Jim Reber: Not for the faint of heart

Bond management is a challenging proposition at the best of times.

By Jim Reber, ICBA Securities

They don’t give medals for successful navigation of the treacherous waters of the fixed-income seas, but maybe they should. If there’s anything predictable about a community bank’s operations, it’s that bond portfolio management is a harrowing endeavor.

It would be a dicey enough proposition to simply manage a collection of debt securities to equal a published index on a total return basis. There are plenty of market benchmarks out there that can be used to measure performance, taking into account both the yield and price changes over a period of time. If only that were the final determinant of success for a community bank.

If you are charged with the management of your bond portfolio, you understand that total return is just one of a myriad of measuring sticks. It has other, more essential duties. For one, the portfolio serves as a storehouse of liquidity. For another, it’s probably the most efficient tool to adjust your bank’s asset-liability posture.

More to it

And unlike non-depository bond investors, you’re charged with earning a reasonable spread over and above your cost of funds (see table). It’s not enough to simply buy a group of debt securities that mimic broad averages and run with them. Furthermore, a side effect of serving as a complement to the rest of the balance sheet is that the actual composition of the portfolio may need to change over time. This can help to improve the diversification of risk and cash flows of your community bank.

Recent history

For proof that portfolio managers have to remain current and nimble, not to mention thick-skinned on occasion, let’s look at how the investment landscape has changed in just barely over a year. On Dec. 22, 2017, the Tax Cuts and Jobs Act became law. Immediately, community bankers had to get in touch with their tax and bond accountants to recalculate variables such as tax-equivalent yields and deferred tax assets for their 2017 tax years, and they had to be quick about it.

For much of 2018, community banks attempted to right-size their holdings of tax-free securities. Many of them chose to lessen their exposures, mainly because the tax-equivalent yields of the bonds they owned prior to tax reform declined significantly. For example, a municipal bond owned by a C corporation that had a tax-free yield of 2.5 percent before tax reform saw its tax-equivalent yield drop from about 3.75 percent to about 3.1 percent.

New favorites

It’s therefore no surprise that between September 2017 and September 2018, the average community bank’s municipal bond weighting decreased from about 28 percent of the pie down to 23 percent. That is a significant recast.

What have investors bought to replace the munis? Again, the ever-resourceful portfolio manager has heard how the needs of his or her community bank have evolved and has responded. In large part, the proceeds have been reinvested into some type of amortizing security.

The logic is sound: Monthly cash flows can be used to fund the still-increasing loan demand and/or deposit needs, and the buyer can pretty accurately choose the new duration, perhaps to mimic the risk profile prior to the disposal of the munis. Tax-free bonds are usually the longest in the portfolio, so duration maintenance could be a motivating factor in reinvesting the proceeds.

So, portfolio managers of the world, it looks like you continue to serve your community banks very well. Risk-adjusted returns are consistent with prior periods, especially considering the decline in effective muni yields. Durations and cash flows are very stable. Net unrealized losses, which virtually all institutions have at this point in the rate cycle, are manageable. Portfolio managers continue to prove their worth to their institutions—and the community banking industry.

Education on Tap

Webinar series tips off
ICBA Securities and its exclusive broker Vining Sparks will begin their 2019 webinar series Community Banking Matters on Feb. 19 at 10 a.m. CST. Daniel Anderson of Vining Sparks will present Positioning the Investment Portfolio for Performance. Free CPE is available. To register, visit www.viningsparks.com

Visit us at the Expo
ICBA Securities and Vining Sparks will be prominently positioned at The Expo at ICBA LIVE 2019, March 18–22. Vining Sparks will be in Booth 430, which is adjacent to ICBA Central. For more details, see icba.org/events/2019-icba-live-convention/expo

Jim Reber, CPA, CFA (jreber@icbasecurities.com), is president and CEO of ICBA Securities, ICBA’s institutional, fixed-income broker-dealer for community banks