20 SEPTEMBER / OCTOBER 2020 FINANCIAL MANAGEMENT Sticking to Your Strategy To avoid pitfalls in a low-rate environment Dale Sheller Senior Vice President, Financial Strategies Group The Baker Group dsheller@GoBaker.com The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member. In an emergency meeting on Sunday, March 15, the Federal Reserve announced it was dropping its benchmark interest rate to zero and launched a new round of openended quantitative easing. The move was a direct response to the coronavirus outbreak, which had disrupted economic activity around the world, including the United States. During this time, the 10-year and 30-year Treasury bond yields reached all-time lows as dollars flowed into the Treasury markets seeking the “full faith and credit” of the U.S. government. The moves by the Fed and the markets left financial institutions with a U.S. Treasury curve at historic lows. As a result, institutions with asset-sensitive balance sheets are facing the likelihood of margin compression. So here we are with low interest rates following a severe economic downturn. Hey, I’ve seen that movie before! In 2008, the Fed sharply cut its target funds rate down to zero in an effort to spur lending and jump-start overall economic activity. In the crisis environment of 2008-09, many banks were tempted to purchase investments outside their typical investment purchases in order to find yield. Private-label mortgage-backed securities and collateralized mortgage obligations, trust preferred securities, preferred stock and subordinated debt were a handful of the types of investments that were purchased. In the wake of that crisis, many of those securities experienced major losses or became worthless. More than a decade later, we’re seeing a resurgence of some of these same types of investments. Dodging Bullets If you are shown an investment offering a yield that seems a little too good to be true, ask questions! Educate yourself and understand the risks. There is almost always a reason for the increased yield, as bond markets are efficient at pricing in risk. As the saying goes, “there is no free lunch in the bond market,” meaning in order to increase the yield or reward received on a bond, you must take on more risk. That increased risk usually comes from a combination of credit risk, interest rate risk and liquidity risk. A recent example of potential trouble is bank subordinated debt. Many banks are actively taking advantage of today’s low interest rate environment to issue relatively cheap subordinated debt to bolster their capital levels (Tier 2 capital). Furthermore, with many economic uncertainties on the horizon, it makes sense for some banks to issue subordinated debt to boost their overall capital positions and total risk-based capital ratios ahead of the economic uncertainty. The issuers are acting rationally, but what about the risk to those who buy these bonds? It’s true that subordinated debt offers enhanced yields. It comes, however, at the cost of increased credit and liquidity risk. When a bank fails, there are numerous claims on a failed bank’s assets, and the holders of subordinated debt are usually left with little to nothing. Data from the last financial crisis shows a high “loss given default” percentage on failed banks’ subordinated debt. Investment in subordinated debt should be looked at as an unsecured loan to another financial institution. As a result, regulators tend to take a harsher view on
RkJQdWJsaXNoZXIy MTg3NDExNQ==