With interest rates at historic lows and economists and the Fed forecasting they will remain there, it is becoming harder to ignore the effects this is having on balance sheet margins. And a decelerating growth rate of U.S. GDP and slowing demand from businesses related to real estate will continue to restrict revenue growth.
While banks and credit Union’s are looking at other areas on the balance sheet–interest income, noninterest income and operating costs–to keep the earnings growth intact, there are limited opportunities that will boost earnings in the fourth quarter. How much room is left to lower expenses and or deposit pricing?
Many will try to cut interest expenses but will inevitably start to take on additional risks to improve net interest margins. Ultimately, they will be forced to face lower margins. In fact, if they shift assets to longer maturities to keep net interest margin strong, this could backfire once interest rates start rising.
Many portfolio managers continue to sit in large cash positions right now. This is a natural response to both the fear of rising interest rates in the future and the dissatisfaction with the yields available on short-term bonds. Historically, institutions have not been penalized for being overly liquid. With overnights below 25 basis points, there is a large opportunity cost that is hard to overcome and in itself is a major penalty. It is very important for investors to weigh the risks of staying in cash against the risks of investing.
Investing in this low-rate environment takes a holistic approach that focuses in on stability and growth of earnings as opposed to market timing.
It is important to minimize holding cash for liquidity and emphasize development of cash flow management that will produce a reasonably predictable stream of liquidity, which can be re-invested in the future, mitigating interest rate risk, or used to help fund loan origination or expenses. It offers a pickup in yield as well. These earnings may not seem significant, but they give you the advantage of flexibility in pricing your loans and deposits posturing you to be competitive in your market.
The most viable approach in this regard involves refocusing on the old-fashioned ladder or the selective use of amortizing products like mortgage-backed securities with stable profiles.
Prioritizing current earnings seems obvious, but in looking at the forgone income derived from the increase in cash holdings may not be so obvious. Waiting for rates to go up or the acceptable yield threshold to appear is a very expensive strategy that is far from conservative. Market timing never works.
Do not be afraid to selectively extend in duration with some portion of the portfolio, even in a low-rate environment. Duration risk is a very real risk, but it is but one of the many types of risk that we manage. Diversifying these risks and keeping them at levels that you are comfortable with is a key element of portfolio management. Adding exposure to quality well-structured bullet-like securities may not look as lush as some alternatives but will reap the benefit of the yield pick-up available in longer maturities and, over time, these bonds will roll in on the curve and make the shape of the yield curve work for you.
Rolling down the yield curve simply means that an investor purchases a bond with a bullet maturity is at the near or at the top of a steep portion of the yield curve and holds that bond until, over time, its maturity reaches a lower yielding portion of the curve in a traditional shape of a yield curve. In doing so, the investor enjoys the relatively high yield of that bond vs. the lower yields at the shorter end of the curve. Further, if done with short- or intermediate-term bonds, yield curve roll may provide protection against the risk of price decline if interest rates move higher. This is just one of the many strategies that need to be used to give your investment portfolio dynamics that work for you.
We really need to look beyond yield and examine the risk-reward profile of how any investment fits in to your balance sheet. It is often over looked that yield is also a measure of risk. It is prudent to develop portfolio analytics that quantify various risks in the portfolio. This starts with internal dialogue and understanding with regard to acceptable levels of the different elements of risk and its ongoing monitoring.
Concentration in any risk limits your flexibility. While credit risk is typically the most glaring barometer to the conservative investor, it is not the only risk. Developing a functional portfolio that complements your core business entails looking at duration risk, call risk, liquidity risk extension risk just to name a few basic metrics. The most successful portfolios are not necessarily the ones that generate the highest yield, but the ones that have the most impact on your overall business model.
Michael Faughnan is managing director of fixed-Income strategies at First Empire Securities.
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