Viewpoints

Positioning U.S. Community Bank Investment Portfolios for 2015

Banks may not want to take extreme views toward investing cash or harvesting liquidity.

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Banking publication SNL Financial recently sat down with members of PIMCO’s Financial Institutions Group to discuss PIMCO’s latest views on the current interest rate environment. Chitrang Purani, senior vice president and portfolio manager, and Thomas Luciano, vice president and account manager, also discussed banks’ reactions to the continued decline in long-term rates and where banks can find value in today's market consistent with their liquidity needs. This interview was initially published on the SNL Financial website in a modified form.

Q: PIMCO has thought rates would remain lower for longer than many other market participants believed. That thesis has been borne out thus far, and rates fell even further earlier this year. Have you seen the decline in long-term rates change banks' investment strategies?
Chitrang Purani: According to the most recent regulatory filings, banks have continued to lock in gains from the fall in longer-term rates by moving securities into held-to-maturity (HTM) status. Based on Federal Reserve 3Q14 call report data, HTM balances have increased roughly 6% year over year, though this maneuver is more pronounced within the larger banks, as their Tier 1 capital is vulnerable to shifts in unrealized losses. Anecdotally, we observe that community banks continue to be conservative in taking interest rate risk within portfolios following the “taper tantrum” in May 2013, which likely led to diminished income and gains. With respect to broader sector allocation, we see larger year-over-year increases in liquidity coverage ratio (LCR)-friendly sectors such as Treasuries and agency MBS, particularly across the larger banks, as well as some increases in municipals late last year as spreads generally widened across credit sectors.

Thomas Luciano: For community banks, three key things have been in focus as a result of lower-for-longer rates: first, revisiting the timing of rate hikes from internal forecasts; second, reviewing investment policies and risk budgets to determine tolerance to add portfolio exposure to additional asset classes; and third, reviewing the local lending environment. This is specific to the community bank space as opposed to the LCR institutions. All three of these points affect the willingness to improve yield in the investment portfolio given uneven loan growth throughout the U.S.

Q: Some banks have instead opted to keep their “powder dry.” What would you say to the average bank that does not want to invest at today's yields?
Purani : Banks should not take an extreme view toward harvesting liquidity when profitability is an ongoing concern and loan growth has been broadly uneven across regions. We do believe that the right level of liquidity, or “dry powder,” will depend on each bank's unique circumstances, but there are opportunities to earn income without taking excess interest rate risk or limiting flexibility against the need to fund future opportunities in the markets.

Currently, we don't see as much value in interest rate or duration risk for portfolios as yields imply a moderate path and destination for future policy rates. We are also cautious on prepayment or convexity risk in light of the decline in rates; prepayment volatility currently represents the largest component of portfolio risk for community banks in the form of elevated agency mortgage exposure.

However, demand from foreign investors may continue to support Treasury yields in the near term given extremely low rates abroad and expansion of foreign central bank balance sheets. In addition, some institutions may be concerned that the fed funds rate will rise over the long term as it had in past cycles. PIMCO expects long-run policy rates will be below levels that prevailed before the financial crisis due to an elevated leverage overhang and modest rates of potential growth. This is our New Neutral secular thesis, and since it was first introduced last year, market levels have converged closer to this view.

Q: A community bank can buy the paper of a large conglomerate such as GE instead of exposure to only a single market such as El Paso, Texas. Historically, we haven't seen banks put a lot of money to work in this way, but have you seen greater appetite or willingness from banks to do so?
Luciano: We have. The corporate credit allocation is not going to represent a material percentage of the portfolio because of the risk weights that are assigned to the asset class itself and the view by many asset-liability committees that credit risk should be taken in the loan portfolio. But from a risk factor perspective, it does diversify the portfolio. When you look at the majority of the assets that have been reassigned to HTM from available-for-sale (AFS), they have been the interest-rate-sensitive assets (i.e., collateralized mortgage obligations and some agency residential-mortgage backed security pass-throughs). Having corporate credit and other types of credit-based products in the portfolio helps diversify that exposure to rates, but it also helps to address, for instance, the risk that some banks might not be underwriting the best loans or using the best standards or guidelines. This is a way for them to supplement their income without taking undue risk in the loan book.

Purani: Currently, credit risk within community bank portfolios is largely represented by municipal exposure. As of 3Q14, community banks had more than 20% of their securities holdings allocated to municipals. In addition to diversifying into select corporate credits, as Tom addressed, various structured or securitized debt not backed by agencies has also been gaining interest and may provide lower risk weights than corporates, depending on underlying delinquencies and subordination levels. In these instances, banks may find high-quality yields that can complement the loan portfolio and buffer potential increases in interest rates without onerous capital charges.

The approach to optimizing profitability with the securities portfolio is a holistic one: Understand the concentrations and opportunities on the loan side, size up liquidity/funding and capital within the balance sheet, and then utilize the securities portfolio effectively to fill in the gap and enhance profitability.

Q: If a bank is keeping its powder dry because it is concerned about rates moving, looking at floating-rate products has to be a better trade than sitting on cash. Is that the decision that banks need to make right now? Do they need to prove they have a plan to put cash to work?
Purani: It's always a trade-off between what you believe you can earn on cash by waiting and investing in the forward environment versus what you can earn today. There’s no crystal ball to predict what the forward environment will bring, which is why we come back to having a balance. Taking an extreme view toward investing the cash or harvesting liquidity is not optimal against elevated uncertainty in the markets and when profitability is an ongoing concern.

The Author

Chitrang K. Purani

Portfolio Manager, Financial Institutions

Thomas Luciano

Account Manager, Financial Institutions Group

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