This generation of investment portfolio managers may be forced to contend with a host of issues that hadn't need tackling for more than a decade. You may have heard:

  • Higher rates will create unrealized losses in your investment portfolio;
  • Disintermediation by your depositors will create funding challenges;
  • Bonds with embedded options will extend as they become out-of-the-money; and
  • Management of income through the realization of losses will demand some thought.

The underlying presumption in all of this is that interest rates are on the way up. In fact, the bond market has been predicting this since 2008, when the interest rate curve steepened dramatically. Although the shape to the curve has fluctuated since, it is still normally sloped.

As the year progresses, there is growing suspicion that the Fed's rate hike train may be traveling the tracks more slowly than had been thought at the beginning of 2017. There are more reasons for this sentiment than we have room to explore here, but the salient point for community bank portfolio managers is that some fundamental strategies utilized in the last ten years are still effective right now. 

Rolling Down the Road

For pure excitement, one can do much better than buying bullet securities. These don't have any call options, so there is no debate over when they will mature. Because of this certainty, many community banks employ the ride-the-yield curve strategy when the curve is positively sloped. This entails buying a series of maturities, holding them until they reach a certain remaining life, and reinvesting into a longer bullet. As long as the curve has some slope, it's a money maker. 

As of this writing, the difference in the 2- and 5-year Treasury notes is 60 basis points (.60 percent). Over the last decade, which included some of the steepest curves in a generation, the average has been 85 basis points. So while the fun has diminished somewhat, it's still a reasonably good bet. 

Pre-Re Munis are a Hit

There may be some money in your pocket that you didn't know about. If your community bank's portfolio includes tax-frees, you know that seasoned municipal issues continue to mature and get called. In fact, these roll-offs have had a big impact on municipal spreads, which continue to be tight, as investors struggle to find the limited supply of Ban-Qualified munis.

A subplot to this is the pre-refunded market. A number of outstanding seasoned munis are not yet callable, although their interest rates are in-the-money to be called. Often the municipality will issue more bonds in anticipation of retiring the outstanding ones as soon as possible. For the interim period, the proceeds on the new issue will be invested in Treasuries to pay off the old debt. This begets the name "pre-refunded munis."

This causes the seasoned issues to be effectively guaranteed by the Federal government, and the prices on the bonds will reflect that. This makes "pre-re's" very logical swap candidates. There is no standard reporting mechanism to inform an investor when a pre-re has occurred, so check with your brokers to stay up-to-date on this matter. 

MBS Consolidations Work

One of the key advantages of amortizing bonds like mortgage-backed securities (MBS) is that the investor receives some cash flow every month, whether you like it or not (and these days, you do). This assures that your investment will have a dwindling remaining balance, which eventually will be of such size that it will have very limited liquidity. 

It has long been the recommendation of Vining Sparks, ICBA Securities' endorsed broker-dealer, to "clean up" odd lot pieces of MBS, and consolidate them into fewer, larger blocks. When to do this? It's something of a moving target, but to put a number on it, when the remaining balance on a pool is around $200,000. The liquidity of these odd lots, and therefore the market prices, will depend on variables such as total pool size, stated maturity date and recent prepayment history. 

It's highly likely your community bank owns some or all of these investment sectors mentioned here. Collectively they comprise over 80 percent of community bond portfolios. So you may be able to put several of these techniques to good use, and demonstrate that the more things change, the more they remain the same. 

Reber is president and CEO of ICBA Securities, a WBA Gold Associate Member.