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US bank bond portfolios should close 2019 firmly in the black

Bank bond portfolios should close 2019 firmly in the black but will not offer the same boost to tangible book values during fourth-quarter earnings season as seen in recent periods.

Long-term rates fell in 2019, with the yield on the 10-year Treasury dropping close to 75 basis points. However, much of the decline came in the first nine months of the year amid concerns about slowing global growth and the brewing trade war between the U.S. and China. The Federal Reserve responded to concerns about slower economic growth with a trio of rate cuts in July, September and October and recession fears have dissipated some, allowing long-term rates to rebound in the fourth quarter.

Economists surveyed by The Wall Street Journal in December pegged the probability of a recession occurring at 26%, down from 35% in September. The yield on the 10-year Treasury rose 22 basis points in the fourth quarter with the improvement in macroeconomic sentiment, which likely put pressure on bond values in the period since prices move inverse to yields.

Most banks' available-for-sale securities portfolios, which hold the majority of bonds owned by the industry, should show slightly smaller gains in the fourth quarter when compared to the prior quarter. Value changes in AFS portfolios impact tangible common equity, and the negative shift could result in a smaller lift for tangible book values in some banks' fourth-quarter reports, which will begin to surface in mid-January.

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The Federal Reserve's H.8 release, which tracks all commercial bank balances, shows that the group reported $14.3 billion in unrealized gains in their AFS securities portfolios through the week ended Dec. 18, 2019. While remaining in positive territory, portfolios have moved in the negative direction since the end of September, when institutions reported $18.6 billion in unrealized gains, a few days before the third quarter closed.

In the third quarter, institutions including U.S. commercial banks, savings banks, and savings and loan associations that file GAAP financials reported $13.31 billion of unrealized gains in their AFS portfolios, compared with $7.89 billion in unrealized gains in the second quarter.

Some banks have shielded their investment portfolios from large valuation swings by placing significant amounts of securities in their held-to-maturity, or HTM, portfolios. Unlike AFS portfolios, banks do not have to mark those portfolios to market on a quarterly basis.

U.S. banks have grown their HTM portfolios considerably in the last five years, but some advisers have questioned the move, arguing that any acquirer or investor valuing the institution would still assume the market value of bonds in HTM portfolios. Increased reliance on HTM portfolios could also bring additional interest rate risk since banks are essentially locking in the yields on securities held in that bucket.

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Banks might have heeded these warnings in recent quarters, reducing their allocation to HTM portfolios. However, some of the move has also come since the passage of the Economic Growth, Regulatory Relief and Consumer Protection Act in May 2018, which gave institutions with assets between $50 billion and $100 billion immediate relief from enhanced prudential standards. The Fed subsequently proposed plans to provide a further off ramp for certain regulations applied to some banks with assets between $100 billion and $250 billion, including the liquidity coverage ratio, which required them to hold higher concentrations of market-sensitive securities.

Through the third quarter of 2019, HTM portfolios fell to 28.1% of securities from 29.0% in the prior quarter and 30.5% a year earlier. With the recent decline, the balances now are at roughly the same level as two years ago but remain considerably higher than witnessed before the passage of the LCR and the Basel III capital rules.

The Basel III rules proposed in 2012 required accumulated other comprehensive income to flow through regulatory capital at all banks. A year later, the final Basel III rules allowed institutions that fall under the nonadvanced approach capital framework — generally those with less than $250 billion in assets — to opt out of that provision.

HTM portfolios have nearly tripled since the liquidity coverage ratio surfaced in its proposed form in the fall of 2013 and have increased even more since the Basel III rules were proposed. Banks' AFS portfolios, meanwhile, have grown modestly since the latter half of 2013.

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