Here’s something you haven’t heard yet from the pandemic, economic shutdown, record stimulus, heroic Paycheck Protection Program efforts, and flight-to-quality dynamics of the past 18 months: your community bank is probably sitting on a record-high length of average maturities in its bond portfolio. And it’s gotten there in a hurry.
But I hasten to add that it’s not arrived there by mistake, at least I don’t think so. After accounting for all the other variables buzzing around the financial management of a community bank in 2021, likely portfolio managers have very intentionally changed the risk dynamics of their collection of bonds. At the same time, the adjustment is so dramatic, it deserves some attention, which is the subject of this column. You may learn from reading that your own bank’s portfolio is right in line with its peers.
Price risk barometer
When ICBA Securities and its exclusive broker, Vining Sparks, teach bond basics at the annual Bond Academy, one of the first topics covered is price risk. This is really the only risk in portfolio management that cannot be avoided or neutralized. It is baked in the cake that the market value of your bonds will move inversely with interest rates. Therefore, it’s a high priority of management to define an acceptable level of price risk and monitor the investment collection to ensure compliance. Enter the concept of duration.
Over the past quarter-century, the average portfolio’s duration has been in the three-year range. The most popular and accurate type of duration modeling is called effective duration, which accounts for principal and interest cash flow, the value of embedded options, and bonds with variable interest rates. In other words, the effective duration is the risk measuring stick for a 21st-century bond portfolio.
Got big, quickly
To keep things succinct, let’s remind ourselves duration tells us how much your portfolio’s market price will grow or shrink, given a 100 basis point (1%) shock in interest rates. A group of bonds with a duration of three years will therefore improve in market value by 3%, given a drop in market rates of 1%. In just the first 90 days of 2021, community banks’ durations increased from 3.2 years to a record 4.5 years. Given what I’ve learned from talking with Vining Sparks’ traders and community bankers, this is no mistake. As rates, especially those for longer-term bonds, have risen this year, portfolio managers have seen fit to do some backfilling on their net interest margins.
Nonetheless, in simple terms, community banks increased their price risk by more than 40% in just three months. That has required a lot of buying of a lot of long investments by a lot of banks in less than 100 days. The extension has been in a variety of investment sectors, too. Munis’ price volatility grew 15%. Collateralized mortgage obligations’ risk increased 66%. Mortgage-backed securities’ effective duration more than doubled. And let me restate that this only took three months.
If you’ve indulged in some duration expansion, it’s now doubly important to keep your price volatility on the rails.
Subject to change
It’s possible that 2021 will give portfolio watchers a case study in risk management. While it’s clear that investment managers intended to build out longer durations, it’s also clear that our old friend optionality is part of this mix. This means that any estimate of price volatility will include assumptions about current and future interest rates, and virtually all portfolios will see their durations positively correlated with market levels. Again, to oversimplify, at least some of the duration growth in the first quarter of this year can be attributed to rates rising, with some call options moving out of the money.
So, just as we’ve seen a record amount of price risk installed in community bank bond portfolios, if rates stabilize or fall later this year, we’ll see durations decline, all things remaining equal. We know they are not, as long as portfolio managers believe they’re sitting on ample supplies of uninvested cash earning next-to-nothing. Nonetheless, here’s our requisite recommendation to keep your eyes on your price risk. If you’ve indulged in some duration expansion, it’s now doubly important to keep your price volatility on the rails. Effective duration is an effective tool for your risk management monitoring.
Education on tap
Balance Sheet Academy
ICBA Securities and its exclusively endorsed broker Vining Sparks announce the 2021 Balance Sheet Academy. It will be presented in a live session Oct. 18-19 in Memphis, Tenn. This intermediate-level course will discuss a variety of topics, including interest rate products and portfolio modeling. Space is limited. Visit viningsparks.com to register. Up to 12 hours of CPE credit are offered.
ICBA Securities is on the road again
We will be on the convention trail in earnest this summer and fall. ICBA Securities will exhibit, sponsor, and make presentations at a number of its state association affiliates’ events between now and October. For a complete list of our upcoming appearances, check out https://www.icba.org/icba-securities/educational-events.
Jim Reber, CPA, CFA is the president and CEO of ICBA Securities, ICBA’s institutional, fixed-income broker-dealer for community banks. Connect with Jim jreber@icbasecurities.com.
