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US banks increase exposure to longer-dated bonds despite regulators' concerns

U.S. banks boosted their exposures to longer-dated bonds in the third quarter despite warnings from regulators over taking on too much interest rate risk.

The Federal Deposit Insurance Corp. highlighted once again in late November that low interest rates and competition for quality loans have prompted some banks to reach for yield through investments in higher-risk and long-term assets.

"Banks have been extending asset maturities to increase yields and maintain margins in a low-rate environment. This has, however, left many institutions more vulnerable to interest-rate risk," FDIC Chairman Martin Gruenberg said in the agency's quarterly bank profile. The FDIC raised the same concern three months earlier.

Expanding duration in the securities portfolio can boost net interest income since longer-dated bonds tend to carry higher yields. Bonds expected to reprice or mature in excess of 15 years rose to 31.34% of bank-held securities at the end of the third quarter from 28.82% at year-end 2016 and 28.25% in the year-ago quarter.

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While longer-dated bonds tend to offer banks higher yield than shorter-term assets, they can also be risky if interest rates rise notably. If rates rise, banks likely would hold on to below-market-rate securities for longer periods of time, while funding costs move higher.

Some advisers that help banks manage their investment portfolios believe the FDIC's words of caution against extending asset maturities are warranted.

"I think we would agree with what the regulators have highlighted in that the search for yield comes with risk, particularly in some of these products," Thomas Luciano, senior vice president at PIMCO, said during a webinar hosted by S&P Global Market Intelligence in mid-November.

Luciano said the easiest way for banks to extract yield from their investment portfolios is to extend duration and go further out the yield curve, either by investing in mortgage-backed securities or municipal bonds.

"As we've seen over the past few quarters, especially talking to some of our clients, their mortgage portfolios have extended, as expected," Luciano said.

RMBS durations tend to extend as interest rates rise due to slower expected prepayment speeds on the underlying mortgages. Most banks' exposure to RMBS held fairly steady in the third quarter at a median of 28.94% of all securities, compared to 29.19% in the prior quarter and 30.18% a year earlier.

Banks, meanwhile, increased their exposure to municipal bonds, many of which are longer-duration assets. Municipal bonds represented a median of 29.44% of securities at the end of the third quarter, up from 29.00% of securities in the prior quarter and 23.95% three years ago. Those balances have become even larger portions of bank balance sheets even as investment portfolios have grown.

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Banks continued to build those positions in the third quarter as long-term rates tested new lows for the year in September, even in the aftermath of a pair of rate hikes by the Federal Reserve in March and June. Investments in longer-dated bonds likely helped mitigate some of the pressure on security yields stemming from declining long-term rates in the second and third quarters, when the 10-year Treasury yield averaged 2.25%, 20 basis points below the average in the first quarter.

Long-term rates have rebounded over the last few months. While the Fed began the long-awaited unwinding of its balance sheet in October, most market observers attribute the increases in long-term rates to positive signs in the economy as gross domestic product grew by 3%, annualized, in the third quarter. The market also reacted to news that Congressional Republicans made progress on proposed tax reforms.

Chitrang Purani, executive vice president and portfolio manager focused on financial institutions at PIMCO, said during the webinar that many 10-year sovereign rates across the globe remain quite low. He said the differentials between those global rates and the yields offered in the U.S. serve as an effective cap on the 10-year Treasury. Purani noted that the front end of the yield curve remains vulnerable to further rate hikes by the Fed. He said, however, the economic impact of proposed tax reforms might not be as great as some expect. He said PIMCO is a little cautious about policy changes coming out of Washington, D.C., and believes some of that caution has been priced in the fixed income markets with the recent flattening of the yield curve.

At the time of that webinar, the spread between the yields on the 2-year and 10-year Treasurys had narrowed to 65 basis points, from more than 125 basis points at the beginning of 2017. In more recent weeks, the yield curve has flattened further, with the spread between the 2-year and 10-year Treasury contracting to 55 basis points as of Dec. 6.

"As you've seen the curve flattening, part of that flattening can be potentially attributed to the fact that inflation expectations remain low," Purani said, "and the expectations around the tax package aren't as constructive from the fixed income investor standpoint."

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