Jim Reber: Financing, fine-tuned

Peter F. Drucker once said, “The greatest danger in times of turbulence is not the turbulence, it is to act with yesterday’s logic.”

It’s not a stretch to apply this quote from one of the most respected business educators of our time to community bank investment portfolios. Over the past 18 months, this column has wended its way through the challenges and risks that COVID-19 has thrown at bank balance sheets. It’s been documented here that traditional risk benchmarks have flown out the window as mountains of excess liquidity and shrinking margins are forcing the hands of investment managers.

Here is the one point I hope you will retain from this piece: The larger the stated coupon of whatever bond you’re buying, the lower the price volatility.

As we suddenly enter the fourth quarter of the year, it’s time to take stock of what the pandemic has wrought on our securities inventories. Year-end is a popular time for community banks to make adjustments to their portfolios for a number of reasons, the most obvious of which is that your bank’s annual earnings number is coming into focus.

Coupon interest is your friend

Since most community banks have taken a huge bite of the riskburger, we’ll discuss some ways that portfolio managers are buying bonds that are performing well in today’s market, with an eye on potentially higher rates later.

Sometimes this column will make progressively more pertinent suggestions about bond management, ending with the big finish. Not this month. Here is the one point I hope you will retain from this piece: The larger the stated coupon of whatever bond you’re buying, the lower the price volatility.

I’m aware that markets can sometimes produce an offering of 115, 120 or even 130 cents on the dollar, which can be an anathema to certain buyers. But for those of you whose durations have doubled in the past six months—and that’s a lot of community banks—premium coupons can help keep a lid on price risk.

To keep things simple, there’s an empirical and a practical application to the more-is-less coupon notion. The first is that durations are the weighted average period of time to receive all cash flows, both principal and interest. The larger the interest payments, the shorter the period. The practical aspect is that the bigger the interest cost to the borrower, the more likely the debt will be prepaid early, assuming it can be refinanced, which is true of about 80% of the bonds that community banks own.

Exempli gratia

One of the best sectors to demonstrate how to control price volatility through high coupons is the municipal sector. To expand the applicability of this strategy, we’ll compare two taxable bonds. Some banks have little or no need for tax-free income, but all community banks can find some benefit in the taxable sector. Also, munis provide a relatively clean comparison because there’s no monthly amortization of principal like there is with mortgage-backed securities.

Recently, LaVergne, Tenn., issued a taxable general obligation (GO) bond with a 1.45% coupon, which matures in 2030, priced at par (100.00). About the same time, Fort Worth, Texas, issued a taxable GO that matures in 2030, but with a 5% coupon, priced at 128.388 to yield the same 1.45%. Many community bankers I know would opt for the par-priced bond, as the sticker price of the Texas muni just doesn’t sound right to them.

Here’s why it matters: If interest rates rise 1% over the next six months, the par bond will lose 13.2% of its market value. The premium bond will only lose about 11.5%. That may not sound like much, but extrapolated over an entire portfolio—which, as a friendly reminder, is probably larger than ever—it’s 15% less price risk. And let me point out that the investor doesn’t sacrifice anything, including credit quality, liquidity or yield.

This analysis can easily be performed on other sectors. Your brokers can—and should—display prospective prices given standard rate shocks using industry-preferred models when they make offerings. The general theme of this column will be on display: The higher the coupon, the shorter the duration.

Given the dramatically longer bond portfolios that we’ve seen many community bankers create in 2021, this is a relatively simply strategy to employ, starting with your next purchase. Repeated use of this tactic can help you fine-tune the financing of your security portfolio.

By taking careful note of the coupons in your collection of bonds, you can avoid the consequences suggested by the estimable Dr. Drucker: “There is nothing so useless as doing efficiently that which should not be done at all.”