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Banks Fear Investment Risks Stemming from Period of Low Interest Rates

Data from the first six months of 2016 show that the extended period of low interest rates has negatively impacted yields through the industry. Many banks have either moved bond durations out or hiked their investments in floating-rate bonds in efforts to staunch decreasing investment income or gain more yield.

Rates have been historically low for an unusually long span of time, and decreased more after the late June U.K. vote to leave the European Union. Bank margins are experiencing even more pressure as a result, and bank managements are seeking solutions.

Treasury yields are at historically low levels.

Security Yields Fall in the Second Quarter

A recently released report by SNL indicates that security yield across the banking sector was 2.06% in 2016's first half, a decline of 12 basis points from 2015 levels and over 20 basis points below 2013. Long-term rates dropped significantly during the 2013-2015 period.

Over the last two years, yield on the benchmark 10-year Treasury has dropped accordingly. In the first half, it declined 80 basis points, and has not risen appreciably since the first half ended.

As a result, banks feel the pressure of reinvestment risk as they need to put cash flows to work in a lower interest rate environment.

PNC Financial Services Group Inc., for example, reported a 2.68% earnings yield during its second quarter earnings report. However, the company also noted any replacement of existing securities are forecast to yield just 1.69%, nearly 100 basis points below the current yield.

Banks are seeking ways to minimize margin pressure.

Contrasting Strategies

Extending duration is a strategy for some banks. Pacific Continental Corp. reported during its second quarter earnings report that the average duration in its securities portfolio was 4.2 years at quarter end versus 3.7 years at the end of the first quarter of 2016. The increased duration was undertaken to gain more interest income and yield on Pacific Continental's portfolio.

However, banks' abilities to shift their bond portfolios to take advantage of longer duration or floating rates needs to take into account U.S. banking regulations, of course. The liquidity coverage ratio, for example, mandates that banks holding over $50 billion of assets keep liquid assets of a high quality that total more than the cash outflows forecast. The high quality liquid assets are often low yielding bonds such as Treasure notes and agency debt. Indeed, banks under this regulation owned over 73% of all securities in the banking industry at the end of 2016's first half.

Despite regulatory pressures, however, the amount of government bonds held in bank bond portfolios during the second quarter did fall. (The government securities categories includes Treasury notes, government agencies, and government-sponsored agencies.) They were 18% of total security portfolios in the second quarter versus 23% in the year-prior quarter and 20.3% in the first quarter of 2016.

These type of securities are sensitive to long-term interest rate fluctuations. Their prices are likely to drop if rates begin to climb.

If you are facing margin pressure, contact a seasoned loan sale advisor. Garnet's loan sale advisory service specializes in meeting the needs of banks. There are a number of high quality, short duration portfolios available that will meet those needs more profitably than securities currently can.

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