The Steep Yield Curve, FOMC Meeting, & What it Means for the Bond Portfolio
This week Tom sits down with Chad McKeithen, Managing Director of Strategy for Duncan Williams, and Greg Rains SVP of Fixed Income Sales at SouthState. They discuss the steepened yield curve, the recent FOMC meeting, and advice they have for CFOs as they navigate their balance sheets and bond portfolios.
Intro: Helping community bankers grow themselves, their team and their profits. This is The Community Bank Podcast.
Eric Bagwell: Welcome The Community Bank Podcast. I’m Eric Bagwell, director of sales and marketing for the correspondent division of South State Bank, and thanks for tuning into our podcast today, we’re going to cut straight to a round table discussion between Tom Fitzgerald, who you hear on this podcast a whole lot. Tom is the director of strategy for our division. I’m here at the bank and he has with him, Greg Raines, Greg is a bond salesman, senior vice president, works out of our Birmingham office and covers a lot of banks down in Florida as well as a couple other states here around the South, but also joining Greg and Tom is Chad McKethan. Chad is managing director of fixed income and AAL with Duncan Williams.
They are a full service broker dealer out of Memphis, Tennessee, and South state actually bought the broker dealer, they bought Duncan Williams. I think the deal closed in February, and so we’re excited. These guys are on board, similar culture, similar strategy as far as calling on banks and trying to bring value to banks, and so we’re excited. Chad’s joining us today. We look forward to our future with these guys and co-branding some stuff and hopefully having some more podcasts like these and maybe even a live stream event coming soon with them. So, we’re going to cut straight to that discussion now, hope you enjoy it, and thanks again for tuning in.
Well, Greg and Chad, thank you very much for being with us today on our this is probably our fourth or fifth investment episode that we’ve done, and they’ve always been some of the most downloaded episodes. So, I’m sure our listeners are looking forward to the thoughts that you have this time, and what’s interesting is, you know, you go back a year ago since we’ve been doing these podcasts, you know, you had a tenure that was under 1 percent, you know, you basically were in a range-bound market for the last year, and so I think for the first time since we’ve been doing this, we’ve actually got some real interesting ideas and strategies. I think that we can bring with you today. So happy to get this going.
We’re recording this right after the March FOMC meeting, and so I wanted to get the thoughts from both of you, Greg and Chad, kind of what we learned from the FOMC as far as, not only of course the statement, but the press conference and the this was one of those quarter end meetings where they do an update on the economic numbers and the rate numbers, and so a lot of information, kind of you’re reading between the lines, and so I wanted to kind of maybe start with you Chad first, since you’re the new guy on the block for these podcasts, with this kind of give us your idea, you know, the fed put out their latest rate dot plot, and so they’re still kind of sitting that medium plot is still sitting at the zero lower bound through 2023, despite all the improvement in their economic outlook.
Do you kind of think that they’ll stay as patient as they’re kind of representing, or do you think eventually they’re going to start to kind of put a few more guys in that movement in 2023, as far as a rate hike goes?
Chad McKethan: Yeah, no. Well, thanks, and thanks for having me, first of all, to answer your question, I think one of the things that that was developed when the fed came out with board guidance, you know, back a decade or so ago was to give the markets an opportunity to kind of digest what they were looking at, as opposed to prior to a decade or longer before guidance where, you know, they could sometimes surprise the markets a little bit, catch the markets off guard and, you know, so with the dot plot forecast, it’s not a black and white, strict playbook of exactly what’s going to happen to rates, but, you know, the one thing when they started that back 10 years ago they do tend to hold pretty tight with what their projections are, and it doesn’t mean there’s not a slip you know, a 2013 temper tantrum type of comment that, you know, might throw the markets for a little bit of a loop, but I do believe you know, that they are trying to push the markets in certain directions and, you know, keep it kind of in between the lanes, and so, you know, what we typically do here, and when we get in with some of our depository clients and we start talking to them, is we kind of look at it, are we in the lane?
So, when the fed gives us a forecast of what’s going to happen to overnight rates and their projections of GDP in the 10 year treasury, you know, do we feel comfortable in that range? You know, we kind of trust that a little bit, and right now they’re giving us, you know, a 2.75 year forecast on at least the overnight rate side that that rates are going to stay relatively low. There was a little bit of green shoots economic info that came out of this meeting. You know, some things that looked positive, but for the most part, most of the voters did continue to extend that expectation of overnight rates.
What they do with the buying side of it or longer end of the curve, you know, they can’t shift that, but I do think they’ll give a pretty long leash when they make, or when they decide to do something on the longer end rates, if they choose to change the mindset in the longer end, I think they’ll broadcast that a little bit more than taking the market by storm and just announcing that there’ll be a tapering of that effect. So, I do trust, I think with board guidance, they are trying to give a longer playbook, I think, from the depository side before, you know, without getting too much into the strategy side of it, I think it’s a benefit because the typical liability sensitivity that most of our depository clients deal with, you know, it eases that a little bit, and you know, they’re kind of giving us what they’re going to do with the fed funds rate.
It could venture off that a little bit, but for the most part that gives a pretty good understanding or a pretty good playbook from a budget standpoint, what’s going to happen with cost of funds and deposit rates. So, I do trust it more and more. I think board guidance is something that the market is starting to fall in line with. So, I think they’re not dot plot projections that came out Wednesday. We tend to trust those a little bit as a most likely rate scenario.
Eric Bagwell: Right. Well, let’s talk, that’s kind of the short end of the yield curve. Let’s take a look at the longer end. Now one thing the market has been expecting or I don’t know, hoping to hear is the right word, but the fed has not expressed any real concern about the backup and rates that we’ve seen since January. Greg, is there a point in kind of a line in the sand where you think the fed will say, okay, we’re getting concerned? Is it a yield number? Is it more financial conditions tightening? Maybe the equity market starts to take a nose dive? Is that something like that that may trigger their concern?
Greg Raines: I think the water watercooler microphone that we have installed at the federal reserve is going come in real handy because I don’t think they’re going to say it out loud to me before they say it at the watercooler or somewhere else at the bar, maybe, and the concern has to be really a lot of it tied to the mortgage market because of the multiplier effect of the mortgage. You know, and I’ve kind of quoting old friends or Keating used to always say that, you know, when you buy a house, you end up with your carpet. Also, you buy the house and then you change carpet to buy new appliances, buy new fixtures, you make it yours, and whoever buys your house does the same thing. The bulk multiplier impact on GDP growth is substantial.
Feds are real aware of that, and they know they’ve got to keep that mortgage market going because it’s such a substantial component of the economy, and I think the point that they get concerned, you know, are two points. I think one point is when there aren’t enough buyers stepping up to buy your sovereign debt.
That’s a point that you really kind of get a wake-up call because of the accumulation and sovereign debt based on the interest payments on top of everything else that’s going on, and then you look at the housing market and the impact on the housing market, and to me, I think that’s where they really began to, like I said, the watercooler mike or the one at the bar down the down the street at The Old Habit might be the place to be there listening when they show up after meeting, but it’s, it’s got to be a concern at that point. I think it probably is concerned now and they have to take the pressure off the markets a little bit, and they can’t really say what they want to say at the statement, and when we get the full blown thing, and we look at the wording in there, maybe you can read into some pieces of it, but we’re going to have to pull our playbook out.
I noticed that steep yield curve comes up next in our discussions, but we’ve got to go dust off our old playbook from the last time the yield curve was steep and that was a long time ago. I don’t think it’s still in the drawer.
Eric Bagwell: Right. Well, and I looked to, and I think, you know, they’ve kind of in fact, Pal talked about it yesterday in the press conference that the financial conditions still look pretty soft. As far as you know, we haven’t seen a significant amount of tightening. I think that would be a key, and I also think like you talked about the real estate market has been a huge engine in the recovery of the economy. They don’t want to sort of, you know, kill the goose that’s laying the golden eggs.
So, you know, you get to a point where rates start to impact the marginal sales, and then that I think could spur, like you said, a little more talk at the watercooler. As far as kind of moving out that year or two in the horizon, and we start to look at the fed, starting to maybe ease off some of that accommodation, not calling it a tightening, just saying they’re kind of dialing back some of the easing that they put in. What’s the sequencing, do you think, I know last time it was, you know, sort of dialing back to QE purchases and then eventually that moved into the rate hikes themselves. Chad, do you expect that it’s going to be the similar sequence that we see this time?
Chad McKethan: Yeah, I do. I think, you know, if you, again, boarded guidance is kind of a new, you know, if we’re looking at this kind of playbook vernacular, I think, you know, the overnight rate is still their bread and butter of what they’re doing. QE and controlling the longer end of the curve is something that they had jumped into, but at the end of the day, they still don’t really control the long end of the curve and in the market, and even though they’re massively buying right now and they push the longer yields down, you know, the 10 years back up close to what it was prior to any of this taking place a year ago, and the markets have dictated that. You know, I think at the end of the day, when we get a year, two years down the road, the economic growth, the vaccine, et cetera, things continue to play out.
I think the last thing that they can really control and know that on a daily basis, they can go to bed at night and feel good about it is that overnight. Right, and I do think that will be the last thing that they you know, allow to take place. You know, speaking to the longer end a little bit, you know, you’ve got a ton of liquidity out there and longer duration assets, and you know, I think bankers and depositories in general understand this better than anybody. If you’re out there and you’re making a 10 year CD, or you’re issuing 10 year CDs as a bank, and you’re offering a rate that is a 100 basis points, 150 basis points higher than your next door neighbor, you’re going to continue to have tons of liquidity.
You’re going to have very little pressure on your rates. Everybody else is going to have pressure on the rates. You take the 10 year treasury right now at a 170, a 175 yield, and you compare it to somebody like Germany, that’s got a negative 27 basis points yield on their 10 year bonds. You can see our dollar pressure, et cetera, everything be very good, and that should also be somewhat of a market anchor on those longer rates. Not that it can’t hit a 2 percent or move a little bit, but I think a robust 200, 300 basis point movement on that long end is something that would be tough to venture into without some other things occurring, but I do think the overnight rate will be that last thing that they kind of loosen up on. If we are looking forward to a year or two from now.
Eric Bagwell: Right, it may be so well telegraphed that it’s a really, almost a non-event when it takes place.
Chad McKethan: I think so, yeah. I think so. I mean, I think they learned the lesson in 2013, of even minor verbiage mistakes…
Eric Bagwell: Right.
Chad McKethan: In announcing things. So, I think they’re trying to be very transparent in what they’re doing.
Eric Bagwell: Well, good. Well, let’s move in now to some strategies for our listeners, and this is kind of, like I said, the first time in about a year where we could really give some real solid strategies that we haven’t had, the opportunities, the opportunities haven’t been out there like we have right now, and I know Chad, you’ve written a lot about the steep yield curve. Why don’t you just kind of discuss kind of what that means for the investor and what are some of the trades, strategies that you’re looking to employ?
Chad McKethan: Yeah, the first thing that we do, we do a lot of bond schools for alcoves and just senior management, and there’s one thing that when you have somebody very new to portfolio management, when they come in and we always break down what are the components of return, and typically for a portfolio manager, a bank manager, it’s the credit spreads and bonds. So, we look at munies, we look at corporate, so we get an additional spread for that yield. You know, it’s option spread, so if we have a prepayment option or we have a call option in a bond, we expect to be rewarded for that additional risk, that bond could be possibly pulled away from us.
The third component is that the shape of the curve, and I think actually the shape of the curve to us from a fundamental standpoint is probably the most important piece of return. It’s the duration is, if I take longer duration, I should be rewarded for that duration risk, and you know, at least if you’re looking at it on a historical basis the curve is in the top 20 percent of the steepest it’s been in the last 50 years. We put out a note on that this actually this morning, you know, you’ve got a spread between the benchmark two year treasury and the 10 year treasury that’s right at about 160 basis points. You know, throughout time that’s been around 90 basis points that spread between twos and 10.
So that does mean the market is rewarding bond investors for that additional extension. You just mentioned a second ago, you know, you talk about a year ago, two years ago, two years ago, the curve’s inverted. A year ago, the curve is relatively flat, not as fun to be a portfolio manager, and when we got a flat curve, because you’re taking a lot of risk and you’re not getting that duration premium, like we’re getting today. So, with our clients that are heavily depository institutions, and they also tend to have a lot of liquidity still, right now, there is a better prospect to rolling out that curve, generating some additional yield, and then hopefully those bonds roll down the curve and generate some unrealized gains that it either can be turned to realize gains or just attractive yield.
So, the curve is attractive. I do think with the fed’s gift of telling us that the front end rates are going to stay relatively low, that overnight rate, the fed funds rate. That gives a banker even a bit more of a gift, because that probably means your one year CD, your two year CDs, your money market account, those things are going to peg heavily to that overnight rate, and so it kind of eliminates some liability sensitivity for our accounts, keeps cost of funds low, and now there’s a bit more of a reward for extending out that curve. Doesn’t really even matter what segment of a bond we’re talking about, whether a muni buyer or a corporate buyer, an agency buyer, a mortgage back buyer, you’re getting a better return for whatever segment you’re looking in, finally, for some of that extension, and so we like that right now for institutions that do have a tremendously large amount of liquidity.
Eric Bagwell: Greg, what are some of your ideas and strategies that have been working so far in 21? I’m sure you’ve probably been doing a lot of these kind of yield curve plays as well, but you know, are there some other ideas and strategies, like I said, that you’ve had that have been working more so in 21 than we saw say in 20.
Greg Raines: We tend to look, you know, I’ve always been a big fan of looking first at the balance sheet for answers, and then using the bond portfolio too.
Eric Bagwell: Right.
Greg Raines: In so many ways leverage what’s going on and the remainder, the balance sheet and hedged it at the same time, and what we’ve seen is a growth in assets sensitivity that Chad just mentioned. We’re seeing more core deposits come into community banks because they’re coming away from bigger banks. Part of that was driven by PPP, so here during a curve steepening, what we’ve seen is obviously something that I don’t know if you remember the scene from the movie, The Jerk where the crazy guys up on the hill and Steve Martin, Navin R. Johnson’s in the gas station, the guy shooting at him.
Eric Bagwell: He hates these cans.
Greg Raines: He hates these cans.
Eric Bagwell: Yeah.
Greg Raines: The misunderstanding is that our clients, whenever rates go up, they hate those bonds they bought last year. He hate these bonds, and reality of it is it’s not the bond’s fault. The bonds are doing what bonds do, but a couple of good things have happened. With rates rising, we obviously have better investment opportunities and we have liquidity. Banks are seeing capital stresses because of all the growth oddly, but that’s not a big problem if they’re making a lot of money, which they are, why are they making a lot of money? The fed has done them a favor of peg short-term rates, and their cost of funds is descending below 30 basis points, 20 basis points. We’ve got some that are in the teams now.
So, they’ve now that they’ve got this opportunity, they’d like to take advantage of it, but they’re scared. All right, but they have to be scared of something completely differently than they were just a few months ago. Just a few months ago, we’re afraid of buying mortgages are going to prepay fast. So, we’re looking at services, we’re looking at, you know, credit scores, we’re looking at loan counts, so all this kind of stuff. Well, you know, right now you can go buy a discount mortgage with a decent yield and you want the fast paying stuff. So, you want the bad services. You want the lower credit score.
You want all those things that drive rapid prepayments if you do that, but on the other hand, do you really want to do that, because you know, now these bonds that I bought last year, even though I don’t like the market value, well, those premiums paid are getting spread out. Over a much longer period of time my yield just, I’ve got to step up, so to speak. So that’s where we are right now, dealing with that.
We’re also looking at the tax issues as it relates to an increase in the federal tax rate. We got some sub S banks out there that buy bank qualified tax freeze and are subject to zero TEFRA when they buy [inaudible 19:02]. A huge, I mean, you know, you get somebody that has a shareholder with a 34 percent tax rate that may be going up to 38, and you know, you take that 2 percent yield on that 22 year tax-free and you divide it by the reciprocal of that. So, we’re talking about, you know, getting 320 yield on a 2 percent bond.
Eric Bagwell: Right.
Greg Raines: So, a lot of alphabet soup in those comments, but, you know, just remember don’t hate your bonds.
Chad McKethan: I think, you know, [inaudible 19:37]. I think just even just to add another aspect of that, I mean I think just the movement in the market over the last say three months, you know, volatility started to increase. You know, we’ve had a back-up and rates sell off that, you know, it is creating some discount structures and, you know, for a while there, it was like, we were in a little bit of a bottleneck where the only thing, you know, premium is on say mortgage back CMOs, for instance is rates were going down and those were refining. It was creating some, you know, some lower returns on some of those types of structures. Now you’ve got this backup.
You’re able to kind of do some hedging on balance sheet, without derivatives, by buying some discounts and things that offer a little bit of a diversification to the portfolio, and we’ve seen a lot of our bank clients actually, you know, get very active over the last two months in kind of what Greg mentioned in some of those discount type of structures that may be, can offset a little bit of that. You know, that typical premium in the portfolio, which we still see is around a 103-ish type premium on mortgage portfolios, our bank clients’ portfolios.
You know, now you’re able to weave in some 99 and 98, and in the event that let’s say, you know, that the 10 ten-year rallies back down to a 115, or, you know, 1 percent, at some point, you’ve got a little bit of a hedge to that still outstanding, 3 percent coupon out there, and I think that’s, you know, Craig said it pretty well, and I read something the other day that outside of airlines banking has more regulators per employee. Airlines is the only thing that’s larger. So, we tend to be a very skittish bunch of people, we’re scared. We were always reacting and doing what we think we should do, but it’s always about six months after we should have done it, and so, you know, the last six months we’ve been running from premiums when probably now as rates are going up a little bit of premium exposure’s probably not going to be bad.
We don’t want all of that because we want that cushion. You know, we want to attend helps EVE, you know, et cetera, to rising rates, but if I could get a cheap discount in there right now, if I can get something that looks very attractive, that might hedge some of that premium exposure, I don’t want to be skittish against that right now. I don’t want to be saying, oh, well, rates have gone up 30 basis points, there’s risk interest rate risk, but if rates keep going up, I want to take advantage of some of those things that are a little bit cheap right now and again, and Greg kind of said it alphabet soup there, but I think you’re kind of looking if I’ve got premium exposure in my portfolio.
Well, right now, all of a sudden, I’ve got some opportunities to get some discounts. I would have died for discount six months ago, nine months ago. So, let me layer in a few discounts and offer up a little bit on balance sheet hedge. With the curve being steep, you can get some of those discounts, get out the curve a little bit and generate a little bit of, I think, value in protection there.
Eric Bagwell: Yeah, and let’s kind of drill down and you’ve kind of already covered some of this, but drill down into the mortgage back market. That’s the largest sector of our typical bond portfolio. I think our bond accounting group is like 59 percent on average is either mortgage banker CMO, and so obviously the largest share of the portfolio is invested in mortgages. So, as you talked about last year, it was all about prepay mitigation.
You know, how to kind of limit some of that cash flow that was coming in, and now it’s almost like, I don’t know if it’s a light switch or a dimmer switch, but it seems like we’re moving to the extension risk is the number one risk, and Chad, you mentioned about, you know, one of the ways to hedge that is with the, you know, or just hedge in general is buying discounts, which we haven’t, like you said, I haven’t had a chance to buy a discount in years. So that’s one way, or there’s some other ways that we can look at, you know, how do we go with the portfolio. This year that’s already sitting there loaded up with premiums, maybe some low, low coupons as well. Kind of how do we start to maneuver through 21, given these higher rates scenario?
Chad McKethan: Yeah, and I’ll always, I’ll disclaim this on the beginning. One of the worst things that I don’t like to do is standing up in a large room full of 200 bank CFOs and tell them all the bond that they should buy, because I think Greg pointed it out earlier. I mean, the bond portfolio it’s there to generate revenue, but it is the AAL joystick, and it is what could create. It is what controls the balance sheet, the interest rate risk. So, I’ll say this with that backdrop of, you know, one of our bank clients might have a duration in their portfolio of six and other one might have a duration of two, and that matters, but if your portfolio has shortened up a good bit, then what we just mentioned a moment ago about being able to extend that portfolio and take advantage of the curve steep, and this may be layering in some of those discount structures.
We do like that in the mortgage side of things. I really something that banks have gravitated towards over the last decade has been some of the CMBS, mortgage space, the commercial mortgage backed types of structures that are well-known as the Freddy Ks, the Fannie Mae DUS, they have prepayment protection. You know, you can get them at par-ish type prices, sometimes even discounts, but if you have a shorter duration portfolio and you want to take advantage of some of the curve, then we’re going to look at some of those types structure CMBS. So, the DUS, the Ks, you know, they’re locked out, they have a contractual monthly cashflow, typically balloon maturities.
That’s a way to take advantage of what’s going on today, but let’s say that, it’s the opposite side of that. Let’s say that, you know, over the last maybe the last 12 months as loan growth has dropped, and you’ve been putting a lot of liquidity to work in your portfolio and your portfolio is already short, then it may be leaning a little bit more on some of these, you know, maybe C’s in higher coupon types of structures. That’s more of an EDE hitch. I don’t believe interest rate risk is a realistic risk right now, and on paper it is, but I think with what the Fed’s giving us, it’s not a real risk, but if you feel that that’s the, you know, that up 300 shock is what you’re trying to cure a little bit. You know, I think right now a lot of institutions are running from the higher coupons.
They’re still going off. Well, prepays have been, you know, fast and that hurts. So, they’re running from their higher coupons. That means that some cheap, you know, and if you have a longer duration portfolio you’ve been buying longer bonds over the last 12 months, and you’re trying to get into something cheap and then maybe that slightly up in coupon, CMO or mortgage back, it might have some value. Now with all of that said, I do tend to gravitate more right now towards lower convexity. Volatility has picked up over the last two or three months. That means you’re getting a better spread, a better return for higher variations in pre-pay ability or call risks, but still historically speaking volatility is low, and when volatility is low, I typically say we don’t sell the options is a bond investor.
You want a little bit more of a bullet style structure in that type of scenario, and that would mean that you want things that have a little bit more positive convexity or lower negative convexity. It would want to extend out the portfolio a little bit. So, in the mortgage space, CMS still likes structure and structure. I don’t mind the link to the average life or the duration being longer.
That really is just more determined based on what the AAL position looks like and what you’re trying to do in your balance sheet, but great opportunities, you know, right now, especially in the mortgage backed sector, and it’s got an automatic hedge to it with that monthly cashflow. So, it’s an area that I think you said 59 percent, Tom, I would be hard pressed to believe that that’s going to lower much and probably would even lean a little bit more towards probably banks and that pre-pay.
Eric Bagwell: Yeah
Chad McKethan: That built in cashflow latter.
Eric Bagwell: I would say just given, like, you talked about getting discounts for the first time in years, just a way to add diversity into your portfolio. You know, we sort of got the boat loaded with premiums, you know, having a little offset or a hedge, like you said, with a discount is not a bad thing to have as we work through, you know, probably a rate cycle, that’s going to continue to drift on us that it’s a coupon, it’s a bond that we haven’t had the opportunity to buy in years, and so it seems like that’s probably a good time to snap some of those up.
Chad McKethan: Yeah, and I think you probably know better than anybody on this call. I mean, what the premium exposure is of mortgages out of the bond accounting clients, and I know it’s not par less, and I know it’s still above that, and I think it just highlights your point there that if you can diversify a little of that premium exposure, yeah, when you’ve got an opportunity and a value play on it, why wouldn’t you.
Eric Bagwell: Right.
Chad McKethan: In that way a little bit.
Eric Bagwell: Now, Greg, let me kind of tap into your thoughts on the muni side, and we would go through the portfolio. We talked about mortgages being about 59 percent munies come in, number two, probably 26, 28 percent of the average portfolio. So, a very key earnings component to any portfolio typically and you kind of alluded to the higher tax proposal that Biden has submitted this week. Obviously higher taxes can only be good, right? For tax-free munies, as far as that reciprocal, that you’re dividing by as that number gets larger that reciprocal, it gets better for the tax equivalent yield.
Do you have any thoughts? I’ve been reading all about it. I don’t know that it becomes law or any time this year, but it’s certainly now that it’s on the table and being discussed, it’s going to be something that’s not going to go away, and I think it’s probably already starting to be priced in I to a certain degree in the muni market, but do you have any thoughts on that, Greg, as far as, you know, the tax?
Greg Raines: It’s our job to kind of keep an eye on that and talk to our clients. I mean, the interesting thing about munies that a lot of people, you know the mathematics are always amazing to me, and we taught this in schools since really back in the 90s, as it relates to events that happened back in the 80s. You really, when you look at taxable equivalent yield, I had a banker tell me one time, taxable equivalent yield is not real, and I said, oh, really? I asked him a question. I said, what’s not real about money that you put in your pocket. He said, come again, I said, the portion of your yield that comes from not paying taxes, what do you do with it?
He says, I spend it, and I said, is that any different than the yield that you get, and he said, well, I guess not. So, as you look at what causes tax freeze to be negatively convex, both naturally and mathematically there are two issues that are real important that we need to look at in a rising rate environment. We look at these and one of those is the impact of refies and the disappearance of refinancing opportunities for the municipalities. When rates go up, what that does to supply. We’re already seeing supplies diminish. That happens, because there are not enough refinancings that are going to work right now to reduce that interest cost.
When that happens the same time, banks in particular become more taxable, they’re making more money, their margins are increasing, and now we have to the tax rate increase in there, and we’ve got another issue that does that. The other thing is mathematically. If you take the taxable equivalent yield and calculate your duration in a rising rate environment, you’re going to see that that makes them more negatively convex. In other words, the information, the news is less bad under rising rates and on any other product in the portfolio, we’ve seen that bond accounting wise, think about bond accounting.
Go back and look at the history of rising interest rate, you know periods at which rates were rising and what that did portfolio, what sector performed the best on a duration versus duration basis. It’s always going to be tax-free municipals and even municipals that are taxable have some benefit from that. The negative convexity is important thing as it applies to the behavior of the portfolios overall and rising rates. What that does to the balance sheet of the bank, again, you know, our philosophy is there’s no good heart surgeon out there that can take the heart out of the patient and work on it, he would if he could because it’d be a whole lot easier it would be more room.
He could just deal with the heart, but the other organs would die. The bank is the same way the bond portfolio has to stay in there. It’s affecting everything else in the bank. So, it has to be dealt with in a holistic type way, but I think munies are going to be very popular, and I think supply is going to be a challenge. I’m dealing with that right now. I’m going to standing orders and we’re filling them a little bit at a time, and I’m trying to reel people in off the beach right now, during spring break down in Florida to get them back in the banks when I have something that they need to look at and thank God for cell phones. [Inaudible 32:43].
Chad McKethan: I’m sure they love you calling them on the beach.
Greg Raines: Oh, they actually. Put down my time enhancer that cell phone. That’s Greg calling. He must have a bond.
Eric Bagwell: Do you see any you know, from a credit concern standpoint, I imagine the money coming from the slightest stimulus 3.0 is going to alleviate any of the lingering impacts of what you might see in a credit concern area or are there certain areas that you just kind of still want to stay away from, you know, as we work through 21?
Greg Raines: You know, from my standpoint, the inland looking, if we’re talking about muni credit or just looking at credit in general, we’ve never really been big on putting too much credit risk in the bond portfolio unless a financial institution has very little credit risk. In other words of they’re a 50 percent loan deposit ratio, and they’ve just got a much smaller loan portfolio. They might dedicate a portion of the bond portfolio specifically for a credit piece.
Most of our portfolios are very similar to what South state has, which is primarily mortgages with some munies, and the bigger bank gets obviously the less munies they buy, because they’re taking risk concentrations because they buy such a big piece, especially if they’re buy BBQs with a small offerings. So, you know, from a credit risk standpoint, most of the credit risk in the bond portfolio would be in municipals. Our average rating, highline rating, not the underlying is about AA right now. Our average underlying, if there is one is an A.
Chad McKethan: Mm-hmm.
Greg Raines: That’s best where we are and Chad probably can speak to that too. That’s pretty much what we see it going forward too.
Chad McKethan: Yeah, I agree. I mean, and again, most of our institutions, they’re going to lean on their loan portfolios first for the credit exposure, and even when they go into the, say the muni side, or maybe even some corporate bonds, it’s typically in very high grade credit qualities, you don’t see a lot of speculative buying. You know, I would even venture to say, you know, sometimes we look at a muni portfolio, I might say it’s clean or even credit cleaner than some of the other areas of you know, the portfolio it’s typically very high grade stuff.
So we haven’t dealt with really, I don’t necessarily know anybody that’s dealt with credit risk over the last year when talking about the muni portfolio, that there may be some concentration risk they eliminated in the muni portfolio, maybe where they were just oversubscribed to a certain area, or they happened to lend in that same area where they might be buying some municipals and they look to lighten up, but it wasn’t a widening credit spreads scenario, and I think a lot of times when we talk about munies we still have that Meredith Whitney kind of thought process in the back of our minds.
I think Greg pointed out a good thing, two really nice things, high performing portfolios, almost always have some segment of munies in the portfolio. If you want to generate, even if it’s a small piece of your balance sheet, your bond portfolio is, you know, they’re having municipals in there having a good credit review process. It doesn’t mean just buy municipal for the sake of buying them., but having that in there does typically historically create a high performing portfolio. The other thing I wanted to point out, and this was a study, I don’t have the exact numbers in front of me, but we did a little regression analysis back a few years ago, typically on our muni portfolio, they tend to that kind of duration number that Greg was speaking to.
They tend to move market volatility wise about 70 percent of whether other taxable bonds move. So, for instance, if you buy a 10 year agency bullet that’s taxable and you go over and in relation to that, it would be comparable to say having a seven year tax free bond, when we’re talking about shocks above 300, et cetera, they just tend to not have the same volatility. So typically, they create higher performance, but also typically the market volatility is a little bit lower.
So, you know, if we get a very favorable muni environment coming back up, and I’m hoping with maybe some announcements of pre-refundings, hopefully coming back down the path at some point and let’s say a year or two, now we are looking at some interest rate risks to higher rates. That might be an area that we can still attack the longer end of the curve, but also layer in a little bit of a hedge to some of the market volatility.
Eric Bagwell: I was thinking back of the average rating for the munies across our bond accounting group and it was AA, and so you’re right. So, the, you know, the credit quality is really strong, and I think, you know, the bankers are going elsewhere to take the credit risk and it’s not in the bond portfolio, which is what we always recommend. Any other things guys, before we wrap that you want to talk about that we haven’t had a chance to touch on today? Chad, Greg?
Chad McKethan: Well, I’ll jump in. Greg’s a much better speaker, so I’ll let him close, you know, I just kind of pulling all this together. I mean, you finally have a market that’s attracted the last two years, two and a half, three years, actually, we’ve dealt with inversion flat curve. While credit concerns didn’t really come to the forefront over this last year, we dealt with credit concerns and possibility of exposure there, and from a bank standpoint, right now you have an environment that while I might not feel that way, when you look at one nominal yield and say, that’s still low on a hundred year cycle.
You know, if you look at the 10 year and you see it at a 170 and you say, well, you know, that’s below the average over the last century, when you partner that with the ability in the security of what the feds talking about, keeping the short ends to low, it does mean that you know, we’re talking about net interest margin and you know, you’re talking about managing them and spreads. The deposit rates should stay relatively low for the next three, four, maybe in five years. You know, if banks can lag their deposit rates to let’s say at the end of 23 of the fed is hiking the overnight rate.
Well, typically you’re going to see a one or two year lag on that front deposit rates going up, barring that you’re not in some weird, you know, competitive pricing environment. So, you know, we’re looking at three to five years of extremely low deposit rates, you know, with this curve steepening out a little bit with us, getting, you know, some better spreads for different types of structures as we extend out. I do like the security that the banking world has now to live off some cheap funding, adequate, very adequate liquidity in a very, very steep curve.
You almost have to even say from a strategic standpoint, you know, when do you see a little bit of leveraging coming into the picture of institutions kind of going out and generating some funding on the liability side and, you know, some wholesale buying either in the loan portfolio or in the bond portfolio as it becomes more attractive, and, you know, so I would say, you know, as this pop-up and rates happens, I think the biggest thing that we’re doing from some of our ALCO meetings and just education series is, you know, don’t be six months too late to this party kind of take what the fed is giving us, and that’s a landscape of low cheap funding for a number of years ahead.
You know, and depending on what your AAL risk is, your interest rate risk, what your balance sheet looks like, you know, take advantage of that opportunity to play this curve a little bit, and I think that’s the big thing. I’m not really targeting a certain segment. You know, it’s saying, well, I think corporates are more attractive than munies. Munies are more attractive than you know, 15 year mortgage backed securities. Everything looks good just depending on what your duration, you know, scenario is, and it’s the first time and in really, almost five years that we’ve had a curve scenario where things are attractive to borrow short, taken deposits, taken funding, you know, to get out there into that four and five year and seven year part of the curve and generate some net interest margin, and so I’ll leave it at that.
Eric Bagwell: Very good. Greg?
Greg Raines: I got say that they both the product and an idea that I think both did have a lot of merit right now. One until February the first, we didn’t have a DUS desk thanks to Duncan Williams joining the family we now have a product that helps us ride the yield curve. I think bullet type structures can be very important. I think having some of the shorter generally and vital maturity than the municipals that we’ve been putting on the books is valuable, and I plan to become more well versed in that product and how to offer it to my clients, because I think they’ll benefit from it.
Some have already told me they want to understand it, and they want to talk about it. The other thing is a strategy, when funding is extremely cheap and exceptionally cheap, Chad referred to that a number of times, and I’ve mentioned it earlier is a really good time to consider pretty re-investing your portfolio. If you look at your bond accounting, and you run a report and you determine that you are confident that you’re going to have an X amount of cashflow over the next 18 months, even two years, you can pre re-invest the cashflow now by using, if you don’t have available funds, if you got available funds it’s no brainer. If you’ve got adequate liquidity to fund your loan needs and potential cash outflows, then you can do that.
Or you can go to the federal home loan bank and structure advance that you’re comfortable with, especially if you’re using loan collateral either commercial with a 50 percent haircut or your traditional mortgage collateral. The other issue is doing brokered CDs to some people that’s a bad word. I’ve used that analogy for that too. A Lot of times the regulators really don’t hate brokers, they hate the banks don’t understand what they’re doing with brokered CDs and they’re funding loans with.
I don’t think there’s any harm in using that product to fund a pre re-investment, and when you do this pre re-investment, all you’re really doing is doubling up in terms of what you’re getting out of those bonds, and one day when the maturities roll off, when you have prepayments and cashflow coming back, you just get out of those advances, you just retire the advances and then move on. You may want to do it again after you get to that point, this is the market in which to do that, when you’ve got this steep of a curve, it is time to go ahead and take that free money into the balance sheet. Shareholders deserve that, and I think that’s a good thing to do. [Inaudible 43:42].
Eric Bagwell: Yeah, he is. Well, Greg and Chad, thank you so much for your time and your expertise in this. These shows as I said, have always been some of our most listened to, and I have no doubt this one will be added to that list of one of the most downloaded shows that we do. I’m sure the listeners have gotten just a ton of good ideas and good thoughts to take back to their portfolios as they kind of navigate through 2021, and again, thank you guys for your time and for all your great ideas and suggestions.
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