The Big Idea

Rebalancing the investment portfolio

Tom O'Hara, CFA | January 19, 2024

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. This material does not constitute research.

A number of banks have started rebalancing their investment portfolios, moving out of bonds with longer duration and low yield and into bonds with shorter duration and higher yields. The resulting realized loss often gets offset with a realized gain. This rebalancing reduces the bank’s overall interest rate risk, which many desire after the bank failures of 2023. It also lifts current income. And equity markets have seemed comfortable with the strategy so far.

Rebalancing from pass-throughs to CMOs

Banks have taken advantage of a number ways to sell longer-duration pass-throughs and replace them with shorter-duration CMOs such as floaters or planned amortization class (PAC) bonds (Exhibit 1). These alternatives usually have significantly less interest rate risk than the pass-through, consistent with a goal of running a shorter-duration portfolio going forward.

Exhibit 1: Example security swap: sell long-duration, buy short-duration

* Floater spread duration, otherwise modified duration
** Floater discount margin, otherwise I-curve spread
Source: Bloomberg, Santander US Capital Markets

While this lifts net interest margin and earnings for the bank, it also realizes a loss. A bank could offset the loss by selling something in the portfolio at a gain, but that could involve selling something with an above-market yield that would reduce portfolio income. Consequently, banks so far have typically looked to sell an asset outside of the investment portfolio. This anecdotally has involved sale of an insurance subsidiary, mortgage servicing rights, Visa B shares or other assets.

The equity markets seem comfortable

Looking at banks that have either announced plans to execute a portfolio rebalancing or have already executed it, their stock prices have done no worse than the overall bank market and arguably have done marginally better (Exhibit 2). Of the 10 banks listed—Auburn National, Bank of Oklahoma, FVC Bankorp, First Busey, Hancock Whitney, Heartland Financial, Pacific Premier, Synovus, Cadence and Equity Bancshares—seven of the 10 have had stock price performance better than the KBW Bank Index. From September 30 through January 11, the median price appreciation of these 10 banks was 25.4%, compared to 21.5% for the index. There are certainly many factors that play into a bank’s stock performance, but the prospect of lower risk and higher earnings may have helped..

Exhibit 2: Rebalancing banks have done no worse than overall bank equity

Source: Bloomberg, Santander US Capital Markets

Reduced portfolio losses should encourage more rebalancing trades

US banks had a total available-for-sale unrealized loss at the end of the third quarter of 2023 of over $282 billion (Exhibit 3). This number is lower today given lower interest rates and higher prices for debt since mid-October, which may spur more banks to move forward with portfolio rebalancing. Additionally, banks have even greater losses on their held-to-maturity portfolios, as this accounting designation had historically been used by banks to stash their longer-duration bonds and avoid any negative mark-to-market implications completely. Unrealized HTM losses stood at $384 billion at the end of third quarter for the industry.

Equity investors have become savvier about unrealized portfolio losses since last year’s bank failures, and are now making adjustments to banks’ capital ratios to account for these losses. Unfortunately, the only way for a bank to manage the HTM portfolio is to allow for runoff, allocating incremental investment to the AFS portfolio, and reducing the size of their HTM bucket over time. Therefore, a more actively managed AFS portfolio that realizes existing losses and reduces the negative mark on the overall portfolio is a welcome activity.

Exhibit 3: Bank securities portfolio unrealized losses

Source: S&P Global, Santander US Capital Markets

Looking at the effective duration of both the AFS and HTM portfolios and applying those durations to the respective interest rate moves for the fourth quarter of 2023 (3-year for AFS, 5-year for HTM), we can estimate the overall portfolio mark-to-market at year-end 2023. This is overly simplistic and ignores the impact of spread movements, among other factors, but provides a directional view as to where marks were at the end of December. Given the significant rally in the fourth quarter, we estimate that almost one-third of the negative AFS mark at the end of the third quarter was recovered. Again, at the margin, this more palatable loss should make banks more willing to transition their portfolios into higher-yielding securities.

Capital preservation should continue to factor into purchases

Along with targeting shorter portfolio duration, the looming Basel 3 Endgame rules should continue to push banks toward favoring 0% risk-weight alternatives. While the endgame rules are receiving massive pushback from the industry and related lobbying groups, capital requirements are still broadly expected to increase – even if the proposals are watered-down significantly.

Banks are therefore prudently looking to proactively reduce capital requirements where possible. This includes a recent increase in the issuance of regulatory capital relief transactions, such as credit-default swaps and credit-linked notes, as well as adding more US Treasury and Ginnie Mae securities to replace portfolio run-off (Exhibit 4).

This group of banks pushed their 0% risk-weight allocation up by two percentage points in the third quarter of 2023 to 21%, and this number should continue to rise in subsequent quarters.

Exhibit 4: Allocation to 0% risk-weight securities should continue to climb

Source: S&P Global, Santander US Capital Markets

Tom O'Hara, CFA
thomas.ohara@santander.us
1 (646) 776-7955

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