Choosing from 0% risk-weighted assets

Chris Helwig | June 7, 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.

Banks continue to navigate mark-to-market losses in their investment portfolios with an eye on possibly higher regulatory capital in the future, and that has put assets with 0% risk weights centerstage. Every bank will make its own tradeoff between market liquidity yield, duration and size. But some combination of cash, CMO floaters, pass-throughs and Treasury debt looks realistic, possibly with some supra sovereigns thrown in.

The actionable menu of assets with 0% risk weights for US banks is straightforward (Exhibit 1):

Exhibit 1: The menu of actionable assets with 0% risk weights

Source: FDIC, Santander US Capital Markets

The menu of 0% risk-weighted assets offers a mix of market liquidity, duration, yield and available size (Exhibit 2):

Exhibit 2: A sample mix of 0% risk-weighted assets

Note: OA analytics using Bloomberg. All market levels as of 6/6/24 2:20p ET

Some thoughts on building the 0% risk-weighted portfolio.

Liquidity: The aftermath of Silicon Valley Bank has put a new premium on liquidity, and nothing has the liquidity of reserves held at the Fed. Fortunately, reserves provide a 5.40% yield. For now. Reserves also have no market exposure, which has also become more important after SVB. Most investment portfolios understandably start with reserves. Then the question moves to investing the remainder of marginal cash after core liquidity needs—plus a cushion—are met. US Treasury debt can nearly match reserves for liquidity, but Treasury yields run below the yield on reserves, and the longer the duration the larger the shortfall.

Yield: A range of floating-rate instruments top the yield paid on reserves. And because the coupon on these instruments float off short indices, they offer some of the highest yields among instruments with 0% risk weights. The set includes SBA pools, Ginnie Mae structures backed by reverse mortgages (HECM), and Ginnie Mae CMO floating-rate classes. The uncapped SBA and HECMs match reserves with nearly zero duration and add yield, so they become the easiest extension from reserves. But SBA and HECMs also come with limited liquidity and with limited size, both potential drawbacks. Ginnie Mae CMO floaters add additional yield and have much better liquidity than SBA pools and HECMs but come with more duration and negative convexity. CMO floaters look best-in-class on this part of the menu.

Duration: Long duration and material negative convexity attract a lot of new attention after SVB, especially from senior management, bank boards and regulators. The assumption here is that banks target duration of between 2.5 years and 3.0 years. Because of the shape of the yield curve, extending duration drags current yield below the levels available from some of the floating-rate instruments. But banks may still want duration to reduce their asset sensitivity. Of the available choices, Ginnie Mae pass-throughs around par add the most yield but come with negative convexity. Ginnie Mae sequential classes show lower yield than pass-throughs and less negative convexity, and PACs also show less yield and less negative convexity than pass-throughs. The comparable OAS across pass-throughs, sequentials and PACs suggests the market fairly prices the relative risks. That pushes the decision to other attributes. Pass-throughs look like a good way to add yield and duration and keep liquidity high, along with sequential classes to reduce negative convexity. Treasury debt and supra sovereigns also add duration and positive convexity, but at lower yield.

Punchline: Start with reserves to meet liquidity needs, plus a cushion. Add CMO floaters, pass-throughs and sequential classes for yield, plus a cushion. Add Treasury debt and a small amount of supra sovereigns for liquidity and convexity.

One more thought: Ginnie Mae CMO floaters with low caps—current examples have 6.5% caps—offer an interesting combination of yield and duration. If interest rate rise, these floaters should drop in price but more slowly than the underlying pass-throughs. And if interest rates fall, the floaters should rise in price, although rising much above $101 will be difficult because of the limited audience for premium floaters. Floaters with low caps strike a useful balance between high yield today and more duration than other floating-rate alternatives.