Preparing for Rising Rates in 2022
This week Tom Fitzgerald sits down with Chad McKeithen to discuss the outlook for rising rates in 2022 and what it means for the investment portfolio. The views, information, or opinions expressed during this show are solely those of the participants involved and do not necessarily represent those of SouthState Bank and its employees.
The views, information, or opinions expressed during this show are solely those of the participants involved and do not necessarily represent those of SouthState Bank and its employees.
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. Thanks for joining the conversation today. I’m Caleb Stevens and I’m joined by Tom Fitzgerald, and today Tom is all about the economy and what’s going on with the fed.
Tom Fitzgerald: It is. We’ve got Chad McKeithen and from our Duncan Williams group, and we are going to sort of, we wanted to kind of kick it off as sort of investment, 2022, but we put the fed meetings and with other things that have happened, since the beginning of the year, it becomes part economy and part investments, but I think it’s going to be a good 30, 40 minute listen for our listeners to kind of get a feel for where we see the economy rates going and kind of how that balances into kind of investment recommendations for the beginning of the year.
Caleb Stevens: We’re recording this on a Thursday. This fed just met yesterday on Wednesday, and this is dropping the following Monday. So, hopefully, nothing too drastic changed over the weekend when this drop. But we wanted to strategically position this show to be right after that fed meeting. So, you and Chad could kind of digest what they said and talk about what that might mean for the next few months here.
Tom Fitzgerald: That’s right. And so, you’re looking at some of the other geopolitical events that may transpire that could, you know talk about Ukraine, Russia, that if you have a something happening there a flight to quality obviously is going to upset the apple cart as far as what we’ve seen so far, but let’s keep our fingers crossed nothing like that happens.
Caleb Stevens: Well, before we get into that, Tom, real quick, tell us about your bond accounting trends report that you put out every quarter for Community Bankers.
Tom Fitzgerald: Sure. Caleb, as you talked about, I do a quarterly review of our bond accounting group, which is about 130 banks and about 13 to 14 billion in par value. And so it’s a good cross-section of the typical community bank, primarily in the Southeast, but we have them spread out across the country as well, but it does what I do on a quarterly basis is just kind of look at that group as a whole, as a single portfolio and kind of put together where they’re invested, kind of take a look at what sectors are they most heavily invested in taking a look to at their trends, looking at the portfolio yields and how that’s trending the durations the unrealized gainer loss, and so we’ve got that prepared for the fourth quarter of 2021, and that can be found at southstatecorrespondent.com/bondreport.
Caleb Stevens: It’s a great report. A lot of folks use it in their board packages, a lot of CFOs. We get requests for it every quarter, and so glad that that’s out. So, you can go get that at, like Tom said @southstatecorrespondent.com/bondreport. And with that, let’s jump into Tom’s discussion with Chad McKeithen. Thanks for joining us.
Caleb Stevens: Well, Chad McKeithen, welcome back to our show. It’s been what, a couple months, I think since we did one of these, we try to do them certainly at the beginning of the year, like we are now but want to welcome you back. I hope everything is as well with you.
Chad McKeithen: Yeah. Thank you very much. No, we always look to given our thoughts out at the beginning of the year and see how things play out. It’s a much better-looking beginning of the year than what we were looking at last year. So, happy to join.
Caleb Stevens: That’s right. For once investment managers have some yields to look at without having a magnifying glass to get to them. So, and obviously, the beginning of the year is if you want to do housekeeping types of arrangements, that’s the time to do it, where we can give you some, you know, there’s enough runway to make up losses and so forth. But we’ll get into all that as we go through the show, but as we record this, I guess we’d be remiss if we didn’t mention the FOMC meeting that just transpired for January. I had been writing ex to expect a pretty hawkish tone coming from the meeting and that’s what we got. And I think even then some, it was the statement itself, I think, was right down the middle of the fairway as to what the market was expecting possibility of rate hikes as soon as March.
And then balance tape or balance sheet runoff beginning somewhere, kind of right after that, whether that’s late spring or midyear, but then when Powell started speaking, he was even more, a little bit more hawkish than what the statement said and so it kind of put a little put the market on its heels, as he continued to talk, as you look at the pricing or expectation for fed funds, it seems to be moving up every week or so. And now, I think we’re looking close to five hikes being priced in by the market, and when Powell had the opportunity to push back on a possible 50 basis point rate hike in March, he didn’t really do that. So, kind of walked away from that feeling that the fed is serious about this inflation and getting it under control, and of course, what that means as far as rates and for the economy going forward is going to be these, some of the questions that we try to look at and at least answer today, and then what that means for investments. So, just kind of tossing it over to you. Chad, did you kind of, what was your feeling of the take of the meeting, and was it anything in there that really kind of surprised you at all?
Chad McKeithen: No, I didn’t come away surprised whatsoever. I mean, we always do a 10 minute after the call kind of a few bullet points, and one of the things clients have always kind of looked for is what did the market do, what were rates doing right before the fed came out with the announcement, especially these when there’s a lot of anticipation about a meeting and then, and then what happened to rates, post their announcement in some of the results and bullet points that they put out. There was very little move in that 10 minutes following what they came out with, as you alluded to when Powell started to talk a little bit, that’s when we kind of started to see the heat thermometer, go up a little bit on yield.
We started to see a little pop in yields. The stock market started to retreat a little bit, and as you alluded to, he added a little bit more of a, maybe a hawkish tone, mentioning the inflation a bit more. I think the good thing going into this meeting is the hawkish tone had really been set by most of the different speakers, three months preceding this meeting. I don’t think anybody went in here, not expecting them to talk about, liftoff in rates, in March. I think the thing that would’ve shocked the market is if there was a feeling that maybe that 50 basis point hike could have been on the table, but I think everybody expected, that we were going to hear possible rate lift-off in March and a continuation.
Of the, I guess the unraveling a bit of the buying program, that they set in place two years ago. So, pretty much par for the course, you know, I think this is a huge quarter, for the fed, if you go back to last year, the first six months of 2021, they really focused on this first quarter it was the transitory language a year ago, but they really focused on this first quarter is where we were going to see the fundamentals of real inflation. That was the first quarter was kind of where we get past that year, over year. We’re, that baseline effect on the year, over year growth and inflation and we start to see what are we really dealing with. So, I still think this first quarter is something that the Fed’s going to be, do we keep economic growth going? Even if inflation’s high, are we outpacing the kind of the inflation growth, with economic growth and if that starts to level off, or we see a little bit of employment change, I think that’s where we could, we could see some maybe, heartburn, I guess, from fed speakers over this first quarter, but original question, I think it was par for the course, little bit of hawkishness in some of his comments thereafter and it moved the market around a little bit, but not, not a lot.
Caleb Stevens: Yeah. And I think they’re going to try that balancing act of we want to raise rates obviously to wrestle inflation to the ground. Like I had said, but also that they have to be mindful of what’s that doing to growth, and we’re, I think the long end of the treasury curve right now is a little circumspect as to whether they can engineer that so-called soft landing, which feds have been always trying to do, but they can, you know, it rarely does they pull it off. So, we’ll see, I think right now Powell from his comments and from what they said in the statement. They feel the economy has enough momentum and enough depth to it that it can survive a series of raid hikes, and so that’ll be sort of, as we move through 22, I think that’s sort of the question is that going to be the case?
And it’s interesting, you know, also as we record this, the fourth-quarter GDP came out and it was the highest, since the second quarter of 2000, at 6.9%. So, it beat all the expectations. When you looked at the numbers, though, it was really being driven by two things. One was inventory restock, and just a huge export number, which kind of came out, I guess, some of the other countries around the world reopened or at least stepped, you know, stepped back in. The flip side to that Chad though, is that you get the inventory to restock in the fourth quarter. There’s always some of that give back in the first quarter. So, we may be looking at a fairly weak first quarter right now. I kind of checked on before we came over here for the show was, looking right at just over 2.8%, I think for the first quarter of this year, as far as GDP goes and for the year 3.8%.
So, that’s kind of where we’re sort of sitting right now is we kind of wait for the fed’s first moves as if we do get that 3.8, that’s an above-trend number, right. I think the fed looks at their long-run GDP is being around a 2% level. So, Powell looking at that saying, well, 3.8, we can certainly stand a raise into that growth and not damage this, or throw us into a recession. So, again, I think that’s going to be sort of the key as we move through the year kind of looking at where, you know, how is GDP doing? And like you said, are we ding inflation? Are we putting a dent in that? And I think that’s Powell expressed a little disappointment that we haven’t, he says that the numbers haven’t improved at all on the inflation front and that’s kind of what I think is drove some of that emphasis to get ready for the rate hikes.
Chad McKeithen: Yeah. I think that’s a good point. I mean, just not to add a lot to it, I think you said it beautifully. I listened to a, it was a few years ago we had a fed breakfast and they said, really the Fed’s goal, they definitely have the dual mandates, but the goal of is not so much focused on is inflation high or low it’s can economic growth support where price increases are at. And so you’ve got an elevated inflation number and even the expectation going into this year is that it’s going to stay relatively above, average, and I think, you know, when the fed governors look at that and they’re looking out long term when you’re looking at close to say, maybe a consensus of almost 4% at GDP that’s a volatile number because that’s well above the average.
So, if that gets dented at all, that drops a bit, then inflation starts to put some real pressure on the market, and that gives them less leeway, to possibly, you know, tighten, if we don’t have the growth to support tightening in general, you’re really going to dissolve the markets and that’s kind of what the IMF, chief pointed out earlier this week is every economy, every central bank is starting to tighten to a degree, but it’s a lot different when the US central bank starts to tighten and what that does to global growth. So, they definitely have some tender areas to move around in, and I think this first quarter’s going to be a lot of looking at how things are setting up. Is it abnormal stuff like inventory, revolving inventory, and just restocking, shelves, because there’s such a supply-demand or a demand or is at fundamental things that are going to create some longer-term growth and then ultimately, do we see a little bit of price relief at some point? So, it’s definitely an interesting time.
Caleb Stevens: And I worry too a little bit, our economy is two-thirds consumption and so the fourth quarter, the consumers certainly stepped up a little bit more than they did in the third quarter. But if you look at December and we remember retail sales was pretty weak, we’ll get a personal spending number tomorrow. That’s probably going to be just as weak, and that’s probably continuing into January, which with the virus cases trending high, both in December and January. So, right now the fed and most of the market says, okay, that’s just sort of, kind of a one-off that these consumers are going to come back and that certainly can be the case, but like you said, I think there’s going to be a whole lot of watching on Tinder hooks as far as how is the consumer going to navigate through the early parts of 2022, and again, how is that, you know, with the ad VIN of rate increases, starting to come around the corner, how is that going to impact, you know, all businesses as well as the consumer. So, we’ll just have to see, I think the tenure treasury, you know, it probably does kind of touch 2%. I think that’s sort of that momentum is probably in place to do that. But to go from say two to two 50, I don’t know. I think they still feel that the longer end is kind of bought into the Fed’s message, that they are going to do what they can to combat inflation and as long as that remains true, that catalyst to get us to two 50 is going to be, I think hard press. So, I don’t from an investment standpoint or perspective, we’ve obviously seen the short end of the curve ramp up, with the expectation of fed funds. But the longer end has been much more hesitant to kind of join that party they’re lifting some, but it’s been much more hesitant. And I think that’s the fact they buy that fed message that they’re going to, they’re going to kind of tamp down inflation, but it’s also probably going to tamp down growth too, by a fair amount. We just don’t know at this point, how much.
Chad McKeithen: Yeah, and that’s the trip tricky topic. I mean, we do a lot of Alco meetings and everybody wants to know what especially with banks, what’s going to happen to the short end of the curve, what that might do to deposit rates and I even looked this morning now, before I think July of next year, July of 23, there’s actually 725 basis points hikes, priced into the options market, not to say the options market’s going to be correct, but it’s a large, robust market and it’s a lot of money that is a lot of smart money that’s being placed on those different contracts and that would push the fed funds rate up to almost 2%. You look at the 10-year treasury right now, and you go out a little over 12 months.
And I think the future’s contract on a 10-year treasury, the March contract next year was about a 2.10. So, you got a market right now kind of forecasting that the fed is going to flatten the curve and I just don’t think if you ask them, from that standpoint, if that’s what they like to do, I don’t think that’s the type of thing that they think would be good, you know, flat two inverted curves have not typically, been followed by robust growth in, in the US economy. So, something’s got to give there, either the market’s got to get a little bit more concerned with inflation, we’ve got to see those longer and rates come up maybe a little bit more allow the curve even a little bit, or they’re not going to if the long end does stay anchored, then I think at some point they probably have to pull off a few of those. I don’t know that seven hikes is the proper pricing right now.
Caleb Stevens: Right, and that’s a thing when you talk to a, it’s hard to say, okay, you know, talk to a portfolio manager and say we investment strategies and he’s sitting there thinking, well I’m on the precipice of multiple rate hikes. Why should I move now that the fact of the matter is that front end of the curve, from zero out, to five to seven years has priced in a fair amount of tightening already opportunities like we were saying earlier, we’ve got yields now that we haven’t seen since prior to the pandemic. And so let me just ask you kind of, from a beginning of the year, do you have some strategies or swaps that you’ve worked with customers that have been kind of taking advantage of that lift and the front end of the curve, to profit off of that before we move further into the year?
Chad McKeithen: Well, in my whole team, I mean, you become a much better strategist when you get a yield move like this in such a short period of time. I mean, the five-year treasury is up, you know, 105 to 110 basis points in the last five months when we dealing with Community Banks, that part of the treasury curve is the most meaningful when you get a nominal yield, push up like that and you’ve got this amount of liquidity, it doesn’t take a lot of value or strategic, reckoning by me to just say, there’s a good opportunity to put liquidity to work. We’ve gone over some of these other things over the next year that are a little confusing to maybe to the market and portfolio managers, etcetera.
Well, that confusion does also create volatility, and over the last three to six months, we’ve seen not only nominal yields. So, say that three to five-year treasury we’ve seen that come up, which makes the bond market, just more attractive from a Noal standpoint, but we’ve also seen volatility and credit and interest rate risk, or option risk kind of show its head again. So, now we’re all of a sudden, we’re starting to get some, some spread where if I go back a year ago the five-year treasuries at about 60 basis points, 50 basis points, and spreads are very tight because the fed is out there, just showering the markets with money. So, at the beginning of this year, first and foremost, we’ve just got better nominal yields and we’ve got a little bit wider spread.
So, the opportunity to put liquidity to are going to be more meaningful. I know that you put out, every single quarter you put out you’re the bond accounting peer analysis, and you show what the portfolios are yielding and where the durations are and I might be off a basis point or two, but around a 175 tax-equivalent yield, and I think you were in the upper fours in average life for all of our bonding accounting clients. Well, this is the first time in the better part of two years that we’ve been able to add money to that portfolio, and we’ve been able to bring the weighted average yield up and not necessarily with, by extending duration any longer, you go back a year ago to, you could not improve yield.
And you certainly wouldn’t do anything to the yield of your portfolio without getting a little bit longer in duration or adding on that interest rate risk. So, it is a better market just from a pure buying standpoint, beginning of the year. I mean, this is where you always make your changes to realize your most revenue for the year, and again, this kind of goes into the just increase in yields that we’ve seen, but one of the things that we had a lot of clients do and I think wisely, over the last couple years is they bought a lot of short agencies and treasuries. I do think there’s an opportunity inside three years, so durations that are three years and less. I do think there’s an opportunity, even if it’s at a loss.
I think the opportunity from a swap standpoint is very strong to come out of some of those segments. There’s some low yields there, a lot of banks bought these when spreads were very tight yields were very low. They didn’t want to take the risk in some difference, say mortgage backs or corporates or Munis, over the last two years is everything really tightened up, but now we’ve got markets much more attractive. So, we have looked at the beginning this year, we’ve had a lot of clients that have come in and they just called or exited those shorter agency, bullets, shorter treasuries and they’ve rolled out whether it’s in two mortgage backs, CMOS, Munis, it’s not so much the sector they’ve gone into, but they’re picking up a hundred twenty-five, a hundred fifty base points of book yield.
And they may have a loss, but because the yield is so high now of what they can reinvest in they can make the loss up in 4, 5, 6 months before year-end and it’s definitely revenue a creative, but before the end of the year and so beginning of the year strategy is purely tons of liquidity out there still with a lot of our clients. So, just the opportunity to add good yield that actually will increase net interest margin and pick up portfolio yield. But I think there’s also some opportunities to clean up a little bit of what we bought in say late 2019, 2020, the beginning of 21, and make that revenue accretive before the end of 22.
Caleb Stevens: Yeah. And the time to do that trade is probably now right where you’ve got the full at least 11 months to work that kind of flip that from a loss to a like you said, a creative to earnings for the year.
Chad McKeithen: As an AO manager, we always look at the first quarter, if we can make things up in the nine in nine months, through the first quarter, if I can make something up that I don’t love that I’d rather not be in my portfolio yield. I think that’s the time that you do some of that calling, not all of it, rates could, everybody’s focused on higher yields and the opportunity right now, but you never know. I mean, something could disrupt the markets. We could have turmoil in other parts of the world that we get a strong rally back and so but I do think the opportunity to eliminate some historically low yields that have been put on over the last two years, that opportunity is available in this first quarter and it’s also available to be able to be revenue created before your end. So, I do think in the first quarter, that’s a good strategy for those clients that have added some of that stuff.
Caleb Stevens: Right now, let’s shift to specifically to mortgage backs. That’s, as you talked about our I do that bond accounting group, peer analysis, and when you look at where that group of portfolios is invested, almost 60% of their portfolios are in mortgage backs slash CMO. So, some type of mortgage product, and it’s predominantly mortgage back pools. So, let’s just kind of look at that specifically, are there given this backup that we’ve had, and it’s been when you look at mortgage backs, a lot of it trades in that four to five-year average life range, and that’s right where we’ve seen the bulk of backups and yields. Has there been one sector within the mortgage backs that you’ve kind of risen to the top as far as a trade idea? Or is it more generally you’re getting higher yields across the board, no matter what product you want. So, go to the one you’re comfortable with, and it’s going to give you the yield you haven’t seen for a couple of years. Is that kind of talk about what you’re seeing there in the mortgages specifically?
Chad McKeithen: Yeah. In GU Bonzo. I think we had her on at our last quarterly investment call and she definitely drills down into this much more than I do, but I think, the mortgage back market was such interesting, you talked about its largest, percentage of bond, accounting clients, historically that’s always kind of been a little bit of back and forth between Munis and mortgage structures and when I say mortgage structures, I’m talking about CMOs also, but what happened over the last few years is the fed came in and said, okay, we’re going to treat mortgage backs a lot like treasury. We’re going to be buying both of these wells for the liquidity and concerns that institutions have. They, funneled into mortgage backs and that’s a lot of that growth. You mentioned 60% of the volume and bond accounting clients is now mortgage backs.
And I think Munis is probably now probably 20 to 30%. And so, you’ve seen that segue over to cashflow ladder-type product. The fed comes in and puts huge backstop support to agency mortgage backs and as a result, we saw a lot of community banks go into the mortgage back sector. Now we’re at a point where yields are a little bit better, the Fed’s coming off and saying, hey, we’re going to stop buying some of that stuff. So, it’s back to really looking at the mortgage market for where the future value is and that’s back to the true fundamentals. What type of spread can I get? What’s the duration? What’s the extension risk, the cash flow ladder that the very important piece to banks is that monthly principle. I would say if you’re truly looking, I don’t ever like to point out one pool.
I like this coupon, or I like this premium, or I like these 30 years versus 15 years, but I will say right now, the tightest spreads are in your 10 and 15 year and mortgage backs and that’s because you’re getting a little bit of a herd mentality down thereof chasing that shoe order duration. Whenever you hear the fed come out and talk about possible rate hikes the typical community bank or the group as a whole is going to chase that shorter structure to look at interest rate risk, or to focus on interest rate risk. I’d say, if you look out a little bit more into that 20-year agency mortgage back that 25-year agency mortgage back, I even like the 30-year agency mortgage back right now, I think you’re smarter or your wiser spread investor is taking a little bit more shot of getting past that 15-year structure.
I’ll give you an example, you know, an agency 15-year mortgage back, a one and a half percent coupon, very plain-vanilla instrument. This morning is about a 178 yield about a 5.3-year average life. I step out to a 20-year, 2% coupon agency mortgage back, same agency, same Fanny structure, just a 20-year structure versus 15. I’m picking up 40 basis points a yield for about six to seven months longer. In average life at 40 basis points a yield for six months of average life extension. I’m doing that all day. It’s not because the 20 year is some valuable structures because so much liquidity is piling into the 15-year structure that spreads very tight right now. So, if you have the opportunity to get out into say a five or a six-year average life structure, I like looking at that 2025-year 30 year.
Now we do have a lot of clients right now that aren’t so focused on longer structures and if you are coming down to the short ends, I don’t love the 10 and 15 years from a buy and hold standpoint. I do like a little bit more, your three-year, two, or five-year CMO pack, sequential structures, and that market’s been very attractive for the better part of two years, but GICA who I just mentioned this morning. You kind of put out some value plays, four-year average life CMO pack. This morning, you can get a two 10 yield. You’re looking at about a four-year average life with about a year and a half of extension risk up 300. That’s been a hard structure to find. Now, look, CMOs are not ever going to be as liquid as an agency mortgage pack, but that’s a great front-end barbell.
You’re getting 50% of your cash flow back and say the first four years, that’s a great product just to buy and hold and the spreads are very attractive. You’re looking at 50 to 60 basis points to the four-year part of the curve, not a lot of extension risk, not a lot of price volatility in that, but if you need pure peer pure agency liquidity, you probably want to look to some of the shorter mortgages back. So, I know that’s kind of a broad brush, but if you’re looking at shorter mortgages and you want some spread, I’d probably lean a little bit more layer in a little bit more of your shorter CMOS. You need pure liquidity, 10 to 15-year agency mortgage backs are fine, but if you’re looking for value in the mortgage market, I think you really got to get out into that 2025 year 30-year structure to get some of those 50, 60, 70, 80 basis points of spread to comparable treasuries on those average life structures.
So, that that’s kind of a broad brush, like I said, on the mortgage market, but I think that’s where the value is and we’re using a lot of short CMOS, as supplements to even floaters. So, for our short end of our barbell, some two and three-year packs, where I can get up into something, that’s given me a two-year type or a three-year type sequential, that’s given me a one 70, a one 90 yield, but I’m getting a heavy dose of cashflow back and say the first 36 months.
Caleb Stevens: Yeah. That’s some good insight too, because and I guess the bottom line and all is to remember the fact that whatever, the most of these yields will be higher than what the portfolio was yielding. So, finally, like you said, the first time in several years, you’re able to be ACC CRE to the portfolio yield, instead of just trying to minimize the yield damage that you’re doing with new investments and so it’s, and we’re talking product that most people are very comfortable with, very familiar with. So, it’s not like we’re stepping out into any type of esoteric, product to get those types of yields either. So, that’s, those are all very good and valid points. I think like you said, the other, you step away from mortgages, the other largest sector that we have in our bonded category up as the municipal sector.
And that is, right now, 22%, it used to be a little bit higher. It’s kind of come down as, the more, monies have been very expensive, I guess, to where they had been historically and so that’s kind of slowed down some of the reinvestment, but they still retain that advantage of having some of the highest, tax-equivalent yields in the sort of the bank universe of investments, just, can you talk briefly about I would think where we are in the economic cycle, the fact that they’ve had a lot of help from some of these programs that came through from the pandemic, that the Muni sector is still pretty well-positioned and I know that you kind of, we’ve kind of compete in some parts of the curve with the retail sector that has a different tax profile but just want to get your thoughts broadly on the monies and where you see them going this year.
Chad McKeithen: Yeah. I, well, that’s a definitely a yeah. Where it’s going this year is, is going to be difficult because, what happened to the tax-free side of the market was, well, a couple of things. We, had over the last couple years we had the elimination of the advanced refunding, so that stopped some of the supply, and especially in the tax-free side, a lot of them did, or still are pre-funding some of those into taxable deals, but it’s definitely still not as robust in the volume that supported a lot of supply before INAX free Munis, and that gave us some attractive Muni ratios compared, tax-free Muni ratios compared to taxable structures. Then last year, of course, as the administration changed a little bit, and there was a focus in possibly higher taxes, we saw even a heavier demand for the tax-free market.
And you saw, we always quote the Muni to treasury ratio. We saw some of those get down to, especially on the 10 years that the AAA, ratio we saw that Muni to treasury ratio gets down into the 50% range, which is historically tight. But, as this administration’s gone through maybe higher taxes, don’t seem like that’s going to be something that this administration maybe wants to battle and I think even as we get closer to the second half, of the four-year term, the likelihood of us higher taxes is probably diminishing some. So, we’ve seen the Muni tax three markets, come back. I mentioned that that 10 years, AAA Muni to 10-year treasury got down into the 50% range. That’s back up almost to 80%, on the tax freeze.
Now we have community banks always buy tax three monies. There’s, there’s a good understanding of them. They’re very, you’re typically your highest performing portfolios do typically have a good, robust mix of tax-free communities with all that said, I do still like the taxable slightly better than I like the tax free and I’m looking at it on my notes here. I mean, if you look this morning at a 10-year AAA tax, three tax-equivalent yields, so community bank let’s take 21%. You’re looking at about a 173 they or tax-equivalent yield on a 10-year AAA structure. You go over to a taxable deal, AAA structure, and you’re still looking to two 20 yields. So, we’re still looking at 40, 45 basis points of yield pickup in the taxable structure versus the tax-free. Now not everybody’s going to buy triple-A.
So, that’s where I’m not going to give a lot of suggestions. You get down into the single a and the double as I do like some of those structures because credit spreads, as I mentioned earlier, are starting to widen out a little bit. When we get a little bit of volatility in the market, the Fed’s a little unsure, the market’s unsure about which way we’re going to go. We’ve been in a pristine credit because of all the stimulus over the last two years. Now we’re starting to lose a little bit of that. So, now you’re double A’s your single A’s. You’re going to start to get a little wider spread in it. So, we do think the tax-free market’s going to get, you know, a little more attractive. Is it going to get back to a 90% Muni to treasury ratio where we were prior to the pandemic?
I don’t know and but we are starting to see community banks get back into the tax-free sector and rightly so, the ratios are getting better. Credit spreads are getting a little bit better. You could give me a million dollars today and you gave me two different businesses. So, look at it, probably still going to lean a little bit of that weighting to the taxable side of the market, but I do think the tax frees are going to find more place back into portfolios. I think where it’s at 20% of bond accounting clients right now are the low 20% range. You’re probably going to see that as credit spread wide now, it’s probably going to pop back up to 25 and maybe even to 30% as is especially for banks that don’t have a lot of loan growth, they’re looking for some different credit support in other sectors. So, I’m not going to target a certain state or a certain credit range of where I think it’s good. If you ask me to put money one way or the other, I’m still going to lean a little bit taxable, but I do think as we move through this kind of administration and maybe a lack of tax increases or diminish some, I do think the tax-free market will be something in 22, to keep an eye on. I think ratios are going to continue to get a little bit better there.
Caleb Stevens: And again, I get, you know, these are ideas and investments that have a yield for the most part greater than what the, what their individual portfolios are yielding, and so it’s just been, again, that’s kind of hand in that issue, but that is something we haven’t had for so long that I think a lot of portfolio managers, every time they have to put money to work, they sort of just kind of did it grudgingly because they’re like, I’m going to, I’m going to hurt my, whatever my yield is. It’s going to drop a few basis points, but this is going to, you know, in the year of 2022, that should be on the other side of the coin where that yield’s going to start creeping back up and that’s always, I think something that’s that everyone will appreciate, as we work through the year.
Chad McKeithen: Yeah, I think a good point to finalize what you said there. I mean, just on that one point, I mean, this morning we were kind of putting some stuff together for an Alco and we were looking at this happened to be on three years sequential and so CMO structure and the weighted average yield of what we were showing on in that three-year sequential was a one 90 yield, and the average life was 3.7 years now with the mortgage backer CMO, you’ve got a little extent risk. So, is that, you know is that a year, year and a half? So, there is going to be some duration lengthening if rates go up. But we go back to your peer average is the pure portfolios were in the one 70 range and the average life was, was up in the form.
So, to your point now we are able to add short-duration investments without layering on a lot of interest rate risk. Like we’ve had to do over the past couple years. You’re actually able to put some money to work, keep duration the same, not layer on a lot of interest rate risk, but also now help net interest margins and help portfolio yield. So, I think that’s a good summation that it’s not so much what sector you’re picking. There’s definitely some that have wider spreads, less extension risk, etcetera, but now we’re able to support net interest margin where the last two years the portfolio has been has hurt net interest margin with rein investments.
Caleb Stevens: That’s right. And so, like I said, it’s kind of a case where, you know, before you were just trying to do as lease damage as possible, now we can actually do something that’s net positive for the net interest margin for the earnings of the institution. Sure. So, anyway, Chad, I want to thank you again for coming on and giving our listeners a little bit of your insights and your thoughts as we roll into 22 and kind of navigate a fed that has now firmly on the side of raising rates. I know you had mentioned in some of our past sessions, most banks were probably more, asset sensitive than they thought or than the reports indicated and I guess we’re going to kind of see that play out real-time this year with the rate hikes, I guess, you know, so we’ll kind of see how that works any thoughts on that?
Chad McKeithen: Well, yeah, and that’s a good thing. I mean, talking about asset sensitivity, I mean, it’s, you know, one of the things that I saw it was BO at bank of America’s CEO this last week, you know, talked about all right, well, we, you know, from 15, when we tapered the last time from, from say 15 to 19, we only saw deposit rates move at about 20%. I think that we know that the amount of liquidity in the market that there’s going to be lower liability sensitivity, or it’s going to increase the asset sensitivity. So, we should see revenue increase. The one thing that’s different in this environment that wasn’t it wasn’t similar back in say 2015 is the huge reduction on balance sheet of the most sensitive deposits and that CDs, and borrowings that they’re almost nonexistent on bank balance sheets.
And so, you know, we definitely had a lower beta on deposit sensitivity in 15. And as a result, we saw net’s margin widen quite a bit, even as the Fed was hiking rates, 225 basis points, from 15 to late 18. All right. So, now we’re in a period where maybe the fed might be hiking rates again, but now we have a liability profile that’s even we have good, we have a good liquidity, so we don’t have to be as competitive on the pricing side, but now we even have a lower sensitive product level on the liability side. So, I’m not saying that to with our ALS and our banks, that we’re recommending that it’s going to be 10%, beta assumptions on cost of funds. But I do think the ability to go out there and make a, to take on a longer credit or to buy a longer bond, if the spread’s attractive or the curve’s attractive.
I think that ability is shifting liquidity is going to be very strong for a long period of time and I think that’s going to work to the benefit of the community banker to be able to control a little bit more of that liability sensitivity, even more so than what we saw from 15 to 18 when net interest margin for almost the first time in history rose as the fed height rates. So, I think that’s a final point to kind of gauge, what different banks feel about their net interest margin. We expect net inches margin our M to widen, and I think it could be even greater, which might give you a competitive advantage when you’re out working with loan customers, or you’re looking at your buying portfolio to generate a little bit more revenue. We’re not as sensitive on the liability side of the balance sheet and I’ll kind of leave it there.
Caleb Stevens: Well, thank you, Chad. Again, again, I want to appreciate your time and your thoughts and your insights for our listeners and I’m sure they’re going to take a lot of this as they start to at least start the road towards 22 and the goals that they’ve set for themselves. Again, thank you so much, Chad.
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