Banks face tough decisions on investment portfolios amid Fed rate pause
It's a tough time to be a bank’s investment portfolio manager: Interest rates are expected to remain flat for the near future while deposit costs keep rising.
That forecast will put pressure on margins — and on the officials in charge of tinkering with banks' securities portfolios to make up for lost net interest income from lending.
But it would be a serious mistake for those officials to make knee-jerk purchases of higher-yielding securities and ignore the long-term implications of that strategy, several experts on interest rate risk said.
“If you aren’t thinking about the rate environment in two or three years, you can do drastic damage to the net income profile of your institution,” said Dan Flaningan, chief strategic officer at the $12.1 billion-asset Bremer Bank in St. Paul, Minn.
The Federal Reserve indicated this month that it is likely to stay put on rates indefinitely amid mixed signals on the outlook for inflation and uncertainty around the trade war with China. The Fed’s stance signals the end of a long period of rate hikes — the Fed has increased rates nine times since December 2015.
That steady cycle of rate hikes had been the motor behind banks’ bottom-line growth in recent years. Many institutions turbocharged profits by slowly boosting deposit rates while loan yields rose rapidly. But with competition for deposits still hot, and consumers' appetite for better rates whetted, banks will probably have to keep raising deposit rates without the benefit of rising loan yields.
Analysts at Sandler O’Neill, in a May 23 report, predicted that net interest margins will shrink five basis points by the fourth quarter of 2020 among the 230 banks they follow. They also forecast that 2019 will be the first time since 2015 that full-year net interest income growth will only be in the single digits.
With an outlook like that, it is understandable that some bankers may scramble to find higher yields through securities, said David Sweeney, managing director at Chatham Investment Advisors in Kennett Square, Pa. But that can unnecessarily add risk to a bank’s balance sheet, he said.
“Sometimes banks say they want to take on a lot of risk to get the most yield possible,” said Sweeney, who manages investment portfolios for community and midsize banks.
Instead, Sweeney advises his clients to adapt a barbell approach, where about half the bank’s securities portfolio is in short-term notes that can quickly be sold to generate liquidity in the event of rapid economic shifts, and half in longer-term bonds that can generate a little more yield.
It is a safe way for a bank to hedge their bets, he said.
“If I was sitting at a cocktail party and somebody asked me how to invest if rates are flat, I would suggest they take a neutral position,” Sweeney said.
Further complicating matters is the flat yield curve— the slim difference in the yield of short-term securities versus long-term securities. Since an investor can get about the same yield from short-term securities as from long-term, some bankers may decide that long-term vehicles are not worth the risk.
But bankers should try to look at where the economy will be several years out, and not go for the quick fix, said Jeff Caughron, CEO at The Baker Group in Oklahoma City. That is especially true if the Fed actually cuts rates the next time it makes a move.
“Right now, counterintuitive as it may seem, is a good time extend duration and lock in yields at current levels, since the trend appears to be headed toward lower, not higher rates” said Caughron, who advises community banks on securities portfolio management.
Some banks are set to benefit this year from past decisions.
The $69.2 billion-asset Zions Bancorp. in Salt Lake City bought a large number of securities several years ago that are now maturing, James Abbott, senior vice president of investor relations, said on May 14 at an investor conference. Those securities yield about 2.25%, but after the Fed’s multiple rate hikes, Zions is replacing them with securities that yield between 2.85% and 2.9%.
“It’s a nice tailwind for the next several years,” Abbott said. “It just doesn’t happen overnight.”
Flaningan agrees that many bankers make the mistake of not planning for future rate moves.
“This is the worst environment for banks, when there’s a flat yield curve,” said Flaningan, who also serves as Bremer Bank’s treasurer. “A lot of banks want to shorten their investment profile because they’re not being compensated for being farther out on the curve.”
The best tactic is to avoid overreacting to the current difficult scenario of shrinking profit margins, Caughron said. Instead, use the securities portfolio as a way to position the bank for profit growth when the Fed takes its next step, whether it is cutting rates or raising them.
Bankers may want to avoid some securities that offer higher yields but are harder to sell and thus are less liquid, Caughron said. These include private-label asset-backed securities and collateralized loan obligations.
“The best managed banks are those that read the signals from market behavior and yield curve trends and make investment decisions accordingly,” Caughron said.