On June 19, 2013, the Federal Open Market Committee ended a two-day meeting and concluded that it may wind down its Quantitative Easing program later in 2013 and possibly end it completely in mid-2014. Ben Bernanke, chairman of the Federal Reserve, stated “the committee currently anticipates that it would be appropriate to moderate the pace of purchases later this year.” There has been much speculation in the global financial markets about when the Fed will begin to “taper” its program of buying Treasuries and Mortgage-Backed Securities, and the majority of economists did not expect that it would begin this soon. This surprise statement from the Fed shocked many in the financial markets, and its effect on interest rates has had a major impact on all types of asset classes, from commodities to equities to bonds.
Current 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 of these benchmark risk‐free assets. The yield on the 10 Yr Treasury ended 2012 at 1.70%, and during the latter half of 2012 ranged from 1.60‐1.80%. During the 1st quarter of 2013, the yield rose slightly above 2.00%, and fell back to 1.60% in early May. At this point, Treasuries began a rapid sell‐off. On April 30, the 10 Yr yield stood at 1.67%. By June 24, it had reached a yield of 2.60%, for an increase of 93 basis points in less than 2 months. From June 19th, the end of the Fed meeting, to June 24th, the price of the 10Yr Treasury declined from 96 ¼ to 92 ¾. For every $10 million held, this equated to a market value loss of $350,000 in a span of four trading days.
The 5 Yr Treasury has followed a similar path. It began 2013 yielding 0.72%, and by April 30th, was little changed, at 0.68%. The resulting sell‐off took the yield up to 1.45% on June 24th, more than doubling in yield. From June 19th to June 24th, it declined in price from 99 ¾ to 97 ¾, or $200,000 for every $10,000,000 held. The price decline for the 5 Yr Treasury (and the 10 Yr as well) would be even more dramatic if considered from the period of April 30th through June 24th. Assuming a typical bank bond portfolio having a duration of 3.5, the change in market yields from April 30th to June 24th of 77 bpts would have resulted in an approximate market value change of ‐2.7% when comparing bond accounting reports from April 30th to June 30th.
This turbulence is directly related to the actions of the Federal Reserve, which is currently buying $85 billion of bonds every month ($40 billion per month in MBS and $45 billion per month in Treasuries). By buying significant amounts of these assets, the Fed is able to keep interest rates at record lows. When the Fed stops buying securities and demand for these assets from the Fed wanes, prices of Treasuries and MBS will decline, which will cause yields to rise. Bond markets, preparing/anticipating this event, have sold off for nearly two months, with the highest volatility in yields occurring immediately after the FOMC meeting June 19th.
Bond Prices and Income
With the recent surge in bond price volatility causing bond prices to decline across the board, of course the first thing that usually comes to mind is their impact on the market value of the investment portfolio. 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.
A bond’s current income also plays a major role in its performance. For example, suppose a fixed‐income asset declined in price from $100 to $98. This decline equates to a $20,000 market value decline for every million dollars invested. A board member may question whether this was a good or bad investment, but market value gains and losses alone are just not enough information to make this determination. Why? If an investment lost 2 points, or 2%, in a year and the bond had a 3% coupon, the return on the investment over a one year would still be 1% (3% in income minus 2% market value loss). Investors should not forget to factor in current income and choose an appropriate time horizon when measuring a bond’s performance. This is an especially important consideration given the level of overnight rates since late 2008 at 0.25%. Interest income earned over the 0.25% benchmark since the purchase date should be factored into the analysis. Remember, many bank portfolios have higher yielding assets with longer duration, e.g., high quality municipals.
The lesson to keep in mind is to remain prudent and not let the recent volatility throw your institution’s plans off course. Staying defensive and purchasing short duration assets will help mitigate a degree of this volatility, because bonds with short durations typically are less price‐sensitive to movements in interest rates. Therefore, defensive assets should comprise a certain percentage of bank portfolios. This is one of the main tenets of diversification. A defensive asset could be described as an investment that has cash flow within a short period of time and/or exhibits low price volatility during a rate rise. A longer duration asset could experience a market value loss, which would hamper the ability to reinvest the funds in a higher interest‐rate environment and usually leave the investor with a below‐market yield.
Furthermore, chaotic situations can often lead to opportunities, and that may be the case here as well. For example, by using this opportunity to stay short, your institution could actually now get an acceptable return on the short‐end of the curve: i.e. 1‐4 years with little to no extension risk. Occasionally, extremely cheap municipals will be available, many with high coupons and high yields to call, because very few dealers are bidding municipal paper or are bidding it very cheap because of the difficulty with hedging the positions.
Tools and Techniques for Gauging Portfolio and Bond Volatility
Expected and actual bond price volatility and the corresponding gains and loses have an effect on 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 ideas to help investment strategy formation:
• Use Cash Flow Scenario Analysis: Model the existing investment portfolio and new security purchases using different interest rate, prepayment, and call assumptions. Applying various assumptions and interest rate scenarios can help identify which investments to avoid or purchase, and can also help uncover how cash flow and income can change under different scenarios.
• Perform Rate Shock Analysis: With interest rates proving capable of making large moves in short amounts of time, examining the effects of rate shocks for changes of +/‐100, 200, and 300 basis points can give a good idea of what to expect in different environments. An analysis of duration, percentage price change, and gains/losses is a great preparatory tool.
• Perform Sector Analysis: Group individual securities with similar risk/return characteristics based on different criteria, such as their cash flow profile, starting yield or spread, and credit quality. Frequent portfolio re‐sectoring is useful because securities change over time and over different interest rate scenarios. Also, one will be able to identify concentrations to see if the portfolio needs further diversification.
• Avoid Yield Chasing: In this low interest‐rate environment, many bankers have been guilty of trying to reach for yield by taking on excessive risks. Proper purchase analysis typically would have uncovered these high‐risk securities and would have prevented the initial purchase.
Prudent investors must evaluate all the risks embedded in a security or a portfolio of securities before making an investment decision. Portfolio managers must also consider the bank’s asset/liability makeup when designing fixed‐income investment strategies. A community bank’s investment portfolio is not a standalone group of assets. Rather, it is an integral part of a bank’s balance sheet, along with loans, deposits, and equity capital. Moreover, more often than not, the role of the investment portfolio as an A/L management tool is simply overlooked. Before making investment decisions, it is critical to have a solid understanding of the institution’s A/L sensitivity, overall balance sheet composition, and short‐ and long‐term goals.
Conclusion: Bond price volatility will likely remain throughout 2013, as markets try to anticipate the timing of the Federal Reserve winding down its bond purchases. To deal with this type of environment effectively, it is important to remember that the market price of a bond is not “the be‐all and the end‐all”, and that there may be opportunities to pick up yield on the short end of the curve. Staying prudent and investing in defensive assets will help mitigate some of the volatility recently experienced in the bond market. Considering other attributes such as income, time horizon, and the A/L profile, and performing purchase analysis, including scenario and sector analysis, may also help to prepare your institution for the volatility risk associated with fixed‐income investing in a rising rate environment.
Taylor Advisors, Inc. is a balance sheet consulting firm and a registered investment advisor based in Louisville, Kentucky. We are not a brokerage firm, but a team of asset liability analysts and balance sheet consultants to community-based financial institutions. Our service is quite simple. We help banks improve or maintain profitability while managing interest rate risk – what we call Balance Sheet Management (BSM). BSM consulting entails providing advice, strategies, monitoring, and most importantly, education in many areas: investments, asset/liability, liquidity/funding, and risk management.
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