From May to September 2013, rising rates erased $58 billion from the value of bank investment portfolios, according to the Federal Reserve. This unsettling trend has many banks rethinking their investment portfolio approaches.
Over the last several years, historically low rates prompted many banks to add duration in an effort to generate higher yields. According to the FDIC, the proportion of community banks holding large volumes of long-term, low rate assets has grown from 20% to almost 50% over the last six years. As the economy approached the end of a secular decline in interest rates, extending asset durations was generally considered a viable strategy to generate returns. We think bank investment strategies will now need to adapt from here.
The regulatory capital framework has pushed some banks into suboptimal bond allocations in investment portfolios. Specifically, capital requirements tend to favor fixed income sectors that generate returns primarily through maturity extension (duration) and negative convexity (mortgage-backed securities prepayment volatility). As the Federal Reserve contemplates removal of its extraordinary quantitative easing program, we believe the risk factors embedded in these securities are likely to be disappointing sources of returns.
We believe that fixed income investors, banks included, may need to look to broader sources of bond portfolio return potential in the future. Now more than ever, portfolio decisions need to be made in the context of an investment process that considers the macroeconomic environment, valuations and market technicals that drive the returns of various fixed income sectors.
Diversify sources of potential return: While this may sound obvious, many bank investment portfolios (particularly at midsize or smaller banks) heavily emphasize investments in government securities particularly those backed by mortgage cash flows. This positioning has been generally favorable in recent years due to its capital efficiency and direct support from Fed purchases that has kept interest rates in a narrow range. While bank allocations may appear solid from a credit standpoint, the emphasis on government-backed debt and mortgage collateral implies heavier reliance on returns derived from duration and volatility (or prepayment) risks.
Other sources of risk including credit, curve and liquidity may provide diversification and potentially improved yield and total return potential. Paying close attention to security selection and valuation, however, is essential to ensure investors are properly compensated for these diverse sources of risk.
Think globally: We believethe U.S. will likely continue to serve as the worlds reserve currency and house the largest and most liquid capital markets into the foreseeable future, but as the global economy has evolved, the proportion of growth contributed by the U.S. has gradually declined while its contribution to total debt continues to rise.
All else equal, banks generally prefer to lend to entities and individuals with lower debt burdens and higher income and revenue prospects and the same preference is natural for the securities portfolio. There are undoubtedly other factors to consider before geographically expanding the investment scope, but foreign exposures among midsize and small bank holding companies suggest ample room to expand where economically sensible: Only 10% of domestic banks have exposure to non-U.S. issuers, with average exposure at 6% for banks with greater than $50 billion in assets and below 1% for banks with less than $50 billion, according to: SNL Financial and PIMCO data as of midyear. Foreign exposures do not require taking currency risk; we believe many global opportunities exist in external (U.S.-dollar-denominated) formats.
Ensure fundamentals are consistent with valuations: Markets saw a sharp rise in interest rates by the end of June 2013 that, in our view, was technically driven and inconsistent with underlying economic realities. A disciplined investment process can help banks uncover opportunities where prices become disconnected with fundamentals. Targeting these opportunities can enhance portfolio return potential.
Focus on portions of the yield curve that may offer more favorable risk-adjusted returns: The short end of the yield curve is anchored by a policy rate that, in our view, will remain zero bound for an extended period of time. If forward rates are pricing in rate hikes too early (as we believe they are), there may be potential to capture yield and benefit from price appreciation. If forward rates appropriately price in the timing and level of policy rate increases, potential unrealized losses may be buffered by returns as bonds "roll down" steep portions of the yield curve (in addition to generating higher coupon income).
Combining these approaches may help banks build more resilient investment portfolios across a range of economic scenarios. Implementation may require modification to policies, processes and resources.
Justin Ayre is an account manager and Chitrang Purani is a portfolio manager at Pacific Investment Management Co., where both are senior vice presidents.