Bank Bond Portfolios Turn from Obstacle to Opportunity

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As we enter the fourth quarter of 2023, bank management’s focus is shifting from liquidity to profitability. While the stress of March has subsided, the challenges it ignited remain. It’s not the availability of funding that is a core issue for banks but the cost. Net interest margins for regional and community banks have fallen 22bps, and profitability, as measured by pre-provision net revenue (PPNR), peaked in late 2022.

Funding cost increases are a primary driver of earnings compression. With a "higher for longer" interest rate outlook and the possible end of a 40-year bull market for interest rates, the banking industry's path to earnings growth looks challenging. Bank equity pricing is beginning to reflect this “potential” new paradigm.

With this backdrop, bank managers and investors alike seek the right levers to pull to outperform these lowered expectations.

Broadly, unrealized losses in fixed-income assets for the banking industry sit near $600 billion, approximately 20% of the overall capital base. While seen as an albatross during much of the past 18 months, bond portfolios can become a potential vehicle for repositioning the balance sheet.

For regional and community banks, second-quarter earnings releases gave insights into management's thoughts on bond portfolio strategy. Unfortunately, much of the conversation concerns "burn down" or “recapitalization.” On the surface, this view looks compelling. Bond losses shrink over time as portfolios roll over and unrealized losses in tangible equity slowly disappear, giving the appearance of book value growth.

This defensive approach may work for some, but while this may be the path of least resistance, it also creates a longer runway for underperforming bond assets. The average bond portfolio yield across the banking industry hovers around 2.50%, but with the Fed Funds rate at 5.50% and marginal funding costs increasing every quarter, a sizeable fixed-income portfolio can become a drag on earnings power.

Those institutions with an offensive mindset have been more aggressive with potential balance sheet restructuring strategies. While it’s not without costs, banks can turn bond portfolio challenges into franchise value opportunities.

As the industry faces rising costs, a changing credit landscape, and an uncertain interest rate cycle, there has been an uptick in institutions’ interest in selling bonds to restructure the balance sheet. The strategy predominantly requires recognizing previously unrealized losses. However, the afforded flexibility and future positive financial statement impact justify the cost for many. Realized losses are captured in the year of recognition, whereas margin erosion lingers for years.

Historically, depository investors focused primarily on trade economics, income, and time to recoup losses. While this traditional approach suffices for small transactions, the objective of this strategy is larger. The goal is to improve net interest margin and profitability measures in the future at the institution level while having a minimal impact on current capital levels. For public companies, forward earnings growth is imperative from the market perspective. Realized losses may lower 2023 earnings, but market multiples will reflect more robust profitability, creating shareholder value through market cap expansion. The same can be true for private companies, although more nuanced. Higher future ROE and profitability drive valuations, another source of franchise value creation.

This strategy does come with roadblocks. Apart from those institutions concerned with capital levels, there has been a surprising reluctance to realize losses. Part of this reluctance stems from the management compensation structure many banks employ, whereby realized losses on securities reduce incentive compensation. In this case, management is incentivized to maximize short-term earnings, which may not be in the best long-term interests of shareholders.

A "higher for longer" interest rate environment coupled with the possible end of the 40-year interest rate bull market sets the stage for a challenging environment for depository earnings. While the investment portfolio has been an obstacle over the last 18 months, today, it can create an opportunity for offensive-minded management teams to outperform their competition, as earnings growth may be hard to come by in 2024.

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