Make sure your portfolio can navigate uncertainty

Community banks entered 2020 after a whirlwind year of shifting interest rates, trade war tariffs and geopolitical uncertainty that caught many bankers off guard.

Unfortunately, 2020 has brought more, not less, chaos to community banks’ portfolio management strategies. The uncertainty has been highlighted, of course, by the COVID-19 pandemic, which roiled the U.S. economy and labor market over the spring and summer. In response, the federal government passed trillions of dollars’ worth of economic stimulus, while the Federal Reserve brought interest rates down to essentially zero.

Given all of this, what should your community bank’s portfolio management strategy look like heading into 2021? Here, the strategists at Vining Sparks, ICBA’s exclusively endorsed broker-dealer, share their perspectives.

Prepare for anything

“Not many people would have predicted at the beginning of this year that a global pandemic would take down the economy in 2020, but that’s exactly what happened,” says Kevin Smith, director of investment product strategies for Memphis, Tenn.-based Vining Sparks. “So, the best portfolio management strategy is to always be prepared for the unexpected.”

Smith says even with loan demand down, 2020 will end up being fine for community banks from an earnings perspective, due largely to fee income generated from Paycheck Protection Program (PPP) loans and residential mortgage lending.

“But next year will be challenging from an earnings standpoint,” he adds. “Community banks have lots of cash on hand, since many people are saving more and businesses are borrowing less due to economic uncertainty.”

Holding cash is expensive for banks in the current low-rate environment, according to George Hancock, senior vice president of trading at Vining Sparks. “Banks are only earning 10 basis points investing cash overnight in fed funds,” he says, “but their cost of funds is higher than this, which puts pressure on bank earnings because it lowers net interest margins.”

Michael Erhardt, senior vice president of investment strategies group at Vining Sparks, puts it more bluntly: “Community banks are losing money every day they sit on cash,” he says. “It’s punitive to invest in Fed funds when you’re only earning 10 basis points, but your cost of funds is 60 basis points or more.”

Another big challenge community banks are facing is the collapse of the yield curve. “The spread between two-year and 10-year Treasuries is down to 50 basis points, so there’s very little wiggle room,” Erhardt says. “In comparison, there was a 200 basis-point spread after the financial crisis a decade ago.”

Deploy excess liquidity

All of these factors make managing an investment portfolio that much more important for community banks. It is, after all, one of the few things a bank can control. “In the current environment,” Erhardt says, “the investment portfolio becomes a larger percentage of a bank’s earning assets. So, the No. 1 priority from an investment perspective is to deploy excess liquidity—whether this is making loans, buying loans or adding investment securities.”

High-grade municipal bonds have always been a bedrock investment for community banks, making up between a quarter and a third of the typical community bank bond portfolio. Erhardt says that munis currently offer the highest yield and spread over Treasuries.

Smith agrees but notes that community banks will need to refocus on the municipal bond review process next year due to concerns about some cities’ and states’ financial standing. Tax collections have gone down in many areas due to the economic impact of the pandemic.

“I believe investment decisions should be made within the context of the balance sheet. Community bankers need to ask themselves if they’re doing things they wouldn’t do in more normal times.”

—Kevin Smith, Vining Sparks

According to Hancock, some community banks have become more willing to assume more credit risk in the current environment in the search for higher yields. “For example, some banks are buying out-of-state munis or lower-rated munis,” he says. “But you have to be careful here. Banks take plenty of risk in their loan portfolios, which is where I believe their risk should be because it’s where they get rewarded.”

Erhardt agrees, recommending that community banks stick with AAA-rated or AA-rated municipal bonds. He says the typical community bank buys tax-exempt municipal bonds and fills in a cash flow ladder with amortizing securities like agency mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs). “These are the core holdings of a community bank’s portfolio; they make principal and interest payments each month that you can redeploy into loans when loan demand comes back,” he adds.

“When bank earnings are stressed, there’s always the temptation to take on more risk,” Smith says. “I believe investment decisions should be made within the context of the balance sheet. Community bankers need to ask themselves if they’re doing things they wouldn’t do in more normal times.”

Bonds provide the flexibility needed to get the community bank’s risk profile in line with where it should be, Hancock adds. “If your risk is declining rates, look for bonds that perform well in a declining rate environment,” he says. “Your asset liability profile and risk appetite will dictate the appropriate bond for your bank at any given time.”

Why prepayment protection is important

In the current environment, Erhardt likes agency MBS with some form of prepayment protection. Community banks that buy a mortgage-backed security with a significant premium and where a portion of the underlying mortgages are prepaid could experience low or even negative yields. He advises community banks looking for agency MBS to consider collateral with prepayment friction, such as low loan balance pools with a maximum loan amount of $200,000.

These borrowers are less likely to refinance, Erhardt says, because the cost to do so is high relative to the potential interest savings. “Community banks should also consider agency MBS with mortgage loans originated in New York, where there’s a punitive tax on refinancing,” he adds. “You don’t want to pay a high premium for a bond that might come back to you at par tomorrow.”

Keep in mind that the Federal Reserve has already bought $1 trillion of agency MBS this year, Erhardt says. “This is driving up the price to well above par, so you have to be careful,” he adds.

Loan trading is another option for community banks sitting on excess cash. According to Smith, banks in regions with more loan demand may be willing to sell loans for their own balance sheet needs to banks where loan demand remains low. “This is a win-win for both banks,” he says.

Heading into the new year, the only thing that appears certain is that high volatility and more uncertainty are likely to continue. It is likely that 2021 will be another challenging year for community banks.