Throughout 2015, the story of the year was “When will the Fed move on rates?” “Will they or won’t they?” We had to wait nearly the entire year for an answer, but finally, on December 16th, the Fed changed its benchmark interest rate for the first time in 7 years. The FOMC felt that the employment situation and inflation expectations were appropriate for an increase. During the year, the economy continued to grow, registering GDP growth of 0.6% in the first quarter, 3.9% in the second quarter, and 2.1% in the third quarter.
Looking into 2016, one cannot ignore the impact of the low price of oil, which began the year below $40 per barrel. Lower oil and gas prices can be a boon for consumers, resulting in extra discretionary cash. After all, consumer spending makes up 70% of the U.S. economy. However, with prices remaining subdued for so long, many companies in the oil and gas industries are experiencing significant stress. The impact has been felt not only among oil and gas companies, but has also been felt by many financial institutions who have made loans to companies in this sector. In most cases, institutions are having to pay extra close attention to these loans.
At the end of 2015, the FOMC moved the overnight rate to the 0.25-0.50% range, the first rate increase in almost a decade. Fragmented employment growth, low inflation expectations, European and Chinese economic uncertainty, and falling commodity prices kept the Fed cautious on its timing for tightening liftoff.
Bond yields generally increased during 2015, with yields on shorter maturity bonds tending to increase more than those on longer maturity bonds. The Treasury curve flattened somewhat, with yield on the 2 Year Treasury rising from 0.66% to 1.05%, and the yield on the 10 Year Treasury rising from 2.11% to 2.27%. The spread between the 2yr and 10yr Treasury contracted 23 basis points, from 1.45% to 1.22%, after tightening significantly in 2014.
Implied forward curves indicate that interest rates are expected to rise gradually during 2016. Approximately a 75 basis point increase in overnight rates is expected (compared to the FOMC’s expectation of a 100 basis point increase). Thereafter, the market expects about another 50 basis point increase in 2017, followed by further gradual increases over the next several years.
Investing in 2016
With short term rates rising, portfolio managers should consider investments that balance the risks from deposit migration out of non-maturity deposits into CDs and slower prepayments on bank loans. Therefore, defensive assets should comprise a certain percentage of bank portfolios. A defensive asset could be described as an investment that has stable cash flow within a short period of time and/or exhibits low price volatility during a rate rise, but also provides a stable source of earnings.
Relative Value and Diversification
Consistent with 2015, mortgage spreads have continued to compress vs bullet Treasuries. In fact, spreads on mortgage products have continued to compress since 2013. Therefore, investors should favor shorter duration cash flows with limited extension risk. Diversifying among collateral types and servicers should also be considered. Fannie Mae and Freddie Mac CMBS (DUS bonds) with locked-out cash flows and short final maturities seem attractive. Other attractive features include borrower prepayment penalties to offset premium risk, bullet-like characteristics, and spread pickup to bullets.
Investors could also look to employ a barbell strategy, investing in short and long term sectors. Shorter securities provide the ability to reposition/reinvest during a rate rise with a significant pick up in yield versus the current Fed Funds rate of 0.25-0.50%.
The second part of the barbell could be longer maturity, call-protected, high quality municipal bonds. Longer municipal securities provide higher tax equivalent yields of 3% – 5% (depending on maturity) with high credit quality. High performing risk adjusted portfolios often have an overweighting of municipals.
Banks continue setting up wholly owned subsidiaries to invest in General Market municipals and take advantage of its relative value yield pick-up vs Bank Qualified municipals with like duration and credit quality. This relative value tax-equivalent yield pick-up can be as high as 1.75% in some cases. The subsidiary also gives the bank the ability to avoid the TEFRA disallowance all together.
Municipal analysis and ongoing monitoring requirements remain in focus as regulatory agencies continue to release updates of their expectations for basic and expanded analysis. Non-reliance on external credit ratings, and more emphasis on independent analysis, will prevent some portfolio managers from taking advantage of the relative value pick up in municipal bonds and consequently outperformance vs. peers.
As the old cliché goes, “Don’t fight the Fed”. Understand how different key rates and sectors perform during Fed tightening cycles and how the bank’s balance sheet is positioned. For example, longer-term municipals outperformed short term taxable investments during the last Fed tightening cycle.
Don’t forget the bank has more control over the investment portfolio than any other component of the balance sheet.
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 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.
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