Where We Are Today
In an emergency Sunday meeting on March 15, 2020, the Federal Reserve announced it was dropping its benchmark interest rate to zero and launched a new round of open-ended quantitative easing. The move was a direct response to the coronavirus outbreak, which had disrupted economic activity around the world, including the United States. During this time, the 10-year and 30-year treasury bond yields reached new all-time low as dollars flowed into the treasury markets seeking the “full faith and credit” of the United States government. The moves by the Fed and the markets left financial institutions with a U.S. Treasury Curve at historic lows. As a result, institutions with asset sensitive balance sheets are facing the likelihood of margin compression.
So, here we are with low interest rates following a severe economic downturn. Hey, I’ve seen that movie before! In 2008, the Fed sharply cut its target funds rate down to zero in an effort to spur lending and jumpstart overall economic activity. In the crisis environment of 2008-2009, many banks were tempted to purchase investments outside their typical investment purchases in order to find yield. Private label MBS and CMOs, trust preferred securities, preferred stock, and subordinated debt were a handful of the types of investments that were purchased. In the wake of that crisis, many of those securities experienced major losses or became worthless. More than a decade later, and we’re seeing a resurgence of some of these same types of investments.
If you are shown an investment offering a yield that “seems a little too good to be true,” ask questions! Educate yourself and understand the risks. There is almost always a reason for the increased yield, as bond markets are very efficient at pricing in risk. As the saying goes “there is no free lunch in the bond market,” meaning in order to increase the yield or reward received on a bond, you must take on more risk. That increased risk usually comes from a combination of the following categories: credit risk, interest rate risk, and liquidity risk.
A recent example of potential trouble is that of bank subordinated debt. Many banks are actively taking advantage of today’s low interest rate environment to issue relatively cheap subordinated debt to bolster their capital levels (Tier 2 Capital). Furthermore, with many economic uncertainties on the horizon, it makes sense for some banks to issue subordinated debt to boost their overall capital position and total risk-based capital ratios ahead of the economic uncertainty. The issuers are acting rationally, but what about the risk to those who buy these bonds?
It’s true that subordinated debt offers enhanced yields; however, it comes at the cost of increased credit and liquidity risk. When a bank fails, there are numerous claims to a failed bank’s assets and the holders of subordinated debt are usually left with little to nothing. Data from the last financial crisis shows a very high “loss given default” percentage on failed banks’ subordinated debt. Investment in subordinated debt should be looked at as an unsecured loan to another financial institution. As a result, regulators tend to take a harsher view on the investment portfolios that hold bank-subordinated debt.
Sticking to the Plan
We have always been big proponents of having a written strategy. A written strategy lets you proactively manage the investment portfolio instead of being sold “the bond of the day.” Your investment strategy should be intertwined with your balance sheet needs and overall risk appetite. If an investment doesn’t fit your investment strategy, then pass on it. Having a written investment strategy helps strengthen your corporate governance and there’s an added bonus of having some tangible to show to the regulators.
The banking industry is likely to have some challenging days ahead due the recession caused by the COVID-19 pandemic. Now is the time to work towards mitigating your credit risk and not reaching for more. Know what you are buying, understand the risks, and ask questions!
The Baker Group is one of the nation’s largest independently owned securities firms specializing in investment portfolio management for community financial institutions.
Since 1979, we’ve helped our clients improve decision-making, manage interest rate risk, and maximize investment portfolio performance. Our proven approach of total resource integration utilizes software and products developed by Baker’s Software Solutions* combined with the firm’s investment experience and advice.
*The Baker Group LP is the sole authorized distributor for the products and services developed and provided by The Baker Group Software Solutions, Inc.
INTENDED FOR USE BY INSTITUTIONAL INVESTORS ONLY. Any data provided herein is for informational purposes only and is intended solely for the private use of the reader. Although information contained herein is believed to be from reliable sources, The Baker Group LP does not guarantee its completeness or accuracy. Opinions constitute our judgment and are subject to change without notice. The instruments and strategies discussed here may fluctuate in price or value and may not be suitable for all investors; any doubt should be discussed with a Baker representative. Past performance is not indicative of future results. Changes in rates may have an adverse effect on the value of investments. This material is not intended as an offer or solicitation for the purchase or sale of any financial instruments.