The U.S. banking system has evolved quite a bit since 2008. Enhanced liquidity, capital, and regulatory oversight have led to more resilient balance sheets. However, net interest margin (NIM) has been challenged by persistently low rates of growth and inflation against robust deposit growth. The resulting low-yield environment has forced banks to re-evaluate their approach to enhance earnings.

As a debt investor in banks, we welcome strengthened balance sheets. But as a manager of assets for bank balance sheets, (fixed income securities held on the balance sheet or within separate account bank-owned life insurance), we see significant opportunities to improve net interest income through the investment portfolio. This becomes critically important if the low-yield environment persists and deposits remain elevated (see Figure 1).

Structural factors are weighing down yields

While historically low yields further out the curve have recently increased closer to pre-pandemic levels, we believe structural factors that have kept rates low since 2008 are unlikely to go away over our secular horizon of three to five years. These include an aging demographic, wealth inequality, low productivity, and an increased government debt burden (see details in our Secular Outlook, “Escalating Disruption”).

Fixed income securities and cash held on bank balance sheets have grown alongside a decline in loan-to-deposit ratios. These securities portfolios have historically been focused on liquid, low risk-weight government-backed debt, which serves as a liquidity placeholder for funding loans or deposit draws, as well as for asset/liability management. However, these portfolios can also be a strategic lever to manage earnings, liquidity, risk, and capital – thereby diversifying balance sheet risk and potentially enhancing profitability (see Figure 2).

Since 2009, increased holdings of securities (versus loans) have been allocated mostly to U.S. government-related debt. Some of the increase may have been influenced by liquidity coverage ratio (LCR)-related flows into high quality liquid-asset sectors across larger firms – but even non-LCR banks have maintained relatively concentrated government-backed portfolio allocations.

Net interest margin likely to decelerate

Asset allocation choices within the securities sleeve may stem from the need to balance risk concentrations embedded in the loan book, the existence of extra resources (or the lack thereof) to analyze and source securities, and/or philosophical differences on the role the securities portfolio should play within the broader bank balance sheet.

Regardless, the effect of growing cash and government exposures with falling reinvestment yields will cause deceleration of net interest income (all else equal) as legacy holdings with higher yields are paid down. This may be mitigated in a risk-appropriate manner by broadening the scope of fixed income securities held within portfolios and more actively managing economic risk/return (see Figure 3).

For example, if we decompose the securities held on bank balance sheets into the basic risk factors they represent – such as interest rate, credit spread, convexity, and liquidity risk – it’s clear the heavier government debt and agency-backed mortgage exposures across the industry result in portfolios more concentrated in interest rate and convexity risks.

A flexible approach may offer higher yields

As noted, these concentrations may stem from factors such as overall balance sheet composition and preferences, as well as risk-weighted asset optimization. But for those facing a more challenging lending outlook, it’s reasonable to consider a more flexible approach by using the securities portfolio (in part) as a loan surrogate by expanding into high quality, low risk-weight sectors of the fixed income market that may offer higher yield spreads to government debt. Even for banks where lending activity has held up relatively well, the impetus for change may be more for balance sheet diversification – using a broader array of fixed income securities to satisfy liquidity and asset-liability matching goals, while seeking to enhance earnings.

Figure 4 illustrates spreads (adjusted for calls and embedded options) across various bank-eligible fixed income sectors where, based on current valuations, exposures that are most represented within bank portfolios today tend to exhibit less favorable stand-alone risk/return dynamics.

Underrepresented sectors include high quality private-label collateralized loan obligations (CLOs), commercial mortgage-backed securities (CMBS), asset-backed securities (ABS), residential mortgage-backed securities (RMBS), and select corporate bonds – market segments in which valuations adjusted for maturity and embedded call risk can exceed those of sectors most commonly held on bank balance sheets. The optimal mix of sectors, however, will depend on unique asset/liability and other balance sheet preferences and constraints, as there’s no one-size-fits-all solution.

It’s also imperative to take an active approach to securities portfolio construction – leaning into (away from) cheaper (more expensive) segments of the market as valuations change and overall balance sheet dynamics evolve. This approach must be optimized in a book-yield and capital-sensitive framework but can serve to mitigate accumulated other comprehensive income volatility on the balance sheet (see Figure 4).

Banks can use securities portfolios more effectively

More than a decade after the financial crisis, banks continue to endure the impact of low interest rates, which have become the new normal as opposed to an anomaly. One notable by-product has been the growth of fixed income securities held on balance sheets (in line with falling loan/deposit ratios) – but the trend in securities portfolio asset allocation shows little change in the composition of government-backed debt held at repressive yield levels, even for non-LCR banks. We believe expanding the scope of fixed income sectors and using the securities portfolio as a more strategic lever to manage earnings, liquidity, risk, and capital may be a more efficient and effective way to diversify balance sheet risk and seek to enhance profitability.