Jim Reber: Pushing the Boundaries

Let’s get right to the point: Your community bank’s net interest margin, which may have shrunk in the last couple of quarters, has been especially compromised by your bond portfolio’s performance. And I’m not talking about the credit quality; this is purely interest rate driven. Historically, when we look at the portfolio’s tax-equivalent yield (TEY) compared with cost of funds (COF), the difference is around 200 basis points, or 2% (see table below).

This has held true in virtually all rate environments. This includes the 2013–15 period, when we were clawing our way out of the Great Recession and the fed funds rate was anchored at 25 basis points (0.25%). It also includes 2019, when fed funds got up to 2.5% and the yield curve inverted for a few minutes. 

The current math isn’t so appealing, and the trend actually began with the monetary policy response to the pandemic. So let’s see what can be done to maintain your own “boundary,” or spread, between the bonds’ yields and your cost of carry.

Back in the day

For those with limited recall (like your correspondent), the mid-2010s was a period with weak loan demand, seemingly no pricing power, and therefore little inflation. Core personal consumption expenditures (PCE) never breached the 2% target between 2012 and 2018. In many months, it was closer to 1%. This normally would have caused the net earnings of the bond portfolio to shrink, as margin compression would have taken over. However, that didn’t happen, as community banks were able to fund themselves with overall cost of funds well below 1%. 

Even when inflation did perk up modestly, as in 2018–19, the 200-basis point net spread was maintained. COF, with its modest beta, stayed put for the most part, while bond portfolio yields rose enough to keep the boundary in place. 

It’s also worth mentioning portfolio durations stayed within their historical bands during the teens, generally around three years, so it doesn’t look like there was “yield reach” in this era. This is especially impressive given the very flat yield curves in 2018–19.

Historical portfolio margins
Community bank investment portfolios

Not all bad news

Just as it appears we’re building out a case that earnings are going down the drain, here’s some welcome news: Things still look quite good for the community banking industry overall. Earnings for the first half of 2023 are about in line with the similar period for 2022, even as funding costs have taken off. Interest rate risk postures for community banks appear to be very well balanced, according to Stifel. So, overall, the higher rates that you’re paying for deposits have basically mirrored the improved yields on interest-bearing assets, at least in the last four quarters. Net interest margins improved initially in 2022 after the Fed commenced its rate-hike cycle. 

Two other elements of banking fundamentals are working well: credit quality and capital levels. These measures are akin to the offensive line on a football team, in that you only hear about them when things aren’t going well. 

Noncurrent loan rates and net charge-offs in 2023 remain minuscule. The FDIC reports the average community bank leverage ratio (CBLR) for those who elected to use the CBLR reporting methodology was 12.1% as of June 30. Both contributed to net income increasing quarter-over-quarter, even with the funding headwinds.

Here we are

By the looks of things in the table, there are still some challenges ahead. The net take, or spread, of the bond portfolio yields over the COF is barely half of its long-term run rate, and we’re probably not finished yet. Portfolio TEYs have improved since the nadir in 2021, although the pace of improvement has been tortuously slow, since depositories have been collectively on buyers’ strikes for two years. 

If deposit betas hold consistent with past eras in which fed funds has met or exceeded 5%, it’s entirely possible that overall COF would approach 3% for the industry. The chance of this improves in the “higher for longer” scenario. 

Still, given that community banks are relatively insulated from further rate shocks, it appears that time could be on your side. For the 2023 holiday season, the boundary that portfolio managers should be most concerned with is their own midsections, not their bond portfolios’ net interest margins.