Pub. 8 2019 Issue 4

23 w i n t e r | 2019 F E A T U R E It was 20 years ago today More precisely, it was 20 years ago this year that com- munity banks, and their investment portfolios in particular, were enduring a period of extremes. Many of the readers of this column were in charge of their bond portfolios then, and were, proverbially, “Riders on the Storm,” which involved: • Inflation, which actually used to be a problem, was gaining traction. The year-over-year Consumer Price Index (CPI) was more than 3% and rising. • Since the economy was doing quite well, unemploy- ment dropped from 4.7% in 1998 to 4.0% at the end of 1999, which was a 30-year low. • The Federal Open Market Committee, chaired at the time by Alan Greenspan, was busy stomping on the brakes. Overnight rates rose 250 basis points (2.5%) between 1998 and 2000, finishing at 6.5%. This remains by far the highest level we’ve seen since. The 10-year treasury note reached 6.79% in January 2000. • Bond portfolios’ market values took a beating: The average community bank’s bonds had more than a 3% loss in 1999, which is enormous on a historical standard. In short, it appeared we were on “The Eve of Destruction.” Glory days As we’ve learned over the decades, bond portfolio man- agement is a give-and-take proposition. If your collection of securities is underwater, at least you have the comfort of knowing that your overall yields are heading “Higher and Higher.” At least, if you continue to purchase bonds in that environment. However, 1999–2000 wasn’t a period in which banks were actually buying many bonds, which is also a mixed bless- ing. The aforementioned Fed rate hikes accompanied a very healthy economy, which of course spawned a favorable lend- ing environment, much like today. Bond portfolios actually shrunk between 1998 and 2000 by a goodly amount of about 25%. This too is a condition that has repeated itself in the very recent past. What were once vices… Peeling back the portfolio onion a bit, we can see how investor preferences and investment products have changed in two decades. Non-amortizing taxable bonds, meaning treasuries and agencies, made up a large portion of securi- ties portfolios in 1999; in fact, more than 30%. Community banks actually owned more agencies than direct pass-through mortgage backed securities (MBS). It was in this period that “step-ups” hit the scene and appealed to portfolio managers Jim Reber (jreber@icbasecurities.com ) is president and CEO of ICBA Securities, ICBA’s institutional, fixed-income broker-dealer for com - munity banks. who were justifiably concerned about a “Bad Moon Rising,” otherwise known as still-higher rates. Today, the treasury/agency slice of the “American Pie” is only 12% of the total. These have been replaced by all manner of MBS and by tax-free munis. Even though banks own fewer munis than before tax reform went into effect in 2017, the over- all industry profitability creates plenty of incentive to avoid tax liability. Also, particularly for the bank-qualified (BQ) muni sector, credit metrics recently have been outstanding. …Are now habits Portfolio managers in the 21st century have proven to be quick on their feet, and well informed. The migration out of one-fifth of their tax-free bonds mentioned in the above para - graph is a perfect example. Something else that community bankers have gotten comfortable with in relatively short order is the dramatic growth of multifamily MBS. Bonds with names like DUS, Aces and K’s have become staples in bond portfolios. Also present is the careful maintenance of average maturi- ties, also known as effective duration. Around 80% of invest- ments owned by community banks have some type of call feature attached. Though interest rates have had some wild swings in the past two decades, and rates have trended lower in that time, bond portfolios’ durations have been amazingly stable. The portfolio managers and the risk management func- tions in general have been able to “Hold on Tight.” Another success for community banks is their still-low cost of funds. Industry-wide, the average remains less than 1%, even though the Fed raised rates a total of 10 times between 2015 and 2018. Included in the toolbox are interest rate swaps, which can be used to lock in historically low funding costs. Not “Money for Nothing,” but close. Let’s party like it’s 2020. The Beat Goes On. 2020 webinar series ICBA Securities and its exclusive broker Vining Sparks will again offer a multi-part webinar series Community Banking Matters next year. A variety of topics that address balance sheet strategies and risk management will be offered. We will again offer CPE to the participants. Be looking in this space for details or visit icbasecurities.com. As we’ve learned over the decades, bond portfolio management is a give-and-take proposition. If your collection of securities is underwater, at least you have the comfort of knowing that your overall yields are heading “Higher and Higher.”