its Quantitative Easing program. By year-end, the 10YR Treasury Notes had increased to 3.00 percent, as the actual tapering began in December of 2013. In hindsight, it appeared the taper-tantrum was over, as the 10YR Treasury yield began to trend lower and recently traded under 2.00 percent. All the while the tapering has continued at a steady pace and was completed in October. It is important to understand, however, that all cash flows generated by the Federal Reserve’s investment portfolio will continue to be reinvested until further notice.
What does this mean to a bank portfolio manager? If your experience in 2013 was problematic, management should re-think the investment portfolio with the awareness that the market is now offering an important opportunity to reposition both the asset mix and maturities. Not only have rates moved lower, but everything you owned over that period of time has rolled down the steep yield curve (1-1.5 years). The unrealized gain/loss position of the overall portfolio has rebounded, increasing the liquidity of certain securities.
So how problematic was your experience in 2013? Portfolio managers should simply compare the unrealized profits and losses for each position in April and August of 2013, determine the level of change that is unacceptable to management, and identify the “less favorable positions” within the portfolio. Managers should then monitor the gain/loss position every month and liquidate the more volatile holdings when the gain/loss position reaches an acceptable level. The proceeds can then be used to fund your expanding loan pipeline or be reinvested in the investment portfolio with the focus being toward the top of the liquidity ladder. This repositioning into bonds with a higher degree of liquidity will help lessen the pain of a higher rate environment.
In doing this exercise, you will discover whether or not your portfolio matches the overall rate conviction of your balance sheet. If it does, managers will sleep easy. If not, now is the time to reposition. Please contact Country Club Bank if you’d like our assistance in this important determination.
Josh Kiefer is vice president - investment officer, for Country Club Bank Capital Markets Group. He may be contacted at jkiefer@countryclubbank.com.
This Information is intended for institutional investors only. The material provided in this document/presentation is for informational purposes only and is intended solely for private use. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instruments.
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