Investment securities have undergone big changes this year.
If there’s a constant in the world of a community bank investment manager, it’s disappointment. If you buy a bond today and yields go down tomorrow, you wish you’d have bought more; if yields go up, you wish you had bought none. If your overall portfolio has unrealized gains, you lament the poor yields that are available; if you are presented with attractive rates on new offerings, it means you’ve got losses on the balance sheet.
As we navigate the volatile rate environment of 2021, I’d like to convey some data that we’ve gathered about community bank portfolios. The motive is expressly not in the vein of misery loves company, but rather to share what your peers’ portfolios, sector weightings and yields look like.
I am also pleased that we’ve got two great reference points by which to measure performance: December 31, 2020 and June 30, 2021. That six-month period saw a rise in interest rates and a steepening of the curve, and more than a 50 basis-point shock (0.50%) in the middle of the maturity range. The five-year treasury note started 2021 at 0.36% and six months later was 0.89%.
Our sample portfolio, which I’ve used often in this space over the years, is the Vining Sparks bond accounting client base. Vining Sparks, which is ICBA Securities’ exclusive broker, provides this service for about 400 community banks with an average portfolio size of $140 million, which is 46% larger than pre-pandemic levels.
These portfolios have more than half of their dollars in some type of mortgage security. Fixed-rate mortgage-backed securities (MBSs) comprise 31% of the total, fixed-rate collateralized mortgage obligations (CMOs) are 14% and floating rate MBS are 7%. Right around 29% of the investments are in municipals. The bulk of the remainder, 8%, is in government agency bonds.
While the sector weightings are essentially unchanged over the past year, there are two stark differences: duration and market values. On December 31, 2020, the average portfolio had a duration of 3.2 years. (Duration is a major yardstick for investment managers, as it affects cash flow and market risk. The higher the duration, the greater the risk.) Six short months later, duration had risen to 4.3 years. So, portfolios, at least in theory, have 34% more risk than at year end.
This duration growth was the result of two separate events. The first was the rise in longer-term rates. I think we’ve come to realize that higher rates move average durations out on the curve, as prepayments of amortizing securities tend to slow, and other callable securities don’t get called. The second — and more salient — cause was the very deliberate extension of average maturities as portfolio managers have tried to sop up the excess liquidity residing on community bank balance sheets.
Something else that’s changed as a result is the unrealized profit. Back in December 2020, the average portfolio was sitting on a 2.7% gain. By June, that number had shrunk to 1.0%. What this, in effect, means is that most banks currently own some bonds at gains and some at losses, which can be seen as condition that affords maximum flexibility.
Plug the leak
Many portfolio managers are now focused on limiting further extension risk. That should not be terribly difficult to do, as most securities that have any seasoning to them have already been repriced to a longer expected maturity. Prepayment “speeds” have slowed from their peaks in the spring, and most models are predicting relatively consistent speeds for the near future.
Nonetheless, not all MBSs are created equally. Collateral with 10- to 20-year finals typically can continue to prepay with some consistency even if interest rates rise. Of course, the scheduled principal repayments will be much greater for shorter pools than for 30-year pools, independent of prepays.
A variation on this theme is to buy “structure.” This usually means a CMO. Recently issued CMOs have low pass-through rates (“coupons”) relative to the borrowers’ rates on the underlying collateral. This allows investors to keep their book prices closer to par, which will preserve book yields if prepayments were to kick back into high gear.
So, there you have a revisiting of the portfolio changes during 2021. By being on top of the changing complexion of your community bank’s investments, you can minimize your disappointments. Avoiding the constant sorrow of portfolio management — with apologies to the Soggy Bottom Boys — can be your milestone accomplishment of the year.
Jim Reber is president and CEO of ICBA Securities, ICBA’s institutional, fixed-income broker-dealer for community banks.