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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

Recent events have certainly put a new focus on interest rates. This unprecedented volatility reminds us that interest rate risk management in not just a trivial exercise, but a critical endeavor to the ongoing safety and security of an organization’s capital

Interest rate derivative solutions (Swaps/Caps/Floors) have become a valuable tool for many financial institutions when managing interest rate risk. These tools allow for customized solutions that can minimize interest rate risk, and in many instances provide additive margin.

The class will explore the interest rate swaps and options market from a very basic and applied management perspective. We will look at how these tools can and should be utilized to properly price various assets and liabilities to meet management’s objectives and expectations in this new rate environment.

Additionally, with the imminent dissolution of Libor (scheduled for 2021) we will discuss potential replacement indices and provide an update as to the progress of the initiative.

From locking in a maximum rate paid on capital and funding structures, to effective pricing of fixed rate loans, the proper application of these interest rate management tools will allow you to tailor interest rate characteristics throughout the balance sheet that will minimize your interest rate risk and maximize interest margins. 

Target Audience: Senior level managers with A/L management background, ALCO committee members, senior level lenders

Presenter: Dan Dwyer, Dwyer Capital Strategies, LLC

Registration Option: Live presentation $275

Recording available through January 5, 2023

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.

May 18 – Stevens Point
9:00am – 3:15pm
SentryWorld
601 Michigan Ave N, Stevens Point

May 19 – Madison
9:00am – 3:15pm
DoubleTree by Hilton Madison East
4402 E Washington Ave, Madison

This one-day WBA Directors Summit will discuss key issues regarding leadership and management of community banks from the director’s perspective. The Summit is recommended for bank management teams, beginning or experienced inside and outside directors, bank CEOs, executive officers, and bank general counsel.

Summit Topics:

  • Directors’ Responsibilities in the Investment Portfolio
  • Unlock and Inspire a Team that Spans 4 Generations
  • A Director’s Role in Today’s Changing Banking Environment
  • Path of Interest Rates
  • Excess Liquidity and Liquidity Management
  • Maximizing Earnings vs. Managing Earnings at Risk

Registration Information

Registration Information The registration fee of $195/per attendee includes all Summit materials and meals at the event. During the registration process, you can pay with a credit card or select to be invoiced. Refund Policy: A refund, less a $25 administrative fee, is provided for cancellations requested on or before Friday, May 13, 2022.

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