Pub. 7 2016 Issue 3

FALL 2016 13 West Virginia Banker High Performance in a Prolonged Low Interest Rate Environment By Bryan Edmundson, Duncan-Williams, Inc. M ost banks have spent the last several years readying their investment portfolios for a rising interest rate environment: investing in cushion coupons, defensive step-ups, and just about any amortizing bond with a short duration. While this ap- proach has seen the yield and duration of bank portfolios shrink, staying fully invested has proven to be a far better approach than the “wait and see” method which forgoes current income. Banks are now faced with a slightly different dilemma: a pro- longed, low rate environment. Most banks would benefit from higher rates. But there appears to be little reprieve in sight: futures markets continue to forecast a slow moving Fed (Graph 1 – Blue g fully invested has proven to be a far better approach than the “wait and see” method which es current income. are now faced with a slightly different dilemma: a prolonged, low rate environment. Most ban benefit from higher rates. But there appears to be little reprieve in sight: futures markets ue to forecast a slow moving Fed (Graph 1 – Blue line), US Treasury debt is still one of the high in the world and while domestic economic data has improved it is still undermined by global mic turmoil. When you take these factors into account, there appears to be little pressure on interest rates. This will result in low bond/reinvestment yields that will drag down yield on g assets. When you partner this with limited loan growth and floored cost of funds it is easy to et interest margin will be pressured. The silver lining is that with the low expectation for future te hikes West Virginia banks should see very low cost of funds (Graph 1 – WV Bank COF correla Fund Futures). Graph 1 Source (Bloomberg LP, Duncan-Williams, Inc.) at now? How can West Virginia banks stay invested and build high-performing portfolios in a lo cenario? Taking a more hands-on approach to portfolio management and consistently assessing performance is going to be critical in answering this question. A buy and hold strategy will be h ly with long-term yields this low and with the curve this flat. The spread between 2yr and 10yr uries is only 84bps which is well below historical averages. This gives little opportunity for bond 0.38 0.85 0.42 0.57 - 0.20 0.40 0.60 0.80 1.00 FF Futures/COF's Fed Fund Futures WV Banks Graph 1 Source (Bloomberg LP, Duncan-Williams, Inc.) line), US Treasury debt is still one of the highest yields in the world and while domestic economic data has improved it is still undermined by global economic turmoil. When you take these factors into account, there appears to be little pressure on higher interest rates. This will result in low bond/reinvestment yields that will drag down yield on earning assets. When you partner this with limited loan growth and floored cost of funds it is easy to see that net interest margin will be pressured. The silver lining is that with the low expectation for future Fed rate hikes West Virginia banks should see very low cost of funds (Graph 1 – WV Bank COF correlated to Fed Fund Futures). So what now? How can West Virginia banks stay invested and build high-per- forming portfolios in a low rate scenario? Taking a more hands-on approach to portfolio management and consistently assessing bond performance is going to be critical in a swering this questio . A buy and hold strategy will be hard to apply with long-term yields this low and with the curve this flat. The spread between 2yr and 10yr US Treasuries is only 84bps which is well below historical averages. This gives little opportunity for bonds to “roll d wn t e curve” and appreciate in value. For a portfolio to generate value, portfolio managers will have to be very opportunistic over the next few years which may be a slightly different approach to managing the investment po tfolio than many bankers are accustomed to. n MFA — continued on page 14