Rock (and roll) into a new decade: A look into a previous era can help today’s portfolio managers

It was 20 years ago today
More precisely, it was 20 years ago this year that community banks, and their investment
portfolios in particular, were enduring a period of extremes. Many of the readers of this
column were in charge of their bond portfolios then, and were, proverbially, “Riders on
the Storm”, which involved:
 Inflation, which actually used to be a problem, was gaining traction. The
year-over-year Consumer Price Index (CPI) was more than 3% and rising.
 Since the economy was doing quite well, unemployment dropped from 4.7%
in 1998 to 4.0% at the end of 1999, which was a 30-year low.
 The Federal Open Market Committee, chaired at the time by Alan
Greenspan, was busy stomping on the brakes. Overnight rates rose 250 basis
points (2.5%) between 1998 and 2000, finishing at 6.5%. This remains by
far the highest level we’ve seen since. The 10-year treasury note reached
6.79% in January 2000.
 Bond portfolios’ market values took a beating: The average community
bank’s bonds had more than a 3% loss in 1999, which is enormous on a
historical standard.
In short, it appeared we were on “The Eve of Destruction.”
Glory days
As we’ve learned over the decades, bond portfolio management is a give-and-take
proposition. If your collection of securities is underwater, at least you have the comfort of
knowing that your overall yields are heading “Higher and Higher.” At least, if you
continue to purchase bonds in that environment.
However, 1999–2000 wasn’t a period in which banks were actually buying many bonds,
which is also a mixed blessing. The aforementioned Fed rate hikes accompanied a very
healthy economy, which of course spawned a favorable lending environment, much like
today. Bond portfolios actually shrunk between 1998 and 2000 by a goodly amount of
about 25%. This too is a condition that has repeated itself in the very recent past.
What were once vices…
Peeling back the portfolio onion a bit, we can see how investor preferences and
investment products have changed in two decades. Non-amortizing taxable bonds,
meaning treasuries and agencies, made up a large portion of securities portfolios in 1999;
in fact, more than 30%. Community banks actually owned more agencies than direct
pass-through mortgage backed securities (MBS). It was in this period that “step-ups” hit
the scene and appealed to portfolio managers who were justifiably concerned about a
“Bad Moon Rising,” otherwise known as still-higher rates.
Today, the treasury/agency slice of the “American Pie” is only 12% of the total. These
have been replaced by all manner of MBS and by tax-free munis. Even though banks own
fewer munis than before tax reform went into effect in 2017, the overall industry
profitability creates plenty of incentive to avoid tax liability. Also, particularly for the
bank-qualified (BQ) muni sector, credit metrics recently have been outstanding.
…Are now habits
Portfolio managers in the 21st century have proven to be quick on their feet, and well
informed. The migration out of one-fifth of their tax-free bonds mentioned in the above
paragraph is a perfect example. Something else that community bankers have gotten
comfortable with in relatively short order is the dramatic growth of multifamily MBS.
Bonds with names like DUS, Aces and K’s have become staples in bond portfolios.
Also present is the careful maintenance of average maturities, also known as effective
duration. Around 80% of investments owned by community banks have some type of call
feature attached. Though interest rates have had some wild swings in the past two
decades, and rates have trended lower in that time, bond portfolios’ durations have been
amazingly stable. The portfolio managers and the risk management functions in general
have been able to “Hold on Tight.”
Another success for community banks is their still-low cost of funds. Industry-wide, the
average remains less than 1%, even though the Fed raised rates a total of 10 times
between 2015 and 2018. Included in the toolbox are interest rate swaps, which can be
used to lock in historically low funding costs. Not “Money for Nothing,” but close.
Let’s party like it’s 2020. The Beat Goes On.