Trivia fans, listen up! This column contains facts and figures on yields and returns over the last 20 years that will make you sound positively erudite as you recite them to your friends and family. Unless it makes you appear boorish. But either way, my hope is that you'll find some useful data herein to improve your community bank's performance.
Lost in the downdraft of yields in virtually everything a community bank would care to own is the fact that the returns are even more hideous when they are paired with inflation over the same period. And yes, we have to go through the "nominal versus real" return gymnastics to analyze this phenomenon, but at least it'll serve as a refresher course. And it could even change your gauges for how you determine what's fairly valued when shopping for investments. First, let's review what "fair value" by historical norms has been.
We'll start our research in 1997 which gives us a full 20 years of history, and also leaves out the hyper-inflation periods of the '80's. One way for bond analysts to assess relative value is to compare similar offerings to each other. Another is to compare the stated return, or nominal yield, to then-current inflation. This methodology, which can be quickly assessed since lots of data is readily available, does have an element of flawed logic: yields are influenced much more by inflation expectations than actual inflation. A recent example is the "Trump Bump" that sent yields soaring late last year. Still, the exercise has some utility.
For the 10 years between 1998 and 2007, the market yield on the 5-year U.S. Treasury note averaged 189 basis points higher than the Consumer Price Index (CPI). Stated another way, a consistent buyer of the 5-year earned 4.49 percent, while inflation averaged 2.60 percent, leaving a real return of a bit less than 2.0 percent for the decade. This average was pretty consistent from year to year, which would seem to indicate that investors had pretty durable demands for net returns. However, all of these norms came crashing to earth in 2008.
Fair Value Redux
Beginning immediately after the Fed began pumping monetary stimulus into the economy in 2008, all the old spread relationships collapsed. For the next decade, which brings us to today, the average spread between the 5-year note and CPI was a negative 3 basis points (0.03 percent). Investors have been willing to accept yields that have not kept pace with inflation. Economists would conclude this has been a lost decade from a purchasing power standpoint.
So what happened? Lots of ideas have been floated, but there are three that seem to keep coming up. First, by the end of 2014, the Fed's Quantitative Easing (QE) policy had gobbled up fully 16 percent of all outstanding Treasuries, which limits the supply. Secondly, almost regardless of who is being asked, inflation expectations for the near future remain anchored at 2.0 percent or even less. Thirdly, a quick look around at what else is available for large, institutional investors shows the 5-year Treasury to be a bargain. As of this writing, the Treasury yields 1.66 percent, while those offered by France, Germany, and Japan are mired in negative territory, and the U.K. is below 50 basis points.
Where to go from here
Analysts are divided on the impact on future yields from the Fed's long-awaited shrinkage of its massive balance sheet. The slowness of the wind-down is designed to prevent market yield spikes, but the facts are that this is uncharted territory. The Fed can, it's true, stop the unwinding if the market signals its disapproval. There are also still a few market hawks out there who believe inflation is waiting to erupt, which could create at least temporary sell-offs.
Still, it's hard to envision that real returns on Treasuries will revisit their days of previous decades. The instruments that banks actually own, which are not issued by Uncle Sam but his cousins, certainly have higher real returns, albeit far less than decades past. The conclusion is a happy reminder: Community banks ultimately are not attempting to achieve a certain real return, over and above inflation. They are instead trying to improve on their net interest margin, over and above cost of funds. Thanks to the rate hikes engineered by the Fed, and careful deposit cost management, many if not most community banks are now experiencing an improvement in net margins, thank you very much.
Reber is president and CEO of ICBA Securities and can be reached at 800-422-6442 or firstname.lastname@example.org. ICBA Services Network is a WBA Gold Associate Member.