This just in: community bank investment portfolios have lost value in 2018. The rest of this column contains good news. At least, it does for those community bank portfolio managers who are interested in improving future earnings, creating a more diversified collection of bonds, tweaking their risk profile and, yes, deferring income. I hope that includes you.
Before we get into the numbers, and at the risk of being Master of the Obvious, I want to mention that all of the decline in value this year is for the purest of reasons: rising interest rates. In the recent past (i.e. the last decade), there have been certain securities whose prices had plummeted because either credit quality had deteriorated or spreads had widened. Two of the more notable examples of this are the cratering of Fannie Mae/Freddie Mac Preferred Stock in the aftermath of their being placed in receivership in 2008, and a couple of episodes of disruption in the muni market. Does Meredith Whitney on “60 Minutes” ring a bell?
Where we are
Even though we’re now a full three years into this rising rate cycle, bond prices have really been quite stable until just recently. The Fed first hiked overnight rates in December 2015 after warning that it might for several meetings. By the end of that year, the typical community bank had a modest unrealized loss of about 30 basis points (0.30 percent).
Fast forward two years, to December 2017, and those losses, on average, were still only 50 basis points. The cause of the relative price stability was two-fold. First, the Fed was moving quite slowly, as there were only four rate hikes in that two-year period. Second, credit spreads on most of the bonds banks owned tightened during that period. As the economy improves, the required incremental yields over those of benchmark Treasuries normally shrink, and such was the case here too.
Today, those losses on average are approaching 3 percent. That means a $100 million portfolio is $300,000 underwater. Many community banks have not a single bond that’s owned at an unrealized gain. If your portfolio sounds like this, you’re in good company. This also represents an opportunity.
Build for the future
If you ask your tax accountant if income deferral is a sound tax-planning and cash flow strategy, you should first set your stopwatch to see how long it takes to receive a “yes.” Selling some underwater bonds, which some might term “dogs,” and buying other securities that have higher market yields will push income into future periods. It will also delay some payment of income tax to Uncle Sam.
So far this year, the banking industry’s earnings are about 20 percent ahead of last year. That’s due to both a still-improving lending environment and (as you may have heard) tax reform. Chances are that your institution could selectively sell some bonds this year and still meet its earnings goals, with all future years also benefiting.
Look both ways
As you investigate your opportunities, a few bond-swap reminders are in order. First, economically, the best bonds to sell are the ones with the lowest current market yields. Examples of these could be short bullet agencies or “pre-refunded” munis. Your brokers could use the term “take-out yield” as a synonym for market yield.
Also, and this may be academic at this point, it’s very difficult to make the math work by taking a gain on a tax-free bond. However, it can be beneficial to buy tax-free securities to replace bonds sold at a loss. Your broker can demonstrate the economics of this “tax swap” strategy.
Finally, from a timing standpoint, it’s wise to act sooner rather than later as year end approaches. The liquidity in the bond market often starts to evaporate by mid-December, so you’ll want to stay ahead of that likelihood. And, if it’s more advantageous to take some losses in the next calendar year, think about pulling the trigger by mid-January. Having nearly an entire year to start making up the realized losses will help the 2019 results.
There are plenty of reasons to think about taking some losses now, and this column contains just a few of them. Your broker-dealers can help you and your management team identify which “dogs” can be converted into “winners” for future periods.
* * * * *
Jim Reber is president and CEO of ICBA Securities and can be reached at (800) 422-6442 or firstname.lastname@example.org.
- Cash Whiplash: Changing interest rates can create volatile cash flow - March 1, 2019
- How ’Bout Them Dogs? Put unrealized losses to good use - November 15, 2018
- Can’t keep a good bank down: Last decade has seen struggles, successes for the industry - October 22, 2018
- Muni Madness: A lot of variables affect tax-free performance - February 23, 2017
- Push and Pull: Two-sided SBA market doubles your chance for success - February 23, 2017
- Call Protection at Rock-Bottom Prices - December 18, 2015
- The Old Switcheroo: Instead of buying bonds, why not sell loans? - July 30, 2015
- Is the Curve Going to Flatten? Why it does and what to do about it. - March 18, 2015
- Roll or Flow? Amortizing bonds require some analysis - November 19, 2014
- Shop Till Rates Drop: Fed to continue its buying spree - July 13, 2014