With investment yields currently well-above their 5- and 10-year averages, many financial institution executives are asking this question. In this article we discuss important considerations that can help provide clarity relating to investment strategies in the current environment:
Spread to Cash. For all of 2023 and 2024 the average spread between the Fed effective rate (cash yield) and the 5-year Treasury (investment proxy) was negative 99 basis points. It was more difficult to find additional income in investments vs. cash without taking on some level of risk. Today, the spread is straddling zero +/- 10 basis points. With various investment options trading at +30 to +120 bps spread to Treasuries, investors can now find meaningful income pick up vs. cash to help widen overall margins. Similarly, with lower short term funding rates, it is no longer punitive to temporarily utilize non-core sources to fund (re)investment activity.
Anticipated Loan Demand. If net new loan demand is expected to be robust, there may not be a lot of cash flow available for deployment in the investment portfolio. However, if loan demand is slowing or is being managed to a slower pace intentionally due to capital, concentration and/or liquidity constraints, reinvesting cash flow could be warranted.
Liquidity Profile. When evaluating the liquidity position it is important to consider current excess cash in the overnight account, along with wholesale funding availability/dependency, large depositor makeup, and pledging needs. Institutions with elevated wholesale funding dependency and higher asset liquidity ratios may choose to reduce non-core funding levels with incoming investment cash flow, especially if capital ratios are constrained. Alternatively, institutions with ample funding capacity should evaluate (re)investing excess cash in the bond portfolio.
Interest Rate Risk. Institutions with clear asset sensitive exposures (i.e., large cash positions) could consider certain types of investments as a balance sheet hedge against a prolonged declining rate environment. Executives should be very intentional selecting investments with various degrees of call protection. It is also wise to evaluate other strategies to help reduce this risk, including derivatives.
Fed Funds Rate vs. Yield Curve. When thinking about “rates” it is important to understand that just because the Fed Funds Rate is decreasing, like it did during the second half of 2024, it does not mean yields across all points of the yield curve are also decreasing. Specifically, the Fed cut the Fed Funds rate by 100 bps between 9/18/24 and 12/31/24, but the 5-year Treasury yield increased by 90 bps during the same timeframe. For those expecting a strong correlation, this created seemingly unexpected volatility in market values.
Current Unrealized Loss and AOCI. Significant Fed Funds rate increases in 2022-23 caused Treasury yields to spike, leading to bond price declines. For financial institutions, the unrealized loss of the AFS portfolio resides in the AOCI account, which reduces book/tangible equity. This is an important consideration when evaluating additional investments that could layer in additional AOCI impact. Depending on the future shape of the yield curve, investments with some duration added today could help reduce the unrealized gain faster (if the yield curve moves lower) or could further increase the unrealized loss (should the yield curve move higher). No one can confidently predict interest rates. Therefore, if the risk of additional unrealized loss is a material balance sheet concern, institutions can consider shorter duration investments, including those with variable rate coupons.
Long Term Investment Strategy Focus. For most institutions, the investment portfolio represents a meaningful earning asset. Therefore, managers should employ a strategic approach to portfolio management. This means principles such as dollar cost-averaging, sector allocation, and yield curve positioning should be viewed from a longer-term perspective. “Chasing yields” and frequent/significant churning of the portfolio can negatively impact returns for years to come.
Utilize Portfolio Management Principles. Individual securities within a portfolio can perform differently in several rate scenarios. It is the whole portfolio performance that should be ultimately evaluated. Investments should be monitored for strategic repositioning opportunities to rebalance the portfolio given changes in market conditions.
Taylor Advisors Take.
Navigating the current fixed-income landscape presents a complex challenge for Community Banks. Prevailing yield curve dynamics and liquidity conditions offer ambiguous signals, requiring careful deliberation regarding portfolio (re)investment strategies. The considerations outlined above provide a framework for this analysis. However, each institution’s specific circumstances, including capital adequacy, liquidity requirements, and prevailing market conditions, necessitate a tailored approach. Consequently, access to robust internal or external investment and balance sheet management expertise is critical. This expertise facilitates a holistic investment strategy, aligning portfolio construction with distinct institutional objectives and needs, ultimately driving enhanced performance and mitigating the risk of suboptimal investment decisions.
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