Pub. 8 2019 Issue 1

The CommunityBanker 14 F E A T U R E Cash Whiplash Changing Interest Rates Can Create Volatile Cash Flow By Jim Reber B efore 2018 gets too much further into our rearview mirrors, it may be worthwhile to review what invest- ment portfolio lessons we can derive for future refer- ence. The popular notion among community bankers is that, for all the positives that the industry enjoyed last year (record earnings, continued loan growth, and solid credit metrics), the bond portfolio was a lagging performer. I believe most of that impression was the result of fixed-income investments being, for the most part, underwater. It may therefore surprise you to learn that, in 2018: • Tax-equivalent yields improved nicely to 2.78%, an increase of 32 basis points (0.32%); • Average lives actually decreased from 4.4 years to 4.3 years; and • Net unrealized losses did increase, but only by about 1 percent of face value. That third bullet point may sound like fake news, alterna- tive facts, or just an old-fashioned spin, but the average net unrealized loss as of December 31 was still only about 1.5 percent. The average bank’s bond portfolio was further under- water than that for most of the year and was down around 3.0 percent as late as November. Late Rally The relative stability in bond prices for 2018 was all the more impressive when one considers that the Fed raised interest rates four times and ran off nearly $400 billion from its still-prodigious balance sheet. Of course, some of the sup- port for bond prices in the last quarter of the year was fallout from the stock market’s correction, and a spate of indica- tors that signaled some weakness in certain segments of the economy. This includes modest, if not disappointing, inflation. And rates did fall by significant amounts. In the 90 days from Dec. 1, 2018, to Mar. 1, 2019, maturities from two to ten years all decreased by about 25 basis points in a rare example of a parallel shift in the yield curve. What that means for the community bank portfolio manager is that some investments may have moved in-the-money to be called or refinanced. Called Upon With overnight rates below 2.5 percent, and yields on government agency bonds not much more than that, it doesn’t take an ambitiously high stated coupon rate to get called. For example, in Feb. 2019, 201 different agency issues totaling $9.5 billion were called. The following issues are cases in point: FHLB 2.54% 5-22-2020 Quarterly FHLMC 2.625% 6-28-2021 Step-Up FNMA 2.94% 8-27-2021 Quarterly Most community bank managers have their portfolios’ ex - pected redemption dates graphically displayed in a bar chart, by quarter or year. Broker-dealers or interest rate consultants commonly provide this information upon request. As most bonds owned by community banks have some type of call