Bond Portfolio Strategies in a Rising Rate Environment

Intro: Helping community bankers grow themselves, their team, and their profits. This is the Community Bank Podcast.

Caleb Stevens: Well, hey everybody, and welcome back to the Community Bank Podcast. I’m Caleb Stevens, and I am joined by Tom Fitzgerald. Tom, we are talking bonds today in a rising rate environment, and you tell me how high can the Fed go?
Tom Fitzgerald: Well, we’ve been beaten up pretty good for the last month or so, and hopefully we’re kind of near the end rather than just at the end of the beginning. So, I’m hoping that’s the case and that’s my line for now and I’m sticking with it.
Caleb Stevens: Well, to make sense of it all, you spoke with Robert Biggs you guys had a good discussion about where rates are headed, what that might mean for the economy, what that might mean for banks, and balance sheets for their bond portfolio. Always a good discussion this is something that we like to dive into at least once every couple month. We love to have a show always dedicated to the investment portfolio for our CFOs out there and for anybody in the banking world who has their pulse or decision making around the bond portfolio. And so, we’re going to follow this up pretty soon with another economic update, but the markets are going so wild today that we’re recording it, that we wanted to kind of see how things shake up from the recent fed hike and so we’ll be getting that out hopefully soon. But for now, enjoy this discussion with Robert Biggs and Tom Fitzgerald. Thanks for joining us.
Tom Fitzgerald: Well, Robert, we’ve got you in studio for this show, and that’s quite the thing I know we’ve been typically doing these via Zoom or some other method like that, but it’s great to have you on site today.
Robert Biggs: Yes, it was nice to travel to Atlanta.
Tom Fitzgerald: I wish I could say the market was nice as well, but it’s been anything but this year and particularly in September as we talked today, we just had a fed meeting a week ago. And they’ve kind of put a real kibosh on both the stock market and the bond market. They kind of came out with a new forecast, said they’re going to probably get to 450, 475 on the funds rate by early next year and it looks we’ll probably get to 4% by the end of this year. And so, the market is sort of digesting all of that in the form of higher yields and in the form of lower stock prices, and in the meantime, the balance sheet runoff continues they’re up to 90 billion a month and so that’s just starting to take hold as well. So, a lot of tightening, not only the Fed, but others, every other central bank except for Japan, is kind of in the same mode. And the situation in the US is being mirrored, I guess in most other countries right now as well. So, with that backdrop, do you have kind of your general impressions of kind of what the Fed is doing and kind of what your thoughts are as to where the end of that road may be?
Robert Biggs: Well, I’ll go back to February and once again, I’m still a phrase it, as you said the Fed is going to combat inflation at the expense of some, if not all economic growth. And so that’s why this is tremendous move upwards shouldn’t come as that much of a surprise. They’ve done a good job of forecasting it and unemployment has given them a long ramp to where they can continue to push the front-end rates up while managing that employment mandate.
Tom Fitzgerald: And I would say too, when you look at kind of theirs, not only did they update their dot plot for the rates, but they updated their forecast and they’re looking at quite a bit of weakening from what they had back in the June forecast. The forecast for this year’s GDP is just a 0.2 so virtually a flat year from a GDP perspective, 23, they’ve got it up a little bit, 1.2% and then 1.7 and 24. But historically speaking, those are real weak growth rates that the Fed is expecting at least through 24. And then inflation coming off of four and a half percent is where they have it at the end of this year, 3.1 next year, and then two, three and 24. So, they’re kind of looking at a long runway as well for getting inflation back to that 2% type level. So, this is going to be a kind of a battle that they see raging for several more years to get inflation down. And so again, that’s kind of the background of what the market is dealing with right now. And as we talk the 10 years flirting with 4%, and I had mentioned in some other venues where the 4% level was a decent level of support. You go back to the 2007, 2008 financial crisis that was a level that held in pretty well. So, we’re hoping we’re sort of at the end of this backup in yields versus being in the middle innings. So, do you kind of have a feel for where you think that might go in the near future?
Robert Biggs: The near future is a little harder to project the Fed’s going to a continue pushing front-end rates up. I think the bigger concern for a lot of people listening; this podcast is not the immediate impact. It’s where we are a year, two years down the way? And just from the shape of the curve you would assume that these long rates would come down when the two year has 35, 40 basis points of inversion over the 10 year that calls for rates to decline on the long end in the long term.
Tom Fitzgerald: And I would say we’ve probably got a lot of listeners that are sitting there saying, well, geez, I’m going to have a four and a half percent Fed funds rate, at least, pretty soon, early next year maybe the end of this year. Why don’t I just sit in Fed Funds, clip that four and a half percent coupon and sort of be done with any other decisions. The issue I guess I would have with that is, yes, the Fed has said they want to keep the funds rate elevated for probably the bulk of 23. But if we get severe economic weakening, then they is going to have to revisit that and I was just updating my economic forecast and I do have them cutting rates in the fourth quarter of next year. And so, the thought that I can just sit back and collect a four and a half percent Fed funds level for a year or more, it may happen faster that turn than people’s kind of sitting here today would think.
Robert Biggs: Yes. You look at just revenue improvements this year and the depository sector, especially the Fed takes the stairs up and the elevator down. And so just as quickly as its improvement has come, it could walk out the door if we do get to this point where unemployment’s rising, the economy’s weakening inflation starts to move in the other direction the Fed may be forced to shift rates in the other direction. I guess the question off there is how long does that take and when does it happen? But you would assume eventually the other side of the cycle will come.
Tom Fitzgerald: Yes, I would think so. And we’ve had lots of discussions, we had a bond school recently, so we’ve been talking a lot to accounts and they’ve been giving us their feedback on kind of their ideas and thoughts as well. But that’s a good point that you make. We’re looking at yield levels like a 10-year mortgage back, which is sort of the most vanilla security that we can offer. And you’ve got yield levels well close to 5% now, I think approaching on some of those.
Robert Biggs: Yes, you can add a 10-year base almost close to a discount with a 5% coupon it’s tremendous.
Tom Fitzgerald: And it provides liquidity because of that short horizon of the 10-year amortization it gives them that lack of duration extension you get that cash flow being thrown off. So, it adds a lot of key elements to a portfolio in this environment that I think an investor would like. Again, the problem that we deal with is in the bond business is you’ve got accounts that sit there and go, well, my Fed funds level is going to be good enough to carry me so, why make those decisions? I made a point a week ago of talking about a year ago at this time that Fed was saying inflation would not be a problem that will be lower for longer through 24, I think, was that they had forecast they wouldn’t be raising rates through 24. So that forecast from a year ago was quickly outdated and so the forecast that they’re coming up with now of keeping fed funds in a 475-type level for a year you still have to question that. Given all of the anomalies in this environment, you’re dealing with a lot of one-offs, the pandemic you’re dealing with the fiscal stimulus that was applied to the economy, and you’re dealing with the supply chains, nephews. So, a lot of one-offs that make their forecasting difficult and so, it’s hard to kind of just sit back and take what they say and say, this is what’s going to happen.
Robert Biggs: Yes, I would agree with that. I don’t think anyone is believing we’re going to go down over the next three, four months but looking past that as the inflation number start to roll over the year over year comparison when we start comparing ourselves to this past June or this past March, what do those numbers look like? Prices may still be high, but the inflation number year over year will come down organically unless we continue to have this pressure moving us upwards.
Tom Fitzgerald: Let’s kind of talk about bank balance sheets and the nature of the balance sheet as far as, if we brought Billy Fielding in, who’s our AL manager, he would tell you most banks are assets sensitive and they’re probably more sensitive than they think. Now through the second quarter, we didn’t see any uptick in deposit rates, from a cost of fund standpoint. Now, the third quarter numbers will be coming out over the next month or two, and we’ll probably see some rise in deposit rates on the bank balance sheets. But it’s our contention that the risk to banks is in a rates declining environment more so than a rates rising environment. So again, we kind of look at not wanting to stay short, but kind of, when these opportunities arise in the types of yields that are out there to take advantage of those.
Robert Biggs: Yes. And I would lean on positive convexity when you do that just because if you look at most AL reports; it’s been surprising they’re completely out of policy for EVE, EAR if rates move down a 100 basis points, 200 basis points. And while no one has that on their forecast just yet, that’s the true risk to the bank, it appears most banks you’re going to have a banner year, just a tremendous amount of revenue and at some point, we have to look out in the horizon and decide we’re going to protect this revenue. And that does come with a little more price risk you go out and you add more bonds to the portfolio, you add fixed rate loans. When you do these things, you do have some interest rate risk associated with it but compared to the downside of compressing margin and falling revenue it seems to make a lot of sense to use this time, use these 15, 20-year high yields to hedge against that move, even though it may not seem likely at the moment. I think I’ve told you before, one of my favorite charts on Bloomberg, they track speculative investors on the 10-year US Treasury. And it’s essentially, they betting rates are going to go up or rate’s going to go down in the 10-year space and it’s the net level and the largest one-sided bet was in, I think September of 2018. And it was that rates going to continue to go up and as we know, they peaked in October, and they steadily moved down through the pandemic. And so, the market is definitely crowding one side of the table, but we can’t just pretend the other side doesn’t exist.
Tom Fitzgerald: Right. And that kind of reminds me, I was preparing some slides for an upcoming economic presentation, and I went back and looked at prior rate hiking cycles and compared the Fed funds were leveled to the tenure and this was going back to 1990 and there were four cycles from 1990 to today. And in every one of those cycles, the 10-year yield anticipated the ending of the hiking cycle even before the last hike was in place, those yields started to fall as, as the market anticipated, the Fed was nearing an end to the rate hikes. And then even, as I said, even before they got into the rate cutting, the 10-year yields, and the yields are dropping in significantly. So again, another reason why we don’t recommend just sitting back and just collecting that four 50 Fed funds income because the mark is going to anticipate that turn from the Fed’s tightening to a stable, to an easing pattern. And then we talked briefly about the 10-year. Are there any other kinds of staying in the mortgage back realm? Are there any other products in there that you like right now?
Robert Biggs: Well, I will say the mortgage world spreads of wide and tremendously with the Feds stepping back to purchasing. And so, you have opportunities to not only increase your coupon stack, but also bring down your premium exposure. You can buy bigger coupons than you own at a discount, which definitely changes the overall profile of your mortgages. And so, I do like that just up and coupon and then at a discount, I heard our CMO trader earlier talking about how you spend a 6% coupon sequential out with a par handle. There’s almost no pre-exposure and a 6% coupon and there’s many traders, portfolio managers mortgage originators who have never seen these types of levels in the past 10, 15 years of their career.
Robert Biggs: Right. I think we were looking, as I talked earlier, some of these levels that we’re at or you have to go back to 2007 and even earlier. And so, as you said, you’ve got traders, you’ve got portfolio managers that have never seen these yields before. It was always in the mortgage, for years we were battling premium risk and trying to kind of balance that out without harming the yields in the portfolio performance too much. And now, as you talked about, we can go way up the coupon stack even in a discount, which is, it’s like 180 degrees from what we were so used to for the last decade or so. Let’s move to the other large segment of our bank portfolios, and that’s the Muni. I was just looking yesterday; one of the metrics that you can use in the Muni market is to look at the yield like a 10-year Muni versus 10-year treasury. And it was about 84%, I think it spiked up over a 100% earlier this year, but then that had kind of backed off a bit. So, I think what’s happened is that we’ve had selloff in treasuries and the Munies have followed that, but they’ve kind of held in a little bit better. But when you still look at that, that raw yield let’s say a typical 10-year Muni, you’re still looking at yields that you’d have to again go back to the early two thousand early to mid-two thousand to get a comparable type of yield. Just kind of what are your thoughts in general on the Muni market? We talked about convexity, and this is one area where you can definitely get it.
Robert Biggs: When we look at adding duration and we look at adding positive convexity, control of our cash flows. The municipals have traditionally been our first choice not only for the structure, but also because they have a muted price fall relative taxable instruments and I’ll give you an example. This tremendous move over the past month, you’ve got the entire market by surprise the 10-year treasury is up 94 basis points in just a month. The same time the 10-year AAA municipal, the index is up only 62 basis points. And so, it moved, two thirds of the move as the taxable did so when we add positive convexity and duration, I like the added advantage of it traditionally gives you a more muted, softer impact to your market values one way do go against you.
Tom Fitzgerald: I would say too, just from a diversification standpoint, when I’ve looked at our bond accounting group, the allocation to Munis has kind of drifted down a bit this year. And I think a lot of that was just the fact that they could get a high yield in a treasury, so they said okay, let’s take out that credit risk component. But certainly, as we look towards a possible recession next year, there is that thought, okay, the Muni market does have that credit risk component to it. But I think you look back over the last decade coming out of the financial crisis, most municipalities have been very conservative in their financial dealings and so, they haven’t really extended themselves. So, there are a lot of issues I think that don’t have any type of significant credit issues and I think that would be a sector that maybe some people are avoiding because of the thought that okay, we might have a recession that might ding some of the tax revenue for these municipalities. But kind of what is your general thought as to this state of a general municipality and kind of how they can navigate through this possible coming recession?
Robert Biggs: Well, what I would always point towards is look at general obligations, especially unlimited GEO Unlimited and essential services, water and sewers, even in a battery recession, people still like to turn on the lights and be able to flush their toilets. And so, they generally hold up better than other sectors of municipal market. And the other thing I would point to is the S&P Moody’s, they use the same rating system for both corporates and municipals, but historically the municipals have far outperformed their corporate counterparts’ ratings for ratings. If I’m going from memory here, but I think it’s about one 10th of the default percentage of corporate issuers with the same IG rating.
Tom Fitzgerald: Yes, I think you’re right. Yes, I think that is the number I remember.
Robert Biggs: So, that speaks what you were saying earlier, that municipalities, that they seem not to have ever extended themselves and they serve a different purpose than a corporation. The city of New York, I expect it to be around for a long time, so it makes sense that it’d be a little more credit conscious.
Tom Fitzgerald: And I can remember our Muni trader yesterday was talking to some people on the floor and just saying that these are yield levels are at points where he hasn’t seen, again, you’re talking a decade or longer. And so, the story is kind of the same, whatever sector you’re in, whether it’s treasuries, mortgage backs, Munies, corporates, the yields are at levels that some traders haven’t seen in their professional lifetime. And so, it’s an opportunity we understand that when rates seem to be only going in one direction that’s higher, that nobody wants to step in front of that train. But at some point, we’re going to get to levels that hold and provide support and as I was talking about the market always anticipates that turn from the Fed. And so, when it becomes clear the next move is an ease or the next move is just on hold that some of these yield levels that we see today are going to be long gone. And so, thank you Robert for coming in today and kind of give us some of your general thoughts and I think the takeaway right now is that if there’s a listener out there that’s looking to put some money to work you couldn’t pick a better time, I don’t think to start legging in. We don’t talk about, dumping in full exposure but certainly, getting your toe in the water at this point I think is, you’ll have yields 4 or 5% that you can certainly live with for the balance of the life of the bond I think you would agree to that.
Robert Biggs: Yes. We rewind, we talking about how quick the market turns, but two years ago around this time, the 10-year treasury was 53 basis points and rates were never going up. And if you could have called anybody in the country especially say, I’ve got a 10-year treasury for you at 2%, they assumed it was mispriced because it exists and now, we’re flirting with 4% in the 10-year space.
Tom Fitzgerald: And it’s hard to get anybody take your call.
Robert Biggs: Well, I think the depository portfolio managers; I think they have one of the hardest jobs compared to other portfolio managers. If you are a portfolio manager for an insurance company, your main focus is matching cash flows, matching liabilities. So, if you are a life insurance, you are buying longer bonds and trying to match an actuary table and depository portfolio managers, they seem to have a lot of money when rates are down and then very little spend when rates move up. And so, it seems like they’re just a little bit challenged, and I would go back to Scott Clemons, I think he said it on your podcast the best bonds he ever bought were the ones where he had no money and rates were going up. And so, just encourage people to put something to work some portfolio runoff, even if you want to shrink the portfolio, put some of it back in. And if you are sitting on cash consider what the investment portfolio yields, what they have compared to what you’re lending. Because loan betas have seemed very, we talk about cost of fund betas a lot; loan betas have been very sticky. We’re up 300 basis points or so on the front of the curve, maybe 400 and no one’s been able to move their loan prices up, 300, 400 basis points. So
Tom Fitzgerald: That’s a good point because not too long ago we’re in a 3% prime world and now it’s going to be a 7% prime world and that’s takes a lot of projects, a lot of off the board from a financial viability standpoint so. But anyway, Robert, I want to thank you for coming in, giving us your thoughts and insights hopefully the next time we meet we can say boy, we hope you guys took our advice and started licking into some exposure and when we talk in a few more months down the road. So again, Robert thanks for coming.
Robert Biggs: Yes, sir. Thank you. And I’ll talk to you next year.