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Chitrang K. Purani, Thomas Luciano
Banking publication SNL Financial sat down with members of PIMCO’s Financial Institutions Group in October to discuss the team’s partnerships with regional and community banks. In November, the editors spoke with Chitrang Purani, senior vice president and portfolio manager, and Thomas Luciano, vice president and account manager, to discuss PIMCO’s latest views on the markets and implications for bank investment portfolio positioning. This interview was initially published on the SNL Financial website in a modified form. SNL: What do you think banks have learned from the summer’s market swings? Chitrang Purani: The market volatility since late May continues to highlight sensitivity to the Federal Reserve and the timing of the tapering of its $85 billion in monthly asset purchases.
This volatility has highlighted the importance of a couple key factors banks need to consider related to the investment portfolio: the impact of unrealized gains and losses across holdings, and sources of return generated from the portfolio.
Volatility in gains/losses has direct implications for a bank’s tangible common equity ratio (TCE), which is closely monitored by banks’ investors and other constituents. It also affects the ability to liquidate securities to fund new loan originations, acquisitions and, more broadly, asset liability management (ALM). Regarding sources of return, fixed income portfolios generate income from risk factors such as duration, credit, convexity and liquidity. Most bank investment portfolios derive the majority of their income from assuming duration and convexity risks. Based on the latest available Federal Reserve H.8 data, banks hold the majority of their investments in agency mortgage-backed securities ($1.3 trillion or just under 50%) and Treasury securities ($478 billion or roughly 17%). While these asset classes play an important role for bank portfolios for liquidity, income and capital reasons, it may be wise for banks with elevated concentrations to diversify into other sectors/securities that rely less on taking duration and prepayment volatility risks for their return.
SNL: For some banking institutions, unrealized losses from the summer have turned back into unrealized gains. What do you recommend these banks do? Do they have more flexibility than other banks? Thomas Luciano: Based on Federal Reserve H.8 data, unrealized gains hit their peak on 3 October 2012 at $43.8 billion. They have since decreased to –$0.2 billion due to market volatility.
We believe the unrealized gain or loss position should not be the main driver for making changes to these banks’ securities portfolios. These positions should be evaluated in terms of their overall appropriateness for the bank investment portfolio. If, for example, a position moves to a loss because of the issuer’s deteriorating credit fundamentals, the holding should be carefully evaluated to determine whether there is meaningful impairment risk. However, if a position declines due to duration (interest rate risk), it may not necessarily be problematic if it is offset by a corresponding liability.
On the other end of the spectrum, harvesting gains reflects a trade-off of lower investment income for increased capital, which may compress net interest margin if a material amount of gains are realized. These considerations create the need to look beyond just gains and losses when deciding how to reposition portfolios.
However, accounting conventions make selling at a loss sometimes more challenging than selling at a gain (e.g., a realized loss could jeopardize a previous assertion that the position was not impaired from an OTTI [other than temporarily impaired] perspective). So, as a practical matter, banks generally have more flexibility to reposition their securities portfolios that are at gains rather than losses.
SNL: For banks that have exhausted their unrealized gains, how concerned should these institutions be about potential hits to their tangible book value? Chitrang Purani: In general, banks should be aware of the mark-to-market impact of the investment portfolio on their tangible book value. Investors have become more focused on TCE metrics, which capture the volatility of these securities portfolios. However, an important question to ask is: What’s causing the volatility?
If the volatility is credit-related, then we would advise a closer look at the portfolio to ensure credit impairment does not become an issue. For temporary changes due to interest rate volatility, the focus should be more on the degree to which the bank can maintain flexibility in managing liquidity, ALM and other strategic initiatives without having to realize losses in the securities portfolio.
From a credit perspective, some banks have elevated exposures to legacy structured assets such as trust-preferred securities (TRUPS), which require a deeper understanding of the collateral and potential cash flows/recovery across various scenarios. Many banks also have large exposures to bank-qualified municipals, which warrant closer monitoring as many municipalities continue to struggle with unfunded liabilities and sluggish local economies. These risks need to be weighed against potentially higher tax-adjusted yields and the potential to earn Community Reinvestment Act credit.
SNL: Loan growth has remained weak across the sector. How should banks weigh the decision to take credit risk in the loan portfolio versus the securities portfolio? Thomas Luciano: Loan growth has remained anemic since the beginning of the year. Based on latest Federal Reserve H.8 data, total loans have grown by approximately 2.0% – and some of the growth banks have reported is a function of competitive loan pricing and weakened underwriting standards, leading to improvements in market share versus realized growth.
Where credit risk is best taken today is a sensitive topic for banks and a question that many executive management teams debate. Many banks are being cautious in deploying excess liquidity for fear of further increases in interest rates. Deploying excess liquidity into new loan originations is the preferred path so long as underwriting standards and pricing are not being compromised to maintain market share. This has the potential to result in reserve-related issues in the future. However, there are also opportunities to add corporate credit exposure in the securities portfolio to complement credit exposure in the loan portfolio.
For example, banks that are heavily concentrated in a certain sector within the commercial and industrial asset class may choose to diversify through investments in corporate credit. Additionally, for banks that have a specific regional focus across their commercial/residential loan book, augmenting high-quality commercial and residential mortgage-backed securities representing different collateral types and/or regions may make sense in the absence of appropriate direct lending opportunities.
SNL: How should banks prepare for rising rates in their securities portfolios? Chitrang Purani: We believe a gradual healing of labor markets, along with weak inflationary pressures, will keep the Fed in a highly accommodative stance as it relates to the policy rate – anchoring shorter maturity yields.
For bank investment portfolios with excess liquidity, this presents an opportunity to increase income from investing along the less volatile, front-end portions of the yield curve, while avoiding exposure to long-duration securities and reducing elevated concentrations to sectors such as Agency mortgages and longer maturity Treasuries – which may exhibit more volatility in response to economic data and the Fed’s corresponding taper timeline. We also believe this environment is constructive for banks to diversify into high-quality credit sectors such as low duration corporate bonds and select securitized products, as investors continue to deploy excess cash into these markets in the face of improving economic fundmentals and continued policy accomodation.
SNL: Does Janet Yellen’s nomination as Fed chair change your view of how banks should position their investment portfolios? Chitrang Purani: Yellen’s outcomes-based approach toward monetary policy – against challenged (albeit improving) employment conditions and inflation dynamics – re-emphasizes our view that the short end of the curve will be anchored to the zero bound for a couple years. However, there is more uncertainty further out along the yield curve, and investors are not necessarily being paid adequately (in our view) to take that risk. We also see high-quality credit risk as being well-supported, given expectations for Yellen to continue to maintain an accommodative policy stance.
SNL: Based on conversations you have had with your bank clients and overall presence in the markets, what would the “ideal” bank investment portfolio look like today? Thomas Luciano: Unfortunately, there is not a “one-size-fits-all” approach. Every bank has different initial conditions – in terms of the composition of the loan portfolios, securities portfolios, deposits and other balance sheet items. But a universal theme we believe all bank securities portfolios should reflect is risk-factor diversification. Fixed income securities in bank portfolios generate returns from a combination of risk factors, including duration, credit, convexity/volatility and liquidity.
Given high concentrations of duration and convexity risk across bank securities portfolios, we would advocate that banks look to diversify into high-quality, short duration credit ‒ which could be complementary (diversifying) to the bank’s loan portfolio and could help improve return-on-equity without adding excessive volatility.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Diversification does not ensure against loss.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2013, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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