Managing Your Balance Sheet Through Inflation Fears, Excess Liquidity, and the Steep Yield Curve

[Intro]: Helping community bankers grow themselves, their team, and their profits. This is The Community Bank podcast.

Caleb Stevens: Hey everybody, welcome to Episode 42 of the community bank podcast. Thanks for joining the conversation today. I’m Caleb Stevens and I am joined by Tom Fitzgerald. Tom, good to have you back on the show.

Tom Fitzgerald: Caleb, good to see you again. Hope you’re doing okay.

Caleb Stevens: doing great. We have convention season coming up and I am headed to the Florida bankers conference in a couple of weeks. So excited to finally get on the road. See some people I went up to Kentucky, about a week ago Pikeville, Kentucky, up in the mountains than over to Lexington so it’s been good to make some rounds. See some folks are kind of having to remember how to talk to people in person because you’re used to just zoom calls.

Tom Fitzgerald: Yeah, I was going to say it’s kind of like, you have an exercise muscle you haven’t used the last year.

Caleb Stevens: Exactly. But it feels good to stretch those muscles and get out again. So thank you guys for joining us today, our discussion is all about the bond portfolio, your balance sheet the economy if your CFO listening if your CEO, this is particularly relevant for you, as you think through what’s next for loan demand, what’s next for inflation fears, what’s next for how you’re managing your bond portfolio, and your overall balance sheet and interest rate risk management. So we have a great discussion today with Tom, Chad Mckeithen. And Andrew Nord, from our broker-dealer, Duncan Williams, who we acquired a few months ago, we’re so excited to have those guys on board. And they are a wealth of knowledge. They’re out in Memphis, Tennessee. And Tom, I thought this was a really good discussion.

Tom Fitzgerald: It was I think, very timely for the listeners in that, you know, we’ve you can’t come into the year thinking that rates were going to kind of just inexorably continue higher. And they did for the first two months. But then they kind of stopped after that. And it’s sort of in this range-bound market in this. We’re like what, you know, what do we do now? How long is this going to last? Meanwhile, cash keeps continuing to pile into the balance sheet. So you know, what do we do with that? So we answer some of those questions as we go through the discussions with Chad and Andrew.

Caleb Stevens: Yeah, and when the rates so low, a lot of customers right now are looking to lock in the long term, you know, 10 15, maybe even 20 years if you’re that buying and hold investor type. And if you’re a lender, if you’re a chief lending officer, if you’re CEO, what do you do when a customer goes to your bank and asks for a long-term fixed-rate loan? Do you make the loan? Do you take on that risk? Do you try to talk them into a shorter term and risk losing their business? Do you try to sign up for a back-to-back interest rate swap program complete with derivatives and are the documents and Dodd-Frank reporting and all the things that make your CFO head spin? That’s why we created the Arc program that’s ARC. The Arc program.

Arc allows you to offer up to a 20-year fixed-rate loan to your borrower book that loan at a floating rate generates fee income and that’s without any Dodd-Frank reporting, no hedge accounting, no mark to market all the things that come with a traditional back-to-back swap we’ve eliminated those that really really simple all you have on your balance sheet as a floating rate note and your borrower gets the structure and the long-term fixed-rate that they desire. So to learn more, go to South state correspondent dot com forward-slash arc that’s arc South state correspondent dot com forward-slash arc so that is our product plug. But before we jump into today’s conversation, and Tom really quick, you put out a bond portfolio trend analysis, you look at all of our bond accounting customers and kind of take an aggregate look at what their portfolio trends look like. Talk about that real quick and tell us how we can get that.

Tom Fitzgerald: Yeah, Caleb, that’s just the first-quarter analysis of our bond accounting group is about 10 billion in par value altogether. So we kind of treat that as a single portfolio and look at the trends in the book yields and the durations in the unrealized gain or loss. And kind of just kind of relate that to you can compare that to what your portfolio looks like. Also, we kind of do a breakdown as to where those investments are allocated. So again, it’s the same address that Caleb talked about South state correspondent .com forward-slash bond report, that’ll get you to the spot where you can pull down that report.

Caleb Stevens: Good deal. Let’s jump into today’s discussion between Tom, Chad Mckeithen, and Andrew Nord. Thanks for joining us.

Tom Fitzgerald: Well Chad and Andrew, thank you for taking part in the latest investment podcast. And, you know, as we’ve done these for the past year, these shows have been some of our most listened to, and I’m sure this will be no exception with everything that’s going on in the markets. And so, you know, as we get into the discussion of investments and strategies themselves, I think some of that has to be grounded and where are you think rates are going? And I’ll just kind of throw out my thoughts and you guys can certainly interject your opinions as well. You know, right now, the market is kind of tied around the idea of the, you know, the inflationary spikes that we’re saying. We saw CPI a week or two ago, we’re going to get the PCE numbers tomorrow, which is Friday.

You know, those spikes have been characterized by the Fed as being transitory in nature. You know, we’ve got a surge in demand as the reopening of economies has taken place. Also, you know that we’re going to continue to see that. So these spikes will probably continue for the next several months. But I think eventually, as the economy continues to open and sort of settles down into a steady-state environment, you know, we’re going to see supply eventually great, you know, arise to meet that demand, and some of that supply surge that is that cause from this, you know, supply deficiency is going to go away. And I think, eventually, some of the forces that were driving the economy are driving inflation, prior to the pandemic. And some of those were, you know, global supply chain, you know, lowest-cost producer. But I think one of the biggest ones really is just that, you know, when you look at the demographics of the world, there was an article in The New York Times recently that has talked about population growth, and all of the developed markets, really, really struggling.

In fact, some of the larger markets, China and Japan are seeing negative population growth, even the US, which tended to be one of the higher growing nations is starting to see that population slip. So I think eventually that I kind of look at that as sort of the Gulf Stream that undercurrent that’s really powering some of the longer trend, inflationary and GDP growth prospects, I think what we’ll see is, GDP will eventually kind of come back down to that to two and a half percent, you know, long-run growth rate, inflation will kind of come back down to that under two around 2% growth that we’ve been, you know, the Fed has been trying to get to for the last decade. And those will be the driving forces, once again, once we get past this, all these reopening surges.

And so, to me, it looks like that the long, you know, when you look at longer-term rates, that the prospects for a significant rate increase still is not out there. I mean, we may see a 2% 10 year in something higher than that, but I don’t see the elements, the catalysts that will drive rates significantly higher from here. And so to me, it set that lower for a longer environment that we’ve been in for several years now. And I think that’s going to continue to be the case as we move forward into, you know, 22 and 23. Chad. Andrew, do you have any thoughts on that as well?

Chad Mckeithen: Yeah, well, I’ll jump in here first, and then let Andrew talk as well. I know, he deals a lot more individually with specific bank clients close to our clients. But I think I mean, I agree, I think back in February, there was a huge spike in volatility. And, you know, we don’t tend to argue much with the bond market. The bond market from a forecasting standpoint is very good at predicting, you know, interest rates and expectations much more than typically a single economist or one prognosticator. But, you know, the volatility spiked, interest rate volatility spiked heavily in February. And it was a result of some of the kind of frothy inflation numbers that were starting to come out. And I think it stayed elevated for a bit because the Fed, you know, to a degree, they kind of ignored it a little bit, you know, they took a stance that we’re not even going to talk about inflation.

And what since then the markets get a little bit more comfortable, I think, in general, that, it maybe is more short term in nature, there’s a lot of supply chain issues right now. And the belief is that as people go back to work, maybe some of the subsidies start to peel back a little bit, people get back into work. But some of those supply chains woven back up, I saw a good report yesterday from I was from the cattle production group. And they say that typically they’ve got to slaughter about 300,000 cattle a day to meet these needs, steak needs, etc. And he said they were doing about a load of 200,000. He said it’s really, you know, the problem. He said it’s both sides from both sides. He said, when people are getting these extra cash inflows, unemployment insurance, they’re able to buy steak, they’re able to buy better meats.

And he said, what the bad thing about it is when they’re getting extra payments like this, I don’t have people that can come to work and the slaughtering factories, he said, it’s not a cow issue. It’s not a raw material issue. It’s completely a supply chain bottleneck issue. So with all of that said, I think you go back to what the feds leaning on, this should be short term, if we if those some of those subsidies do pull back, and people do have to go back into the, you know, into the employment lines, then we should see some of those supply chains start to open back up. And of course, with the vaccines, as we’ve always pointed, you know, that should open up the economy to some degree too. So I think they’re well-founded in there. The feds, you know, forecast that you know, inflation will stay relatively low. And I think that’s the take we’re taking, like I said the bond markets typically very good at predicting rates.

And of course, when you think about inflation, you’re worried about rising rates. The bond markets really kind of pull back on a trade forecast is calling for a fairly low-rate forecast on the short end and long it for the most part, so the bond markets digesting all this inflationary information, we may get a great read tomorrow. Hi, read tomorrow. And that PCE number you mentioned, but the bond markets pretty, pretty stable with us being in a range-bound environment for the next three, four years. So I’ll let Andrew go a little bit. But that’s kind of some of our early thoughts about the inflation and kind of rate market in general.

Andrew Nord: Yeah, obviously, it seems like it’s kind of just boiled down to inflation here, it seems like that’s what a lot of bankers are in tune with and trying to stay up to date on all these inflationary numbers that are coming out every month. And you kind of look at the past. And it seems like, in the past, when we’ve seen some very inflationary times, it’s because we have a very productive economy that is, growing, and it just doesn’t seem like with all these, these payments that the government’s making, it doesn’t seem like it’s breeding a very productive economy that is kind of growing in the way that they want to. So I would think that you know, if a lot of this stimulus money were going towards investing in the economy in and investing in building bridges and kind of making everything more efficient, I would think that that would probably lead more towards an inflationary type of environment, but you know, replacing last paychecks, it doesn’t seem like that’s going to breed towards long term inflation and kind of seems to be more or transitory. Like Tom said earlier, yeah.

Tom Fitzgerald: Well, thanks. So let’s, let’s turn now to the upcoming June FOMC. The meeting is going to be on June 16. So you have to put your little prognosticator hat on and say, Okay, what are they going to be talking about, this is the, you know, one of the quarter in meetings, which is the big ones when they do their update on the dot plots when they do them, update on their economic forecast. And so, you know, this sort of has all of the fruits and vegetables in the, in the in their report. So, you know, obviously, one of the questions will be coming out of that meeting, are they still going to have a rate hike that is delayed until beyond 2023? Or are we going to start to see some of the members be pushed that forward a little bit into 2022? I’ll start with you, Andrew, do you have any thoughts on that where they might be in June?

Andrew Nord: Well, you know, it kind of boils down to their mandate of controlling inflation and controlling jobs. And, you know, there might be there when it comes to inflation. But when it comes to job numbers, it kind of seems like a lot of people are stuck at home, not trying to get back into the workforce right now. And as long as you know, the longer they stay out of the workforce, the longer or harder, it seems, it might be for them to get back in. So, you know, I feel like they’ve completed part of their mandate and inflation. But you know, when it comes to the employment side of it, it seems like it’s going to be tough to meet that goal. So I would imagine it would be lower for longer and, you know, probably not raising for any time soon.

Tom Fitzgerald: Right. And Chad, let me ask you this question. As far, Of course, the other, you know, the two big conundrums with the Fed is, you know, when did they start, you know, when it what do they start positioning for a lift off and raise, but also one of they start talking about tapering, and that was, obviously a big issue in the last minutes when there was some mention of it, maybe coming up in the future meeting, and that kind of got the market in a turmoil for about a day. And then they settled down after that. But do you suspect we’ll see any tapering talk at the June meeting?

Chad Mckeithen: No, I don’t? Well, I don’t think I do think that though, broadcasted in discussions before, you know, we go back to the taper tantrum period of 2013, when we saw the 10 years, you know, go up to 15200 basis points in a matter of months. And, you know, I think they’re, you know, they know, history. And, and so I don’t believe that they’ll just decide one meeting to answer a question about pulling back. But, you know, I think they’ll talk about it in future in a future stance, but I don’t think they’re going to try to do something, I don’t think they’re going to try to come out and say, well, it’s going to happen in November, it’s going to happen in December.

So I think they’ll stay relatively vague about that. I think they’ll address you know, I think at this next meeting, Andrew hit it perfectly. The main goal of these meetings is price stability and unemployment. And I think the biggest thing they’re going to focus on this is getting employment back to a normalized level. And that takes a little bit of work from the federal side, too. You know that they’ll look at the unemployment rate just because it’s at 6%. That doesn’t natural. That doesn’t necessarily mean we’re at a high unemployment rate level. But they’re also looking at the participation rate level, you know, and with that close to 60%. You got a lot more extractors from the economy. Then you have people that are supplying tax dollars. And revenue to the economy. And so yeah, I think they’re going to focus on the unemployment level but also an unhealthy level of unemployment. Now, too, and that’s, that’s we’ve got a large number of people that aren’t, they’re not injecting consumption, and they’re not buying things and they’re not putting that tax dollar, etc. So I think they’re going to really focus on that, they’ll probably talk a little bit about inflation, I don’t expect them really to hit on the tapering discussion whatsoever at the June meeting.

Tom Fitzgerald: And that’s a good point, you brought up about some of the secondary labor, you know, force participation, numbers, and so on. I was listening, or I read a speech yesterday from the Fed governor Randy Quarles. And he was talking about that since December, we’ve only seen six-tenths of a percent decrease in the unemployment number, we basically see no change in the labor force participation rate. So they are, I thought, he said, I think they’re laser-focused on that on the labor, you know, on the labor market right now. And understanding that we’re going to see some spikes and inflation, and trying to look past those, as they’re still focused primarily on that, that that full employment or maximum employment mandate, and I was, just before we came in to do the podcast, I pulled up the on June 10, we’ll get late the May CPI reading.

And it’s expected the monthly reading on the overall is expected to go from a point 8% growth to about point three, and the core from a point nine to .4. So those are still high readings, historically speaking, but certainly well off of the spikes that we saw in April. And so I think they will be very, probably pleased to see that those you know that that’s kind of heading in the direction they expected it to head. So I do agree, I think their focus, again, is going to be more labor market, getting that back to where it was pre-pandemic, and kind of letting the inflation run. But certainly, keep an eye on it, but kind of let it do its thing over the next several months.

Let’s move from that discussion now that we’ve kind of talked about rates and talked about what we expect to see from the, you know, from the FOMC, in the June meeting, to kind of going back to some of the investment themes that have been with us for a while, and certainly one of those themes has been the steep yield curve. Since March, you know, the two-year tenure on the Treasury curve has been the steepest in six years. And we’ve kind of, you know, we went from a 1% rate to a 150 rate almost in the blink of an eye. And we thought, you know, we’re getting to 2%. Before long, but, you know, obviously, we’ve been in this range between 155 or so to 175 for a month or two.

But anyway, from a strategy standpoint, Andrew, can you talk about a little bit of what you’ve been doing with your customers as far as taking advantage of the steep yield curve that’s been in play now for several months?

Andrew Nord: Well, yeah, I think the main strategy is worked with a lot of institutions last X amount of months has been more of a barbell strategy, and really kind of concentrating here on the long end. And taking advantage of the steepness of the yield curve is just adding some products with convexity on the long end, mainly, you know, CMBs, taxable, mutinies. Obviously, you know, the last few months, tax-free mutinies, haven’t made a ton of sense for, you know, bank clients, but I think, just adding convexity is kind of the name of the game on the long end of the curve so you get something that has some nice rolled down potential opposed to something that’s going to get called or prepaid. You know, what, that long end of the curve, and that allows you to participate in some type of total return games, right. That’s kind of been the name of the game.

Chad Mckeithen: Now, and I think, too, I mean, a steep yield curve, and your, you know, the spread between treasuries has averaged about 90 basis points for the last 20 years and bring around that 150 basis points. For most of this year 2021. You know, the one thing I always say whenever we’re doing bonds, it doesn’t take a great portfolio manager to learn to buy bonds when the curve is steep, a lot of good comes when you buy when you’re buying bonds, and it’s an inverted curve, or it’s a flat treasurer. It’s much harder for some of those bonds to become great bonds and time they’re seasoning down a flat environment or seasoning up an inverted curve environment. But when the curve is this steep, it becomes much easier to be good at being a portfolio manager and we do have that very steep curve.

But I think one of the things that are done too is this curve is steep and out this year. You know, I look yesterday at a five-year Treasury yesterday, at the same yield is where the 20 years Treasury was nine months ago. Well, I mean, you shed off three-fourths of the interest rate risk to get the exact same yield and that part of the curve and so what is also done is I know Andrew’s clients just because we work with some of them. It’s a lot of these clients who have a ton of cash. The FDIC came out yesterday and showed the first quarter’s cash increased heavily over the first quarter again, it’s not slowing down.

But what that first evening has done is it’s made some of those banks be able to invest in some shorter parts of the curve, where nine months ago, they had to get out into the 10-to-12-year part of the curve CMBs has been a huge bank, you know, the Fannie Mae, that’s the Freddie case. But they had to get out into that 10 12 15-year part of the curve to get the real yield bang for their buck and rolled in that part of the curve when now, you can get some of those calls protected types of instruments in the five to seven-year range, and you’re getting yields that are better than where they were, say nine months ago, or 10 months ago. And I think that’s the beauty of the curve going up. There’s no real great one strategy, there’s a different set of than others.

But when the curve gets this steep, you kind of stop asking questions, and that’s when you put your money to work. And those are the bonds that are going to gain gains, they’re going to generate gains in the future plus just the nominal real-time. And so it is easy, it doesn’t take too much of a strategist to tell you what to do when a curve is steep. One last thing I’ll say also, is it does magnify the cost of cash, when the curve is steep like this, it makes every day and this has been something that we’ve seen a lot this year, I’d say in the last six months as this curve has gotten steeper, a lot of cash that our clients and when you get a steep curve it makes every day that you wait, that lost revenue, much harder to makeup, you need rates to rise a good bit more, the steeper the curve is the further you move along. So if you wait three months, 6 months, you’re nervous about all of that liquidity.

You’re going to have that a pretty big rate increase over that three to six, one-year period, to make up that last revenue. And so that’s kind of what the steep curve is, I think, given us some better yields for folks that wanted to get a little shorter and durations, it does really magnify that high liquidity level and what rates need rise in the future if you choose to sit on cash longer.

Tom Fitzgerald: Yeah, and that’s another theme that we’ve had, for probably a year now is this excess liquidity that just sloshing around on balance sheets? And initially, it was like, Well, how sticky is this money going to be? Do I want to invest in the long term, if it’s going to be going out the door, you know, to go buy a car or whatever, then, you know, to in the next month or two, it looks like that money has been a lot stickier than, you know, we everybody really anticipated. But that might that like you were saying, Chad, the latest numbers are that it’s just growing that deposit inflow, you know, from whatever source stimulus checks, whatever continues to find its way on bank balance sheets.

And so, there’s a question of, okay, we know, the banker says, I know I need to invest some of this, but really how much and what type of, you know, structure to do that to be safe from the fact that I may see some, you know, runoff in the near future, I may be confronting higher rates sometime in the near future? Can you list some of the thoughts or ideas of what’s some of the strategies you’ve come up with to say, Okay, let’s see your concerns and go and do this type of strategy with some of the excess liquidity?

Chad Mckeithen: Yeah. And a couple of weeks, we can focus on a couple of different points, you know, regarding this, but Andrew, keyed on it earlier in the primary strategy we’ve been looking at for the better part of 12 months, it’s been what we call its barbell investing where you have some shorter duration bonds, and then you match that with some longer duration bonds. And the longer duration bonds, you know, really, really have a lot to do with that particular institution an opposite risk that they want to take, how long does that yield they need but what we’ve been doing lately is what we call a modified barbell strategy, where, you know, we might be going out, say, into some longer Fanny Mae dust and longer taxonomies. So that might be our call-protected, longer-duration position.

And then we don’t want to bet against the market. What if we’re all wrong? What if disinflation is not the push-up to some degree, and, you know, we definitely want some shorter duration products. And we’ve been doing that primarily with shorter CMOS, shorter, MBS high-quality agency, that type of structure is not taken a lot of risks with some credit flyers out there. And then for institutions that want a little bit more interest rate stability, we might throw in a couple of floaters since and CMO floaters and some SBA floaters have started to see some interest grow in that a little bit. But I think that kind of barbell strategy with the front end being heavily cashflow focused, that’s going to give the institutions a little nervous, what if because it’s run out of the bank?

You know, what if the Fed moves rates up on the short end a little faster than what, you know what Chad and Andrew are telling me, that gives them that front end protection at longer and gives us more of what the bottom markets kind of calling for. And that’s the low range rate environment over the next three, four, or five years. Those are the bonds that are going to roll down that steep, steep, steep part of the curve and we hope they have gained, and as they do that’s a season in. So I think that’s a let’s does not call one rate direction or the other type of strategy, what we call a modified barbell strategy. And you know, other than that, it’s really just kind of understanding that the interest rate position about that particular bank so I’ll leave it at that.

Tom Fitzgerald: And Andrew, let me ask you as far as get talking to your accounts and trying, I’m sure everyone you talk to has got excess liquidity. What are some of the concerns that they have that you’re you try to alleviate as You kind of create a strategy to at least invest some of those funds for them?

Andrew Nord: Well, I mean, as you said earlier, these deposits have kind of stuck around, they’ve been a bit stickier than then a lot thought initially. But you know that that continues to be the main fear is, how long is this going to stick around is this going to, are these deposits going to fly in the next couple of months. And I think the main thing you can do to alleviate that is just adding heavy cash flow products to the front end of that barbell.

You know, make the main two that I’ve been concentrating on are just short duration, MBS pools, and 10 and 15. The year that with, you’re going to get more of a liquidity aspect as well added to them, you’re always going to have that TBA bid behind them. So, you’re going to have a little bit more liquid piece in case you do have a little bit more runoff than you think, deposit-wise. And then I’ve been pairing that with some shorter CMS, you can kind of get some yield on the front end, especially probably the last two months, the most popular trade for a lot of our institutions. And I know for a lot of other regionals has been short Ginnie Mae CMO trade, where it’s been one in one of that one and one and a quarter coupons that have been at discounts that have been right around a two-and-a-half-year average life at base case, and a four-and-a-half-year average life up 300. And you’re actually able to get just over 1% with those. So for the two-and-a-half-year bond at you know, plus 80 plus 90 type spread. That’s kind of been the other piece of the front-end cash flow that has kind of helped alleviate some of these deposit runoff fears.

Tom Fitzgerald: Right. Right. And I think too something that Chad’s been writing about kind of plays into this almost hand in glove is that you know, obviously, you’re taking, you know, short term or you know, non-trivial, basically transaction accounts or non-time deposit accounts that have, you know, very little, you know, inherent maturity to them, and investing them, you know, at some point further out the curve. So, there’s that asset-liability question. But, you know, Chad, you’ve been writing a bit about how the sensitivity of those that this latest, you know, round of deposits, kind of showing up on balance sheets is probably not as rate-sensitive, as previous, you know, historical trends have been when we’ve sort of been in this portion of the cycle where we’re kind of waiting for the Fed to start lifting rates. Can you talk a little bit about what that, you know, the implications that have that, that lack of rate sensitivity, you know, from an ale perspective, and how, what are the implications, those are towards investments as well as also towards, you know, the pricing of deposits?

Chad Mckeithen: Yeah, I mean, it’s, it’s a, it’s a common-sense, discussion. I mean, you know, going back to 2008. I mean, the Fed is pumped almost $8 trillion of new money into the system. And anytime you supply, you oversupply, something, you’re going to reduce the volatility and the sensitivity of that particular metric. And so, then for banks, I mean, if you look at deposit sensitivity, historically, prior to that, that QE that quantitative easing, the Fed started typically we would look at cost of funds or deposit rates, and most banks there was about a beta of about 40 to 50 basis points for every 100 basis points historically, going back 60, something year 50 to 60 years, there was a beta of about 40 to 50 basis points, whenever the Fed adjusted their rate up 100 basis points. So if the Fed hiked rates, they don’t ever do it 100 basis points increments, but if they hiked rates 100 basis points, then we knew what the next 12 months trailing 12 months it typically a particular bank would increase their cost of funds about 45 basis points or 45% of that move.

Well, is this liquidity in a way starting to come to the market and the Fed has remained active in injecting liquidity for a good period of time over the last 12 years. That has reduced the sensitivity of all asset classes, volatility has fallen incredibly over that period. And we saw the same thing deposit sensitivity from 2015 to 2018. When rates went up, the Fed hiked 225 basis points. But this time around, we only saw a cost of funds move about 19 to 20% of that in less than half of the historical move. I think that we just got another 4 trillion in this last year from the Fed. And so, if you look at it, you are even trying to contemplate inflation or maybe higher interest rates. You have to take that into account, and you know, if we’re not as liability sensitive as we’ve been in the past, then that does give me the ability on loan price on bonds, lengthening the duration of those bonds and in trying to pick up a little bit of extra yield, maybe getting out on that steeper part of the curve if deposits are not going to be that sensitive going forward.

The FED is not about to get rid of the balance sheet, they’re not about to get rid of that 8 trillion dollar of introduced money or take a long time to do that. And so that should keep the sensitivity of cash deposits, you know, low in that aspect. So, again, I think if I’m doing strategic planning at my bank, then I’m maybe looking at doing some longer fixed-rate lending, try to be a little more competitive in my environment. And when I’m looking, I’m talking to Andrew, and I’m sitting there talking about what bonds I’m going to buy, you know, I am going to look a little bit more at that longer duration that the more call protection, I want to protect my net interest margin more than down rates, maybe then I’m fearful about what will happen if rates go up, because I don’t think my deposit rates are going to be as sensitive as they as historically been. So, it’s an adjustment of no strategy.

You know, for most of these depositories, big banks have been doing this, they caught on and it’s very early in their Treasury functions. They’ve had this in the beginning, they have lengthened things, shortened heavily on funding because they’re not as worried about liability sensitivity, the smaller the community bank, under 10 million, still kind of goes off that old fashioned, my regulator is going to come in and get me if I go too long, I’m alone for too long and my bonds, but I think it’s one of those things that they have to test their own deposit rates through that rate cycle and prove to the regulator that we’re just not as liability sensitive as we’d met. And that gives us more liberties to do things a little longer, we can change our investment policies and be a little bit more strategic. So I just think that’s something that’s going to morph the depository environment to give them more ability to do some things on the asset side of the balance sheet. Historically, it shied away from insurance purposes.

Tom Fitzgerald: Yeah, it’s hard to kind of shift your you know, if you’ve grown up in that environment as you talked about, have a 40 45 basis point, you know, beta. And all of a sudden, it’s half of that if even that, that it’s hard to shift into that mindset, when you’ve you know, you haven’t had that in your career to this point.

Chad Mckeithen: Yeah. And Andrew can speak to this a little bit because I know we do some ALCO and strategic planning with some of his clients. But I know that a lot of his clients have gone to the longer and longer Fannie Mae does type structures and Freddie Kay’s is taxable and tax-free munities as they start to, you know, we get these low rate environments, and all of a sudden, you know, we don’t see deposit rates go up all that much, they’re doing more protecting against lower rate environments than they’re trying to protect them so much against higher rate environments, net interest margin at banks in 15, to 18, Rose almost 40 basis points net interest margins, the two prior rate hike periods in the up to the 2003 2005 period, net interest margin fell in the previous period before that in the late 90s, into the early 2000s. The net interest margin stayed flat. So that’s kind of proof that we’ve become much more assets since. And I think the Fed has just introduced something that still new to digest and but if you’re starting to see some clients start to do it.

Tom Fitzgerald: let’s shift gears a little bit. So far, we’ve been talking pretty much about, you know, we’ve got excess liquidity or, you know, we’ve got this money sitting around, what do we do to invest it? Let’s talk about some sectors that the spreads have tightened, you know, almost to historical levels in some areas, and that, does that create an AI strategy or a, you know, position that we probably should take advantage of some of the spread tightening and sell out of some sectors and reallocate given what the market is pricing certain of our bonds for right now? And I’ll start with Andrew, maybe you can talk to that since I’m sure you’ve had those discussions with plenty of your customers lately.

Andrew Nord: Yeah, absolutely. We put out Chad’s group that puts out a yield spread matrix that shows historical yields are just about every product. And you’ll get just not all of them are close to two all-time lows, but there are definitely a few that are lower than others. Namely, I think the big strategy for banks here recently has been in the Muni sector. A lot of individuals about rising tax rates and we’ve had record inflows for a lot of Muni funds over the last you know X amount of months. So,q you know, these Muni funds have been buying up just about everything as far as new issue supply and secondary supply. So they’ve kind of driven that reward to risk valuation out the door for banks to where it doesn’t make too much sense for banks at near a 20% tax bracket to be investing in or holding munities I recently had a bank, sell a tax-free bond on the 15 year part of the curve and they actually got a negative tax low equivalent yield spread to treasuries to where you know the person that bought it was probably around a 40% tax bracket made sense for them to buy it, it didn’t make sense for my customer to sell it. So that’s been the main strategy is getting out of sector like that and getting into, you know, a sector like MDS or CMOS that makes, makes a lot more sense.

Tom Fitzgerald: Right, right, you know, and I think like you said that that difference in tax rate between the corporate and what the individual is having to pay just, you know, there’s, There’s, you know it’s maybe a rational investment for him at that. He said that 39 40% tax rate but at a 21% rate. It just makes you know makes no sense and almost a layup trade, you know, for you as far as let’s, let’s sell it to him. He can take advantage of this higher tax rate and we go back into something else, it’s much more amenable to our tax rates. So, and, I guess, you know, Biden has talked about raising the corporate rate and course, you know that. I think what we’re saying is that even with a unified government where they, you know they’ve got the house and they’ve got a, you know 50 seat. Majority counting the Vice President in the Senate, it’s still going to take a long time for some of that that fiscal side to kind of work it’s way through into law, and so that 21% tax rate may be with us you know for a little bit longer than we think.

But I’ve heard talk that you know even, you know that 28% That he threw out has already been negotiated back down towards 25. So, you know, still competing, you know, even at 25% competing against that higher rate from an individual’s, it’s still, you know, going to make sense for the individual a bit that bond higher than what the bank should probably be paying for it. So anyway, Andrew some other thoughts that you, in your discussions with your customers that you’re hearing that we haven’t really talked about this, you know, in today’s discussion as to what their concerns are maybe what their issues are that they’re most, you know most concerned with.

Andrew Nord: And I think, you know, as far as kind of a switch from last year to this year you know, last year I would say the main conversation talking piece would be, you know, nail crunch, and you know this year, I think what I’ve talked to mainly about after shoe we’ve seen a rise from 90 basis points to 160 ish right now on 10s this year so a lot of customers have had to do some rebalancing the portfolio due to just some duration, extension mortgage backs have extended from, you know, say a four to a six-year average life and that’s moved overall duration out meanings have gone from being priced to the call being priced to maturity as rates have gone up so that’s been a little bit of a concern for some of my bankers, but really I mean I think the main concern is, you know, something we’ve already talked about inflation and taper talks, just the fear of rising rates has been kind of main one. And, you know a lot of them just like we just talked about with immunities. A lot of them have been kind of killing two birds, with one stone and selling a tight sector also in reducing some duration risk as well. Just kind of preparing for if rates do rise here going forward.

Tom Fitzgerald: Chad Do you have any thoughts on that some of your, I know you talk with a wide range of depositories. Have you had any sort of a continuing theme that you’re hearing from you know, coming back to you?

Chad Mckeithen: We had to, we had the opportunity last week to speak to the Kentucky Bankers Association and they had about 70 bankers that were there and I mean that’s one of the things that they continued to mention, you know everybody in the room that we’ve talked to, I mean, it’s one of these things that they go into last year they thought deposits were going to leave at some point that’s true that you know we have a surge of deposits and then they get pulled out. And I, you know savings rates have gone up for 12 straight years almost there have been little fluctuations here and there but the trend has been a continuation of consumers deleveraging in holding more safe money in the bank for savers and delivering and so I think that you know the cash side of this is going to have to be something that banks, credit unions, doesn’t matter what type of depository you are. You are just being viewed more as repositories for safety.

And so, you know, we saw a number just mentioned the FDIC came out with some quarterly numbers and deposits grew by 635 billion in the first quarter. And almost all of that asset growth went into cash and there were $400 billion, you can take that down to community banks, I saw a staggering number yesterday it was at the end of 2019 community banks under 10 billion had about 5.6 million assets per employee. In one year that grew to 6.8 million assets per employee to me that changes the way that you start managing your organization it comes more about efficiency ratios than it does just about net interest margin spreads, spreads are going to stay tight. With this much money coming from the Fed, there’s no way for things to go and they’re going to reduce volatility, just as we mentioned earlier, so I think a lot of these folks that listen here, you know they’re going to have to look at staying invested more so than Am I getting the widest profit margin spread that I can get when taken into deposit make alone or buy a bond. And that’s the old school mentality is, what type of spread and making but, you know, even if it’s that cash going into the bonds portfolio, we pointed this out the other day, growing the bond portfolio doesn’t take any extra employees, that’s one of the most efficient revenue growth some bank can have.

So, if you’re in a position of low loan growth right now. But the money and safe assets, even if you’re earning 1% yield if you’re bringing in mostly non-interest dbas, you’re not paying anything on 1% Better than staying in cash at eight bases. So I think the big thing, you know what we’ve seen going on is we’re not trying to hit home runs with where we’re going in the bond portfolio, but we definitely want the money, if we’re going to grow that many assets to the employee, I want to make it, I want to make my efficiency ratio as low as possible while I’m going to sit in that loan growth comes back at some point, that’s great, that’s a higher spread product, but for the foreseeable future, it looks like loan growth is going to remain relatively low and so I, if there’s a bank or a CFO or president if I’m listening to this you know I’m basically saying quit biting the system, that the liquidity has been injected is going to keep volatility low therefore spreads are probably going to stay low, you know, stay invested.

And what I think the other thing that Andrew mentioned, is, you know spreads of titans in sectors where maybe you’re trying to reduce some credit exposure, you might be able to sell some of those bonds, you know, the spreads are tight enough you might be selling the gains long duration, you know, something that makes you nervous out there well spreads is tight saying, tax-free means, and take the gains of it makes you nervous because you’re getting an opportunity right now in the spread environment with bonds Raspbian is tight. We just haven’t seen it before. And so take advantage of it I know people are dealing with a lot of cash and they say well why would I create more cash, but they’re still portfolio opportunities for performance and you know thank you brings up a good point about looking at those takeout yields that they’re low, you might be able to generate most of the revenue now versus waiting for the bond to do it and coupon income.

Tom Fitzgerald: Right, let’s close the discussion of the kind of circling back to mortgage backs in specifically this is our largest when we do our bond accounting peer group analysis. This accounts for about 60% of most portfolios. So Andrew, can you talk about, you know on the mortgage back realm, what have you been moving a lot lately as far as you know, last year it was all about prepay mitigation. I think that’s still a concern, but it’s certainly probably come off the boil that, you know, was doing last year, but kind of just talking about what you’ve seen kind of product that’s moving in this current environment.

Andrew Nord: Yeah, I mean it’s been a little bit of everything, but like I said earlier the Ginnie Mae CMO on the short end has been a hugely popular trade recently, especially for probably the last three weeks or so. Also, you know I call protection is honestly really cheap right now. You know, there are a lot of people harping on that extension protection so buying call protection, you know, kind of everybody’s leaning towards that extension trade so it makes that call protection trade a little bit cheaper. I was looking at some 15-year mortgage-backed pools, the other day that we’re 100 percent New York, which of course you have the 100% mortgage recording tax on those which makes them perform a bit better and a downgrade scenario in the payout to just the standard 15-year pool was only four or 5 30 seconds where, you know, in a traditional market, you know, I’ve seen it go higher than a point before. So like I said call protection is pretty cheap, so I like adding that right now, just as kind of a hedge to down rates, and you know also adding some of that journey trade, that’s probably been to most popular trades recently.

Tom Fitzgerald: Those are good points, Chad, do you have anything to add on that.

Chad Mckeithen: Well, I mean, you know, you mentioned earlier, you don’t want to be a great bond picker when the curve is steep, you know and you know you just want to get things invested when, when the curve is steep like that I think the second thing to that, you know that we always teach us is you know if you’re going to be buying bonds adding a mortgage batch of CMOS that is giving you monthly principal and, you know, monthly cash flow is kind of that second nature approach, you know, am I going to get out on the curve a little bit and maybe I want to have those types of cash flows, so that in the event rates go up, I’ve got that constant re investable, you know, the flow of funds and I think if you stick with that approach, I think you’re in good shape. You mentioned the prebate risk last year and a lot of that had to do with premiums and now you can get some lower, you know premiums you can even in some of the CMOS we’re seeing, you know Andrew mentioned the shorter Ginnie Mae’s memories and some of those that at some discount so I think that’s a great cash holder, you know, short-duration CMO at a discount if for some reason it ramped up and pre base speed you’re writing the discount up to par versus what everybody was struggling with about this time last year where they were writing a lot of bigger premiums down to par.

So, you know, I don’t think the prepay scenario is in focus as it was a year ago. But again, the curve is steep, I think, a final thought for me curve is steep, you know get invested somewhere. And I think if you’re trying to hedge all environments not trying to be a perfect bond picker, I think something that’s monthly cash flowing is very good and I’d kind of leave it at that.

Tom Fitzgerald: Yeah, well I want to thank you, Chad, and also Andrew that you’ve provided a lot of illuminating information to us, it’s, you know, dealing in a pandemic we’ve, you know, all of us obviously have never gone through that so you’re sort of like dealing with how to navigate through a dark bedroom, you know, and not wanting to stub your toe or worse. So, I think you’ve shed a little bit of light on the subject as far as investments go and I know, I’ve really enjoyed it and I’m sure our listeners have enjoyed it too. And hopefully, they’ll go back and have a little bit better idea of how to manage through their investments, their portfolio as we kind of travel through 2021 and into 2022. So again, thank you guys for your time today. We really, really appreciate it.

Chad Mckeithen: Thank you.

Andrew Nord: Thanks for having us.