Historic Bond Market
Various articles have been written on the 2022 bond market. Many of the seasoned bankers remember going through something similar in the early 80s, an environment observed over 40 years ago! 1980 was the last time the Fed Funds Rate increased by 400+ bps over a 12-month timeframe. For bond market investors, there was no place to hide – every bond investment seemed like a lemon with instant feeling of buyer’s remorse. Even the shorter-duration 2 Year Treasury declined by over 5% in market value as market yield jumped from 0.78% to 4.41% over the course of 2022. As we look to 2023 and beyond, we believe there are important strategies to guide your portfolio and investment decisions.
Bond Prices and Income
By now, everyone is intimately familiar with bond price volatility. While this has implications for balance sheet management, 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 and, in isolation, ignores these important factors:
- 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 alternatives when measured over longer time horizons.
Loss Trade Considerations
With bond trading volumes down significantly in 2022, many institutions are being approached by broker dealers with the idea of executing a loss trade. It is being presented as taking a one-time loss and reinvesting at higher yields to improve future profitability metrics. The messaging reads something like: “Everybody is doing it, so should you!” We have several thoughts on this topic:
- Loss break-even period is important – Generally, break-even periods should be no more than 18 months. Too long of a break-even period (2-3+ years) makes the trade less compelling as many things can change in the market and with the balance sheet over this timeframe. 2022 is a prime and recent example.
- This trade is very balance sheet specific – in cases when there is an extraordinary gain that can offset the loss, forward-looking economics can become more compelling. However, the break-even period still needs to be considered before making a capital “investment” (taking the loss).
- Optimal reinvestment assets are not always securities – high quality loans can be a viable reinvestment option.
- AOCI is reduced by selling at a loss, however the realized loss flows through as a permanent capital reduction resulting in lower regulatory ratios. Again, the economic reality is that for this trade to make sense, you must earn back the loss over a reasonable timeframe and then be in a better position going forward.
Another consideration is you are generally selling shorter assets (lower % of loss), effectively taking that cash flow away from your ladder, and then reinvesting longer on the curve (or taking some other risk, like call, prepayment, or credit) to create a shorter break even. Therefore, impact on near-term liquidity and overall portfolio duration needs to be considered.
Call Protection leads to Balance Sheet Outperformance
Historically, low-rate environments last quite a bit longer than periods of relatively higher yields that we find ourselves in today. Therefore, if your balance sheet calls for rates-down margin protection, call-protected investments must play a key role in the investment portfolio.
Many financial instructions have little call protection in their loan portfolios, as it can be difficult or impossible to institute prepayment penalties. Customers oftentimes have free or low-cost options to refinance existing loans and the recent increase in residential ARM loans add to this optionality. This can make it challenging to manage cash flow during times with interest rate volatility. Investment managers often unknowingly compound this optionality by overweighing investment portfolios in callable agency bonds and certain MBS and CMOs. Our view is that financial institution portfolio construction should have an allocation in securities with longer periods of call protection and/or bullet structures. These investments will act as a natural hedge to the loan portfolio.
Taylor Advisors’ Take:
A potential continuation of a rising rate environment presents a new set of challenges to portfolio managers. Varying expectations for the pace of remaining rate increases and volatility in interest rates on different parts of the curve are just a few of the issues portfolio managers are likely to face. Fortunately, financial institutions have more control over the investment portfolio than any other component of the balance sheet. With proper planning, these risks can be managed while maintaining or even improving portfolio returns leading to balance sheet outperformance.
You have already subscribed to distributions. Thank you for your interest in our publications!