Asset-liability impact of the coronavirus rally in debt
admin | February 28, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Most US Treasury rates have dropped by 60 bp or more since the middle of January, putting a new round of potential pressure on portfolios at banks, insurers and other asset-liability managers. Portfolios that held mortgages or other callable assets now face shorter durations on assets and lower reinvestment rates. If the cost of liabilities did not come down, then net interest income is at risk. These portfolios have a few levers to pull to mitigate the risk.
The pressure on banks
US banks hold nearly $4.2 trillion of MBS and mortgage loans or 30% of total assets. Using estimated duration on the Bloomberg Barclays MBS Index as a benchmark, the duration of holdings has moved from 3.0 years in the middle of January to 2.4 years currently. The recent rise in the MBA Refinancing Index to a 5-year high points to heavy prepayments and reinvestment at least through the middle of the year if not beyond.
The market move leaves the banking sector with challenges to the value of the balance sheet and net interest income. With the loss of duration in assets, assuming an initial duration-neutral balance sheet and no change in the duration of liabilities, any continuing drop in rates could see the economic value of liabilities rise faster than the price of assets. Net interest income, which peaked at the end of 2018, should continue dropping.
Some important choices for banks:
- Leave current asset duration in place. Banks could take the resulting interest rate risk and reinvest in floating-rate assets, which, in the current market, often carry yields higher than fixed-rate alternatives. Steady reinvestment in floaters would likely further shorten asset duration.
- Extend asset duration to rebalance to liabilities. Banks could mitigate reinvestment at lower yields by moving into assets with more negative convexity, into lower credits, into less liquid assets or into some combination.
- Shorten liability duration. Banks could swap fixed-rate bullet deposits such as CDs, its own fixed-rate corporate debt or other similar sources of funds back to floating, assuming the swaps gets hedge accounting.
The pressure on insurers
Life insurance general accounts hold $280 billion in agency-backed securities, most of them agency MBS, or less than 5% of total assets. Insurers also hold unsecuritized residential mortgage loans. These assets also have likely shortened in duration, creating duration and reinvestment issues similar to banks’. The choices in mitigating those issues parallel banks, although insurers historically have taken more credit and liquidity risk in the investment portfolio
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