During most of 2020, Treasury yields remained very low with a flat yield curve as investors wrestled with the pandemic’s impact on global growth prospects and inflation. As we turned the page to 2021, market optimism emerged, with some data indicating the pandemic was waning due to global vaccine roll-out. As a result, investors began assessing higher inflation risks, and bond yields started to rise on the longer end of the curve, creating yield curve slope. With higher market yields, investors began to see lower bond prices in their investment portfolios, impacting the unrealized gain/loss position. With more potential volatility on the horizon, it is important for management teams and Boards to understand the mechanics of fixed income investing and assess if a change in strategy might be warranted given the ever-evolving economic landscape.
Bond Market
For purposes of this eBrief, we will focus on the 5 Yr and 10 Yr Treasury yields, as many fixed income investments and loans are priced based off these benchmark risk-free assets. The yield on the 10 Yr Treasury ended 2020 at 0.92%, and by the end of 1Q21, it increased to 1.74%. This equated to a price decline of approximately 7.5 points, or $750,000 for every $10 million held, over a span of 90 days.
The increase in 5 Yr Treasury yield was less pronounced but still meaningful for bond prices. It began 2021 yielding 0.36%, and by March 31st, it rose to 0.94%. The price decline for the 5 Yr Treasury was approximately 2.8 points, or $280,000 for every $10 million held, over the same period.
Many bank-permissible investments have a relatively high correlation with Treasury yields and prices. Therefore, bond portfolio market values saw declines during the first three months of 2021, creating swings in the unrealized gain and loss positions.
As discussed above, this sharp move in yields can be attributed to higher inflationary expectations by the market given expected economic rebound and significant government stimulus inflating the money supply. Another force driving Treasury yields higher is the Fed’s eventual tapering of their bond-buying program.
Bond Prices and Income
With the recent uptick in bond price volatility, the first thing that usually comes to mind is the impact on the investment portfolio’s market value. While this is a legitimate concern, it is important to keep things in perspective. Bankers often have two common misconceptions when it comes to market values: if interest rates go up and the price of a bond goes down, the bank is losing; if interest rates go down and the price of a bond goes up, the bank is winning. However, bond price volatility is only part of the story. Other key factors to consider include:
- Interest rate related price volatility is temporary, and many bonds will mature or be called at par. Over time, as investments age and roll down the curve, price volatility will lessen as pricing converges towards par.
- A bond’s current income and contribution towards capital generation is permanent, which outweighs the alternative of the current cash drag and limited price volatility, especially when measured over a longer time horizon.
Diversification and Analytics
A key to portfolio management is diversification and understanding that not all bond prices move in tandem. For example, tax-free municipal bond prices declined by a much lower amount than Treasury bonds of comparable duration because of the higher appetite for tax-free municipal bonds in the market. With the steeper yield curve, investors should not shy away from “certain” municipals, given increasing demand because of potentially higher Federal income taxes for corporations and individuals, which will help cushion market value declines of municipals relative to Treasuries.
Expected and actual bond price volatility and the corresponding unrealized gains and losses affect the investment decision process. Remaining focused and disciplined during these uncertain times is critical in forming a well-thought-out investment process. Below are several tools to help investment strategy formation:
- Cash Flow Scenario Analysis
- Rate Shock Analysis
- Sector Analysis
- Breakeven Analysis
Balance Sheet Perspective
Within the balance sheet, transparency in price volatility is unique to the investment portfolio, where we receive monthly market-based pricing. It’s important to remember that other assets and liabilities have price volatility; albeit the impact is not included in accumulated other comprehensive income (AOCI). However, economic value of equity provides a snapshot of market pricing of all assets and liabilities and should help alleviate some concerns. Furthermore, for nearly all institutions that ‘opted out’ of the advanced approach for the AOCI election in 2015, unrealized gains and losses are excluded from regulatory capital for AFS/HTM portfolios provided price appreciation/depreciation is temporary (interest rate risk) and not a permanent (credit risk) impairment of capital.
Taylor Advisors’ Take:
Keep Calm and Carry On! What we mean by “Carry On” is in reference to the carry trade, which is investing some of the excess cash along the yield curve as opposed to holding it in your Fed account. Financial institutions generally make more money when there is slope in the yield curve.
We recommend that our clients prudently deploy excess liquidity into higher-yielding earning assets and begin building retained earnings today to fortify capital accounts in anticipation of larger balance sheets over the next few years. It is their least expensive source of capital vs. debt or equity issuance.
The implied forward curve is currently pricing in over 200 bps increase in short term rates over the next 5 years, equal to Fed’s Long-term Fed Funds Target. “Select” investments are paying you for the interest rate risk you are trying to avoid by staying in cash. With this in mind, we want to capture income and stay ahead of the steep yield curve.
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