U.S. banks have steadily increased their exposure to longer-dated bonds over the last two years, even though regulators have flagged the practice because it makes banks more vulnerable to rising interest rates.
Longer-dated bonds generally offer banks higher yield than shorter-term assets, but this strategy can bring risk if interest rates rise significantly. In that case, banks likely would hold on to below-market-rate securities for longer periods of time, while their funding costs move higher.
The FDIC once again highlighted in its quarterly bank profile that banks have responded to low interest rates and competitive lending conditions by "reaching for yield" through investments in higher-risk and longer-term assets. The agency has raised the same concern in every quarter since the fourth quarter of 2016. The OCC made a similar observation in its most recent semiannual risk perspective in the fall of 2017, noting that the low-interest-rate environment pressured banks to "reach for return" by extending credit and liquidity risk exposures and lengthening asset duration.
But banks have continued to reach further out the yield curve to combat persistent margin pressure. Bonds expected to reprice or mature in excess of 15 years rose to 31.62% of bank-held securities at the end of the fourth quarter of 2017, up from 28.82% at year-end 2016 and 26.25% at year-end 2015.
Some banks have substantial exposure to longer-dated bonds. At the end of the 2017 fourth quarter, securities expected to reprice or mature in excess of 15 years equated to more than 75% of securities at 49 banks, while those positions comprised more than 50% of investment portfolios at 200 institutions. Most of those institutions were relatively small in size, with a median asset size of less than $350 million.
Meanwhile, some banks have maintained large exposures to securities on the short end of the yield curve, with 505 institutions reporting that more than 75% of their portfolios were in securities set to reprice or mature in less than three years.
Investing in short-duration assets, particularly in the fourth quarter of 2017, might have seemed wise as long-term rates rose considerably off recent lows. The yield on the 10-year Treasury fell to 2.05% in early 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 that came with falling 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.
But opportunities to put new cash to work emerged in the fourth quarter, when long-term rates rebounded considerably as economic conditions improved. The market also reacted to the prospect of tax reform in the U.S., and then yields rose even further after tax legislation was enacted.
The yield on the 10-year Treasury has risen by about 80 basis points through mid-March since the recent lows in September 2017, leaving banks with far more attractive investments today than were available six months ago.
Banks that reached further out the yield curve last year, however, might not have the same ability to take advantage of new opportunities and could find themselves sitting on lower-yielding securities as funding costs continue to rise.