If your responsibilities include your community bank’s bond portfolio, you’ve been confounded by several elements of its performance in the last 18 months. To the extent your portfolio has mortgage-backed securities (MBS) and government agency bonds, and the clear majority of all bonds owned by banks are in these two categories, they’ve certainly lost value since 2022. It is easy enough to put the “blame” on the Fed’s Federal Open Market Committee (FOMC), which as of this writing has taken overnight rates up fully 500 basis points (5%) since March of last year. However, something else has occurred in period that’s contributed to the decline in bond prices: Yield spreads have actually widened during this time frame, which is highly unusual for a rising rate scenario. It has aggravated the market losses in community bank portfolios, which stood at around 8% as of June 30. About one-fifth of the market losses can be attributed to spread widening. What’s going on here? Maybe it’s time to review why spreads widen and tighten, and why the various bond market sectors behave differently. If we can conclude with the notion that there are some opportunities for long-term benefit for your bank, all the better. SPREAD BASICS First, a refresher on “spreads” in this context. It is the incremental yield for a collection of bonds, over and above VALUE ADDED High Baseline Yields Accompany Surprisingly Wide Spreads BY JIM REBER, PRESIDENT AND CEO, ICBA SECURITIES the benchmarks. The benchmarks are comparable maturity Treasuries, which are presumed to be risk-free. (We don’t have time here to revisit the recent elaborate game of chicken over the debt ceiling. Notice I said “elaborate” and not “elegant.”) Incremental spreads on bonds will tend to widen as rates fall, as lower yields accompany an economy that is losing momentum. This slowdown brings with it a higher likelihood of debt service problems, so lenders, including bond investors, ask for additional yield protection. In 2023, there’s no slowdown, yet, and so the FOMC has now hiked overnight rates to their highest levels in 15 years in its quest to get inflation under control. And still, spreads are wider in virtually all bond sectors, so something different is in play. One factor is the Fed’s posturing related to its own balance sheet. Currently, the Fed is removing $95 billion per month from its own Treasury inventory. It has reserved the right to actually shed some of its $2.5 trillion MBS portfolio, but hasn’t yet. Another difference this time around is the well-documented decline in excess liquidity on bank balance sheets, which I hasten to add is not the same thing as deposit runoff. Globally, 12 | CURRENCY
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