Jim Reber: Hit the Bid

Quick: What are the most saleable assets on your community bank’s balance sheet? If you get this wrong, you need to be running a “not-for-profit depository financial institution,” if you know what I’m saying.

Bonds, of course. Most people I talk to consider the liquidity feature a close second (to safety) in importance when contemplating a purchase. That has come into play for thousands of community banks in the last year, as liquid assets have evaporated. According to the FDIC, in 2022 investments (including fed funds sold) as a percent of assets dropped from 43% to 39% for the commercial banks nationally. Since loan demand rose only modestly last year, the vast majority of the difference was investments running off as deposits “intermediated.” 

This situation has continued apace in 2023, as evidenced by the huge jump in wholesale borrowings, including FHLB advances. Although there’s plenty of debate regarding the direction of monetary policy, community banks are still looking for more, versus less, sources of liquid assets as we proceed into the second half of the year. 

Go to the well

Bond prices have risen modestly in 2023. Bond yields, particularly those with maturities of five years and longer, actually peaked last October. For example, if you had purchased the new five-year Treasury note last November, you would now have a one-point gain (1%) in that bond. The Bloomberg Aggregate Bond Index, which is a hypothetical collection of investment-grade bonds, had a total return of 2.0% through June (after falling 13% in 2022). 

That has lessened, but not eliminated, unrealized losses in community banks’ bond portfolios. As of June 30, the average portfolio was around 8% underwater. That number was around 12% in October 2022. So while you may have a few bonds with gains, if you’re looking to sell, you’re going to choose among those with losses. That may be opportune.

It appears that 2023 industry earnings will still be quite good, so it is entirely possible that a bank may choose to realize some losses on sales of bonds now, and then push that income (and tax liability) into future years. This strategy will make your tax accountant proud. 

Priced to move 

By way of review, there is a basic rule of bond selling to achieve maximum efficiency. This is the concept of the “take-out yield.” Take-out yield has several other nicknames, like market yield or give-up yield, and what it quantifies is the yield that a purchaser of your bond would get if you were to sell that bond today. 

The lower the take-out yield, the more efficiently you have sold your bond. Economically, the seller will have to re-employ the proceeds at a return higher than the take-out yield for the sale/reinvestment to make economic sense. So, a wise portfolio manager will resist the temptation to liquidate, unless the sale item results in a low take-out yield or there’s a higher-yielding use of the proceeds. 

Your brokers can readily quantify the take-out yield on any security that you’re thinking about selling. What makes these selections a bit trickier is the inverted yield curve. Usually, the shorter the bond, the lower the take-out yield. That may not be the case now.

Keep these in mind

There are a couple of other variables that could influence if, or what, your community bank might sell. One is that you likely can’t sell a bond that is designated Held to Maturity (HTM). Community banks have been putting ever greater amounts in HTM as unrealized losses have persisted. Around 20% of all bonds in bank portfolios are now HTM, which is a four-fold increase since 2021. 

Another variable is that the values of call options are very high at the moment. This means that yields on callable agencies and “current coupon” mortgage-backed securities (MBS) are uncommonly high. A seller, then, would be better off by selling bonds that have little or no optionality. Examples are “bullets” and MBS that came to market in 2020 and 2021. 

Also, you likely have other liquid assets on your balance sheet besides your investments. There is a robust secondary market for most performing loans beyond conforming residential mortgages. Floating rate SBA 7(a) loans can be efficiently sold, likely at substantial premiums. And sale-leaseback strategies, while more complex than bond or whole loan sales, could potentially produce some gains and liquidity.

So, to recap: Get some advice from your brokers about which bonds should produce the lowest take-out, or market, yields. Don’t be too quick to take gains unless that fits with the overall earnings picture for the bank. And look around for other saleable assets, which could well produce gains to offset bond losses. 

Bid thee well!