This week our strategy team discusses the rising rate environment and what it means for your investment portfolio. Click here to access our Loan Pricing & Relationship Profitability Series

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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. My name’s Caleb and I’m joined today by the one and only Tom Fitzgerald, Tom, how you doing?

Tom Fitzgerald: I’m doing good, Caleb and how are you?

Caleb Stevens: I am doing great. Tell us about what we discussed on today’s episode.

Tom Fitzgerald: Well, we had a chance to talk to Robert Biggs and Geetika Bansal out of our broker dealer Duncan Williams group in Memphis. Geetika was actually out in San Francisco attending an event. But anyway, they work in our fixed income strategies group. So, they’re very in touch with what banks are doing and what banks are saying to them as far as they’re in investments and just balance sheet activity as a whole. So, it’s an excellent conversation. I think as we kind of navigate coming out of the fed meeting and the rate hike and what the Fed’s expecting to do with rate hikes in the future. So, I think it’s going to be a real good listen. I think our listeners will get a lot out of it as they try to navigate again, this new rate hike cycle that we’re in.

Caleb Stevens: Well, that was a really helpful discussion. I think you guys provide some great strategies around the bond portfolio to navigate the coming months. Before we get there, I have some news to share with you. We want to tell you about a brand-new resource that we’ve created for you and your lending team. If you’re looking at this year and you’re seeing the inflation, what’s going on around the world, the fed raising rates. You’re wondering how to price loans that are both competitive and profitable to your bank. Our own Chris Nichols has created five free videos to help you price more profitable loans this year and retain your best customers. It’s a great series. It’s five videos. They’re only about five minutes each, so you can fly through them. But we talk about how focusing just on that interest margin can get you in trouble. Why too many banks mispriced their credit risk, how to drive the right behavior for your lending team and the most important element of loan structuring that you need when you book commercial loans. So, to get this video series, we’ve actually included a link in these show notes of this episode. So, you can click there. Or you can visit south state correspondent.com/loan pricing. That’s south state correspondent.com/loan pricing. Five free videos. They’re about five, six minutes each. You can fly through them, but we think it’s going to be extremely helpful to you and your team, as you think about relationship profitability. Loan pricing and your goals for 2022. With that here’s Tom’s discussion with Robert and Geetika.

Tom Fitzgerald: Well, Geetika and Robert, I want to thank you for coming on our show today. I think Robert is this your first appearance with us?

Robert Biggs: It is. It is the first time, I’m excited.

Tom Fitzgerald: Well, good and I know Geetika, you’ve been on once or twice before, so welcome back. We obviously like your input, so we keep calling you back, which is a good thing. So, glad to have you.

Geetika Bansal: Thank you so much. I like being here as well.

Tom Fitzgerald: Oh, well, good. I know you’re calling in from way across the country in San Francisco. So, we appreciate, you’re taking some time out to sit with us today. I think we need to just kind of preface everything that as we record this, the FOMC just had their meeting for March. So, obviously, it was quite the important meeting, and it was one where they started their rate hiking cycle. They gave us 25 basis points; they’ve promised to do up to six more this year. Whether that’s some combination of 50 and 25 remains to be seen, we’re getting some talk from some officials. They’d like to get a little bit front loaded and maybe put 50 on in some of the early meetings coming up. But we’ll just have to see. But anyway, we sort of knew it was coming. It’s been pretty well telegraphed. It kind of when it’s here, the first rate hike in several years, it sort of still creates some volatility. You know, the volatility in the market is something that we didn’t have to experience for a year or two. All of a sudden, we’re sort of, kind of being buffeted by one news headline, whether it’s the fed or whether it’s the war in Ukraine, we’re sort of having to deal with a lot of cross currents. That creates challenges for our portfolio managers, as well as bank managers as a whole. When I kind of look through some of what they forecast in addition to the rate hikes and what they plan for this year and even into next year. They’ve got three hikes penciled in next year, which gets you almost to 3%, I think, 2.75 to be exact. But I think Robert, you had mentioned, given that sort of the constraint there is, can they do this and still keep the economy growing at a decent pace? Obviously not maybe the numbers that we did in the last year or so. But you always worry that you start dialing in rate increases and then with other things coming in, you know. Is the economy really going to be able to perform. But Robert, from your standpoint, you kind of feel what the fed has done as far as this hawkish turn. How do you feel about where they think they can go on rate hikes?

Robert Biggs: Well, I’m old enough to remember two years ago when we were looking at 0% for their foreseeable future. Now we’re talking, oh, I heard Bullard coming out saying 3% before the year’s over. So, I look at what’s the follow through and can they execute as plan? If I was to wager you know, the entire market is predicting seven rate hikes. But if we were going one way or the other, I would believe, would be more difficult to get the seven than it would be to go past seven. So, I think the market’s done a really good job of pricing in with what the fed has forecast for scheduling this year.

Tom Fitzgerald: That’s a good point. I think the fed has almost followed the market in this respect where the market pretty early on was looking at much higher rate hikes than what the fed was projecting. Then when they got to seven rate hikes the fed was still talking about three or four. So, they’ve finally, I think been pulled by the market in their direction. I think part of what we’re seeing and we’ve looked at the yield curve today, it’s certainly flat. In fact, you’ve got some inversion in parts of the yield curve right now. I think sevens are inverted over tens and that’s probably going to spread. To me, that’s an indication the market thinks, well, if you get those rate hikes in, it’s going to do some. I don’t want to say damage, but it’s really going to put some headwinds up there for the economy and you’re not going to see that. One of the reasons why I think we’ve seen those backend yields hang in there is that they think that it’s going to slow the economy. It’s going to slow inflation significantly. So, that kind of keeps those longer ends of the curve range bounds. That’s one of the things I got coming out of that. That obviously has implications, for our listeners. I mean, when you look at the yield curve now, it’s been priced in really. Those seven or six or seven rate hikes. So, if people are sitting there waiting for the rate hikes to actually occur. The yield curve is really already reflecting that. So, by just sitting around and waiting, we’re almost leaving money on the table thinking that oh, rates are going to go even higher. They certainly can. There’s no reason why they can’t, but certainly the short end of the curve has already taken a look at you know, the lay of the land and said, okay, we’re pricing in six to seven hikes. The yields that we’re seeing today are yields that were really unimaginable even a year ago. I would like to ask kind of following through on that. Go ahead, Robert.

Robert Biggs: Oh, yeah. I would say that even a week ago it seemed unimaginable. We started March 7th, last week with a 1 70, 10 year. Now we have a two-year treasury that’s flirting with 2% and so it’s been a big shift.

Tom Fitzgerald: It’s interesting and I’ll just mention one more thing on their forecast. They had really marked down in December, they looked for GDP this year to be about a 4% number. Then now this latest forecast, it’s 2.8, which it’s a significant markdown. But it’s still in their eyes, they would tell you or Powell would tell you, well, it’s still almost a percent above the long run rate that they think the potential is for the US. That’s 1.8 to 2%. So, that markdown to 2.8 is not going to keep them from not hiking it. In fact, again, they would tell you, well, that’s still above potential. Just the wild card that sits out there. I think for all of this is that war in Ukraine and how long that goes on. Obviously, it creates headwinds both on the price aspect and from a growth aspect and if the news there continues to get worse and continues to drag on. That continues to be another headwind for the economy, which to me means that again, another reason why the longer end of the curve could continue to be sort of in this range-bound area. You know, the real action being kind of what the short end is doing to the belly of the curve. So, in that regard, talk about some of the strategies that you’ve been pitching or seeing from your clients that are getting some traction or at least getting some positive feedback? Robert.

Robert Biggs: Well, I’m hearing from, I’m a depository focused strategist. So, when I talked to banks, the big discussion has been on the unrealized losses in the portfolio. You know, if you rewind back a year and about 7% of bank portfolios had net losses now with something around 95%just tremendous shift. So, our conversations are focused on that, and we’ve had some accounts consider pumping the brakes. You know, that’s been the big concern are these unrealized losses sustainable. Then I always try to flip that question, are you telling me that yields are too high for you to invest? So, what happens is portfolios, the duration has extended as optionality reached out with the shift in rate. You know, a lot of investors, they’re cautious. They should be. But what I would say to you this week that I wouldn’t be able to say to you last week, is you can still stay involved and even the most duration conscious investor can look out the, two your treasury, the three-year treasury and see value in the short-term investments. So, the strategies that have been working, the strategies that people are focusing, it’s not evaluating what they already hold. Because for the most part, they own those bonds. They’re not going to be selling them unless they want to incur penalty in a form of the law. The overarching thing is let’s stick with the market. Well, the curve has given us an attractive entry point from two years on out. So, when we try to even sit down and strategize you know, liquidity is still at a very high rate. For investors who have been able to hold on this long almost gets the question of what were you waiting for? If you’re not going to put the money to work now you know, the 2% in the two, three-year space, it just, like it’s calling on investments.

Tom Fitzgerald: I would say too like you mentioned, there’s for the first time, in a long time any investment we add is going to be accretive to the yield of the portfolio. I think our bond accounting group is somewhere in the neighborhood of a 180-book yield. It’s been a while since we could choose from a smorgasbord of investments to say, well, we can certainly beat that by a healthy margin. That’s again, a reflection of the market pricing in those rate hikes to the point where you’re getting what 250ish with, with no problem at all. Then if you want to get a little bit more than that, you certainly can. Geetika, I wanted to bring you into this. You know, you are sort of our mortgage back expert. That’s kind of where we really go to get your insights. The mortgage backs. When we look at our bond, again, our bond accounting group has about the largest sector is in the mortgage backs. About 60% of the typical bank investments are in mortgages. So, obviously a critical area for portfolio management. Can you just kind of step back, give us kind of your thoughts on what you’ve seen in your market over the last several weeks and how it’s played out as we moved closer to the fed hiking. Also getting the discussions too about when the Fed’s going to start rolling off their balance sheet, because I think all those really bear on your sector in fixed income markets. So, we really would like to hear kind of what you’ve seen and what your thoughts are right now.

Geetika Bansal: Yes, Tom, for sure. I think coming back to what you said at the beginning of the podcast. One of the most anticipated Fed meetings, for sure. We have had so much volatility since the beginning of the year, but specifically over the last four to six weeks with what the yield curve has done and really already delivered on the rate hikes that the Fed is promising for the rest of the year. That yield is already here and to tie in sort of what you and Robert were saying. I firmly believe you want to make hay a little bit while the sun shines. On my last podcast, I also said that one strategy, we always advocate. Given the broader context of you have to look at your specific situation, your balance sheet, what your revenue goals are, what your duration tolerances are, and you know, what your loan situation looks like. But one of the strategies we always advocate is working with what the curve gives you. As you said, if you’re looking at your bond accounting clients as a whole, and you’ve got a yield of 180. Looking at just the CMO sector alone, F med CMOs, and depositories like to buy F med CMOs that from a regulatory perspective are within the approved parameters of risk. In an F med CMO, you can easily beat a 2 70ish yield. Now you’re somewhere in that range. So, that’s almost a hundred bay basis points pick up on what the average bond accounting yield would be. When I say F med CMO, I’m talking about it could be that in an up 300 basis points shock in the CMO sector versus you could have a five-year average life. Or you could have a seven-year average life. That’s where most depositories are playing now. They’re picking preferences. Some of them are trying to stay under five years in this instantaneous shock from a regulatory perspective. Some of them are going out and can stay under seven years. That is a 20-basis points difference in yield between those two preferences and depending on the coupon you choose to do and your premium tolerance. But for that two-year difference, in extension in an up 300 environment, you’re looking at a 20 basis points range, and within an approved parameter of risk by regulatory standards, that’s F med CMOs. You’re looking at a 2 70 yield. So, it’s sort of like coming back to what Robert is saying. You’re behooved to really go out and invest where the curve is giving you that yield. We are starting to see that over the last few weeks. This is what everyone’s been waiting for. You know what we’re starting to see is, it’s a fact that some market evals, when you’re looking at your portfolio at the end of the month, the market evals have been a little painful to say the least. That’s a given and we’re working with that. But I still think the way yields are given liquidity positions for most depositories. You want to stay invested and you want to keep layering it in, especially as the Fed is kind of detailing their path to you. For that, I think we’re starting to see some depositories pick their spots on the curve. Those that are anticipating loan demand, that are anticipating having need for greater liquidity coming down the road. They’re sort of picking that three-year part of the curve and the CMO sector offers a lot of options in that three-year part of the curve and structured bonds with short payment windows, minimal extension. They’re starting to pick that or they’re going towards collateral 15-year MBS with the deliverability that TBA bid. They can take that three-year part of the curve because they’re anticipating having need for that liquidity. They want to stay short. We also have others, like you said in an effort to combat inflation, the Fed is willing to, if the curve needs to get inverted, that’s what’s going to happen. But they are committed to combating inflation. That may bring with it a little bit of a stalling of the economy. So, that long end is going to be range bound. It’s going to stay anchored, but if there is spread there, we are seeing investors who are not sure about their loan needs going forward and who are still sitting on excess liquidity. That if the spread is there, they’re investing out in that five-to-seven-year part of the curve. In fact, I would say this last 10 days, I have seen more interests coming into that five-to-seven-year part of the curve with longer collateral structures. Such as 20-year MBS that are almost at a 3% yield. At poor handles and seeing a lot of depositories choose to put money there at very attractive spread levels. So, given that the Fed has been very transparent about what they’re choosing to do and their commitment to inflation or combating inflation is so clear. I think they’re going to let that roll off just continue and not try to cap it or put a much larger cap on it. You know, it’s going to provide a very interesting environment for investors because the yield is finally here. There is a reason to now stay invested and take advantage of it depending on other broader influences.

Tom Fitzgerald: Well, let me ask you, I would think it’s almost an impossible question, but I have to get your thoughts on it, because I think it’s going to be a key issue. I think with client conversations in the next couple of months, and that is, as you talked about, as the Fed moves to a shrinking of their balance sheet. Letting investment start to rule off, initially the speculation was, well, this would probably start in July and now we’re hearing talk that it could start as early as May. You know, from some of the Fed officials, do you think, and if you look back at mortgage spreads, you can see the spread, like you said, has been widening for the balance of this year. I think part of that’s anticipating that, that roll off from the balance sheet. Have you seen any activity of spreads widening even more in the wake of this, maybe accelerating that run off earlier into the year versus what we were thinking, it would be a couple weeks ago?

Geetika Bansal: So, you said it right? A little bit of an impossible question. Definitely.

Tom Fitzgerald: When we didn’t do the pre-show on either. So, I’m sorry.

Geetika Bansal: No, that’s totally fine. I mean they have been winding over the balance of the year. That’s coming back a little bit to what we were talking about earlier. So, much of what they’re seeing they’re going to do for the rest of the year. The market’s gotten ahead of that and already priced that in, you know? Right. I think this morning, in fact, spreads were a little tighter in mortgage sector this morning. I mean, not significantly tighter or measurably, just a little tighter as the curve was. You know, I would say to put it just casually a bit of a mess and it was inverting, and it was all over the place. So, there were a little tighter, do I think from here on out, you are going to see significant spread widening? No. Could they leak a little wider slowly throughout the course of the year, perhaps it’s likely. But something that’s going to cause where overnight, you’re going to wake up and you’re going to say, oh my God I’m not expecting that. You know, again it’s a bit of a tough question to put my prediction out there, but that’s where I would lean. What would you think?

Tom Fitzgerald: I tend to agree just because, and I think this wasn’t at the Fed meeting press conference. But it was prior to that. Powell, well, he was on Capitol Hill. He did talk a little bit about the running down of the balance sheet and about a three plus year process. So, I think they’re going to be very deliberate. Now they may get pressure from some of the more hawkish members. I’m sure Bullard would be in there pressing for a faster runoff. But I think at least Powell initially has said, this is going to be over a three-year window. So, you know, it’s not going to be this dramatic shift in what they’re doing. So, to me that limits some of that spread widening potential. Like you said, it could leak a little bit, but I don’t know that we’re going to see dramatic pullbacks. The Fed, Powell lived through the taper tantrum under Bernanki and I’m sure he does not want to have something like that happen on his watch. So, I think deliberate is going to be sort of their watch word for letting the balance sheet kind of come back down to some level. Close to where it was pre pandemic.

Geetika Bansal: Yeah, because I think the Fed does not want to cause disruption, right. I think they already know what fighting inflation is going to entail in the broader picture of the economy. While that is their number one focus and they’re willing to make tough calls related to that, they do not want to cause disruption.

Tom Fitzgerald: Right. I think if you look in fact, I looked at yesterday, the beginning of the year, the 30-year bond or 30 year mortgage rate was, what was it? It was right around three and now it’s up over almost 4 50. So, it’s gone up 150 basis points more or less in the space of this year.

Robert Biggs: I would like to jump in there.

Tom Fitzgerald: Sure. Robert.

Robert Biggs: You know, Geetika made a great point last week you know, over everything she put together. We addressed the demand side when we talk about the Fed on one of their balance sheets. But the other side of the equation of course, is the supply side and most of the new issuance that’s come to market in the past couple years has been the refi doing that we have seen. She pointed out that at a 3 75 mortgage rate, only about 16% of borrowers are eligible refinance. So, 50 basis points, incentives. If that dropped to 3 50, only 23% of borrowers would be eligible with 50 basis points would be finance incentives. So, to couple the shrinking demand with the Fed doing the roll off there is a shrinking supply as well.

Tom Fitzgerald: Right. That’s a good point. I think with that, maybe Robert, we can pivot to the other large sector that is in our bond accounting portfolios. That’s the Muni sector, which I think at latest count, the typical portfolio had about a 22% of their investments in Munis. So, let’s kind of talk about how Munis are weathering this volatility. Specifically, are is there sectors that you would maybe say let’s focus on these as we kinda work our way through this hiking cycle versus other sectors that may have been more attractive or prevalent in kind of coming out of the pandemic?

Robert Biggs: Yes. Tax exempt, municipals have been the best performing investment in the last couple series of taxable schedules. I like that structure, especially, you’re going to add duration to the portfolio. You go back the past 20 years and the relationship between municipals and taxable investments, like the treasuries is about 85%. So, if the tenured treasury goes up a hundred basis points, the municipal curve would go up about 85 basis points. So, that gives you a little built in price fall protection. It’s a great place to add the duration. That’s why it’s been one of the highest performing asset classes, the highest of traditional bank investments. That’s before taking into account any tax equivalent adjustments. If you’re asking which sectors I like, if I was investing today, I would stick with GOs and essential services. You know, with flow into the account schools are great credits. For the most part. I would not want to open myself up to any credit migration having some ready downgrades that would be a accrued of the losses over what’s already happened just for the interest rate business.

Tom Fitzgerald: That’s a good point too, because you think about it in the Fed hiking cycle, we are talking about the economy kind of moving into a, kind of a slower gear. So, even though municipalities tend to I think, in fairly strong positions financially. You know, moving up to, like you said, that GO or that essential service is probably a safe bet to kind of weather the next couple years as the Fed moves through the hiking cycle. So, that’s some good points there. We have seen some activity in those areas too, as well. So, I think a lot of our clients have already heard that message and are acting on it. So, you know that was good information there, Robert, and let’s just kind of finish up. Just sort of stepping back and looking at it from an AL perspective. I know Robert, you’ve got some thoughts on that as to, as we do move into a hiking cycle you know. There’s that whole, how sensitive are deposits going to be as we sort of model our AL position. So, you know, can some of your observations, Robert, as we move through this hiking cycle.

Robert Biggs: So, we went back and plotted the cost of funds, federal margin, interest income in compared it to what the Fed did going back 20 years and from 04 to 07, when the Fed was racing rates. The cost of funds beta was about 42%. So, for every a hundred basis, points of movement defend you know, banks moved up 42 basis points. When we went to 15 to 18, it was 21%. So, it was roughly half and even more interesting than that is when we ran a series of them for all these institutions. What we found is that the correlation fell off tremendously. What I mean by that is back in 04 to 07 of this 92% correlation, which means that. For a lot of institutions and the 15 to 18 run there was 55, 60% correlation, or there said a non-statistically significant correlation. I think that is a example of the new relationship between the depositor and the bank. As at one-point, traditional bankers they were borrowing the money from depositors and giving them money in exchange giving them interest, income, and exchange for that. Now a lot of banks look at themselves more so as you know, just storage facilities and instead of giving interest and income to the depositor they’re providing services such as mobile banking and mobile bill pay and just a safe place to keep their cash. With that new relationship you’re going to see deposit data fall, even further. I think that brings us around to when we look at the investment portfolio or a lending portfolio as well duration has definitely gotten longer. But perhaps it should, since our liability duration has also got longer most institutions are extremely asset sensitive and probably more asset sensitive, than their AL report dictates. Because it’s unlikely that their cost of funds will really ever materially rise. It’s also very unlikely. They can cut them much further. So, the real risk the institution is that rates do go back down, rates do fall, and that interest margin would presses again. So, from an Al standpoint, that would be my bigger concern.

Tom Fitzgerald: I would say that so for everybody out there who runs their AI models, take a look at those deposit BES and make sure they’re not still sitting up there at 75% or something like that. Where obviously in a higher rate environment, that’s going to kind of skew those deposit costs moving up quicker than they probably. Will and maybe like you said, Robert influence or weigh on some of the investment decisions because you want to keep that ale policy within parameters. I think it all just comes back to. You know, a couple years ago we could throw out a strategy and it would be applicable for 75% of the banks that we talked to. But I think today, each bank is really unique. You know, one bank may have strong loan demand. One bank may not one may have excess liquidity, still one may be kind of struggling with that. It behooves us to kind of as we talk to our portfolio managers to really understand where they are in their. In their bank and also for those portfolio managers to communicate that to us. So, we can kind of look at strategies, look at the whole area that the portfolio bears on, which basically is balance sheet management. So, understanding where that bank stands on those key areas, I think is going to be critical. You know, going forward versus just throwing out blanket recommendations that may have worked a couple years ago because everybody kind of looked the same. So, I think that’s another point. To make, so I guess in wrapping up you know, Geetika and Robert, I want to thank you again for taking the time outta your day to talk with us and share your views with our listeners. I’m sure they’ve taken quite a lot out from this. Everybody is kind of having to sort of navigate these cross currents that we’re having. So, any bit of additional insight and information I’m sure is well received. So again, thank you guys for your time and for your insights. We appreciate it.

Geetika Bansal: Thank you, Tom.

Robert Biggs: Thank you.

 

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