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By Jim Reber, president and CEO of ICBA Securities 

Community bankers are nothing if not predictable, and I mean that as a compliment. They are bright, enterprising, have a nose for the risk/reward dynamic and a sense of duty and loyalty to their customers and staff. They’re also deathly afraid of rising interest rates.

The last is understandable, speaking as one who has A. worked for a bank when overnight rates were double-digit, B. personally borrowed money for a home at 12%, and C. worked in financial services during the near-death of the thrift industry. We know how low rates can go. What we don’t know is how high they can go, nor for how long.

But what’s a bit curious about this widespread fear is that by a number of measures, community banks in 2022 stand to profit from higher interest rates. This comes from banking regulators, interest rate risk modelers, and even bankers themselves. I suppose the notion of a bond portfolio losing four, five or six percent of its value drives some of this thought process. So, as we haven’t had to endure a rate hike scenario since 2018, we’ll use the rest of this column to remind ourselves which bonds stand a good chance of performing well if higher rates do indeed prevail in the near future.

Old School

Certainly, the bonds that fit the most traditional definition of a floater are those which have very short reset periods, are indexed to money market equivalents, and have large or no caps, both periodic and lifetime. The model for such a security is a Small Business Administration (SBA) 7(a) pool. These securities float based on the prime rate, which is 100% correlated to fed funds. Most SBAs reset monthly or quarterly and have no caps—so wherever prime goes, so goes your yield.

The rub on SBAs, at least from a risk standpoint, is that many of them come with large premium prices of 108, 109 or even higher. This exposes the investor to unwelcome prepayments. Still, the many benefits (have we mentioned 0% risk weighting?) make them attractive to short investors. It’s not uncommon for them to yield around prime minus 2.75%, which will beat fed funds by about 25 basis points (0.25%). They are true money market alternatives.

Mortgage Floaters

These days there are few true mortgage-backed securities (MBS) floaters. The ones that do exist usually have an extended period of time with a fixed rate, before they convert to adjustable. This “extended period” can be three, five, seven years or more so they’re really not floaters, yet. However, the fact that one day they will adjust can help their market value stay relatively stable.

Something new about these is that the Secured Overnight Financing Rate (SOFR) index is becoming more visible. SOFR is the U.S. alternative to London Interbank Offered Rate (LIBOR), and it has generally tracked fed funds, so far. And, since these will have prices closer to par, the investor doesn’t have to take a gigantic bite of prepay risk. Starting yields are wholly dependent on the fixed rate period and other variables, but they deserve a look.

Clip Coupons

Even if you don’t own a floater, an easy-to-execute trade that will help limit your price volatility is “up-in-coupon” securities. It doesn’t matter if they’re MBS, agencies, or munis: The bigger the stated interest rate, the greater the cash flow and the lower the duration.

The best example of this strategy is a tax-free municipal bond that has a big stated interest rate, or “coupon.” It’s common to see a newly hatched security with a 4% rate, that comes to market at an original issue price of 120 or more. This is a quality to be embraced. For one thing, the fact that the yield is tax-free makes the security less volatile that a taxable bond. If (and when, it appears) interest rates rise, the large interest payments will further help keep the value of the bond from falling off the table.

Do-it-Yourself

There’s another way to inject floating rate securities into your bond portfolio, and that’s to build them yourself. It’s a simple task to buy and own a collection of long-durated municipal bonds—that’s how they typically come to market. A recent innovation is the ability to execute an interest rate swap to instantly, or at some designated point in the future, turn the munis into floaters.

Interest rate product providers are equipped to price out transactions whereby a community bank can convert a bond, a collection of bonds, or a subsector of your balance sheet into short-duration assets that will see their yields improve every time the Fed has a “policy adjustment.” Maybe the best news is that these transactions can now be executed in sizes that fit your community bank’s needs.

How many rate hikes might we see this year? That’s the subject of myriad conversations around the board room, water cooler, and ALCOs. I’m pleased to report investments that are built for rising rates can take on a variety of appearances, and are fully accessible to your community bank.

Events

The WBA Adjustable Rate Mortgages Webinar Series will include 3 virtual half-day sessions. Sessions will be held on Zoom from 9:30–11:00 a.m. CT on October 18, 9:30–10:30 a.m. CT on November 1, and 9:30–11:00 a.m. CT on November 8.

About the Program:

This ARM webinar will provide comprehensive training on Regulation Z early ARM regulation requirements, including early disclosure requirements, Note/Agreement disclosure requirements, and a comprehensive training on Regulation Z ARM regulation requirements related to ARM notices and potential consumer harm when servicing ARMs . In addition, you will gain an understanding of the differences between variable rate and fixed rate loans, so you can explain the features and benefits of each to customers.

Who Should Attend:

This informative series is useful for any personnel involved in the consumer ARM process including loan officers, loan operations personnel, underwriting personnel, compliance personnel, auditors, attorneys, and managers.

About Our ARMs Facilitator:

Tracy Bush, CRCM
Senior Manager
Wipfli, LLP, Eau Claire

As a key member of the Wipfli’s Financial Services Regulatory Compliance team, Bush has more than 20 years of financial institution experience, including a strong background in compliance and Bank Secrecy Act (BSA)/Anti-Money Laundering (AML), as well as lending, deposit and teller operations. This experience has allowed Bush to develop strong advisory, training and leadership skills. She has designed, implemented, and monitored full-scope, risk-based compliance and BSA programs. Bush has a deep understanding of the issues facing financial institutions and is able to provide meaningful insight and recommendations.

Registration Information:

The registration fee of $500/bank includes one connection to each of the three live webinar sessions, as well as access to each session recording for 60 days following each live webinar. If your bank plans to join a session (or all sessions) from multiple locations/connections, please contact WBA Education for discounted additional connections.

An exploration of interest rate risk measurement techniques such as GAP, earnings sensitivity analysis, Duration GAP, and economic value of equity sensitivity analysis. Risk management policy implementation and how to change overall interest rate sensitivity through balance sheet adjustments or derivative contracts are discussed.

The required textbook for this course is Bank Management, 8th Edition.

IMPORTANT:  Be sure to order the required book for this course if you do not have it.  We recommend that you FIRST select and add your course session to the shopping cart, then select your preferred format of book from the “Recommended Training” options that appear alongside the shopping cart.

Please note this book is used for all four Bank Management courses: Managing Interest Rate Risk, Analyzing Bank Performance, Managing Funding, Liquidity, and Capital, and Managing the Bank’s Investment Portfolio.

An overview of tools and techniques to analyze and improve a bank’s financial performance. Participants observe the effects of certain kinds of risk on a bank’s financial track record, and the correlation between risk optimization and superior financial performance.

Audience: This course is designed for junior-level bank officers all the way up through CEOs who need to analyze their bank’s performance. Participants should have basic knowledge of balance sheets and income statements.

The required textbook for this course is Bank Management, 8th Edition.

IMPORTANT:  Be sure to order the required book for this course.  We recommend that you FIRST select and add your course session to the shopping cart, then select the book from the “Recommended Training” options that appear alongside the shopping cart.

*Please note this book is used for all four Bank Management courses: Analyzing Bank Performance, Managing Interest Rate Risk, Managing Funding, Liquidity, and Capital, and Managing the Bank’s Investment Portfolio.*

Price: $660

An overview of tools and techniques to analyze and improve a bank’s financial performance. Participants observe the effects of certain kinds of risk on a bank’s financial track record, and the correlation between risk optimization and superior financial performance.

Audience: This course is designed for junior-level bank officers all the way up through CEOs who need to analyze their bank’s performance. Participants should have basic knowledge of balance sheets and income statements.

The required textbook for this course is Bank Management, 8th Edition.

IMPORTANT:  Be sure to order the required book for this course.  We recommend that you FIRST select and add your course session to the shopping cart, then select the book from the “Recommended Training” options that appear alongside the shopping cart.

*Please note this book is used for all four Bank Management courses: Analyzing Bank Performance, Managing Interest Rate Risk, Managing Funding, Liquidity, and Capital, and Managing the Bank’s Investment Portfolio.*

Price: $660

An exploration of interest rate risk measurement techniques such as GAP, earnings sensitivity analysis, Duration GAP and economic value of equity sensitivity analysis. Risk management policy implementation and how to change overall interest rate sensitivity through balance sheet adjustments or derivative contracts are discussed.

Audience: Managing Interest Rate Risk is a rigorous course designed for individuals involved in asset liability management or line managers making pricing, investment, or funding decisions that impact interest rate risk.

The required textbook for this course is Bank Management, 8th Edition.

IMPORTANT:  Be sure to order the required book for this course if you do not have it.  We recommend that you FIRST select and add your course session to the shopping cart, then select your preferred format of book from the “Recommended Training” options that appear alongside the shopping cart.

*Please note this book is used for all four Bank Management courses: Managing Interest Rate Risk, Analyzing Bank Performance, Managing Funding, Liquidity, and Capital, and Managing the Bank’s Investment Portfolio.*

Price: $660

An exploration of interest rate risk measurement techniques such as GAP, earnings sensitivity analysis, Duration GAP and economic value of equity sensitivity analysis. Risk management policy implementation and how to change overall interest rate sensitivity through balance sheet adjustments or derivative contracts are discussed.

Audience: Managing Interest Rate Risk is a rigorous course designed for individuals involved in asset liability management or line managers making pricing, investment, or funding decisions that impact interest rate risk.

The required textbook for this course is Bank Management, 8th Edition.

IMPORTANT:  Be sure to order the required book for this course if you do not have it.  We recommend that you FIRST select and add your course session to the shopping cart, then select your preferred format of book from the “Recommended Training” options that appear alongside the shopping cart.

*Please note this book is used for all four Bank Management courses: Managing Interest Rate Risk, Analyzing Bank Performance, Managing Funding, Liquidity, and Capital, and Managing the Bank’s Investment Portfolio.*

Price: $660