Magazine article Independent Banker

Spreads Thin

Magazine article Independent Banker

Spreads Thin

Article excerpt

There are precious few rules that can be relied upon in the real world of community banking. You veteran bankers out there have firsthand experience with booms and busts over the last quarter century or so, in which lending decisions and marketing strategies that seemed like a good idea at the time didn't quite pan out as hoped.

It appears strategic initiatives will continue to be fraught with uncertainty. Nonbank lenders, fintech, AI and regulations all are forcing community banks to consider the type of institutions they want to be in the future. "Game theory in practice," as I've heard it described.

So, as a counter to these intangibles and uncertainties, I offer several bits of certainty that exist today and will exist decades from now. First is the immutable rule that interest rates move in the opposite direction of bond prices. The second is that spreads narrow as rates rise. This column will review and expound on this second tenet of portfolio management.

Spreads reexamined

The term "spread" has many uses. It's one thing to use it in the context of an athletic event vis-avis Las Vegas, and quite another to describe the application of peanut butter to a Ritz cracker. In the investment world, it is the additional yield an investor earns over and above a benchmark. For community banks, the benchmark is almost always the term structure of the Treasury curve.

There are a number of variables that determine the amount of spread an investor earns on a given bond, and each variable is an attempt to quantify the amount of risk. There are three primary risks that any bank assumes when purchasing a bond: credit, liquidity and reinvestment.

Risk premia embedded

The most obvious reason a bond issued by anyone other than the U.S. government yields more than a Treasury note is that it has a lesser credit profile. In the case of bonds issued by an agency of the government or a state or local government, the credit quality is minimally lower than a Treasury issue, but it's lower nonetheless. …

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