Active portfolio management can balance out rate fluctuations
For the past few years, ICBA Securities' consulting CPAs and CFAs have tracked the performance of bank portfolio investments purchased during low interest-rate environments versus those purchased during high interest-rate environments. Let us review these findings and offer suggestions for maintaining a portfolio of securities purchased during high rates.
Chart I represents a typical community bank portfolio profile. This bank's portfolio profile is typical in that it is as good as, or better than, the vast majority of the portfolios ICBA Securities has studied.
The chart shows that during the past six years, 35.7 percent of this bank's securities were purchased during the six quarters of lowest rates. It also shows that 39.8 percent of the bank's securities were purchased during the next six quarters of low rates. Less than 25 percent of the bank's securities were purchased during the 12 quarters of relatively high rates.
Why does this typical bank own more securities purchased during low rates than during high rates? Several factors are at work, one of which Rutgers University finance Professor Paul Nadler illustrated at the Michigan Association of Community Bankers' last convention.
Nadler said that when loan demands shrink and rates fall, banks have more money to invest. Later, when loan demand and rates rise, investment managers have no money to invest-and they get yelled at because the bonds they bought during low rates are now underwater-just when their banks need funds for the increased loan demand.
Prepaying or callable securities can also fuel security purchases during low rates. When rates fall, callables are called and prepayments increase, and banks' money must then be re-invested at the lower rates. When rates rise, callables extend and prepayments slow down, and there is less money for banks to invest at the higher rates.
Why would bankers buy callables instead of single maturities? Because callables yield-substantially more than single maturities, and rates have to fall significantly before loweryielding single maturity purchases would be the better of the two options.
So what can bank investors do to own at least a reasonable volume of securities purchased during high rates rather than having a majority of their securities at the lowest rates? Because banks will have less money to invest when rates are high and more money to invest when rates are low, their portfolios must be actively managed to keep a balanced portfolio. This means that each portfolio needs a reasonable volume of securities purchased during high rates to offset …