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As rates move higher, growing HTM portfolios should offer banks some protection

Some banks' moves to protect against rising rates just might pay off in the near future.

A number of banks have steadily built their held-to-maturity bond portfolios to shield securities from swings in the market. The benefit of those decisions could be evident when banks report fourth-quarter earnings now that long-term rates have jumped in the aftermath of the U.S. presidential election.

Banks have more than doubled their held-to-maturity portfolios in the last three years as they have reacted to new capital and liquidity standards and prepared for higher interest rates. Much of the increase in HTM portfolios came while long-term rates remained low.

Securities with longer durations could face intense pressure when rates move higher but HTM portfolios can offer institutions some protection from changes in the market. Unlike available-for-sale portfolios, HTM portfolios are not subject to mark-to-market adjustments on a quarterly basis. Those mark-to-market adjustments in AFS portfolios flow through accumulated other comprehensive income and impact tangible common equity. Banks have sought to mitigate the impact of changes in market valuations on their book values through an increased reliance on HTM portfolios.

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The market has changed considerably in the last month and a half. Long-term rates fell for most of 2016 but have jumped since the surprise election of Donald Trump as the next U.S. president. Shortly after the election, investors sold long-term Treasurys on the belief that Trump will increase the deficit by boosting infrastructure spending while cutting taxes. The yield on the 10-year Treasury has jumped 66 basis points since the election, rising to 2.54%, or nearly 100 basis points higher than witnessed at the end of the second quarter.

The increase in long-term rates appears to have negatively impacted valuations of banks' bond portfolios. Since the end of the third quarter, the Federal Reserve's H.8 release, which tracks commercial bank balances, shows that the group of institutions reported net unrealized losses totaling $5.5 billion through Dec. 7. That compares to a net unrealized gain of $28.0 billion at Sept. 30.

Compass Point analysts noted in an early December report that banks with large available-for-sale securities portfolios likely would see unrealized losses in the fourth quarter, adding that the shift could have a meaningful impact on tangible book values.

"On average, we expect banks could see a 3.1% reduction in TBV in 4Q based on the recent move in interest rates," the Compass Point analysts wrote in the report.

Banks have looked to limit the impact on their tangible book values by increasing HTM portfolios to 24.3% of all securities at the end of the third quarter, up from 22.0% a year ago and 19.5% two years ago.

In the third quarter, the banking industry in aggregate grew HTM securities by 17.2% from year-ago levels, while AFS securities inched 3.0% higher in the period.

The threat that raising rates could pose to banks' securities portfolios has become even more pronounced for institutions with more than $50 billion in assets, which are subject to the liquidity coverage ratio. That provision requires them to hold higher concentrations of market-sensitive securities such as Treasurys and Ginnie Maes.

Other regulations have caused banks to be more wary of swings in the market and the impact changes in values would have on their balance sheets. The originally proposed Basel III rules in the summer of 2012 required AOCI to flow through regulatory capital at all banks. Ultimately, a year later, the final Basel III rules allowed non-advanced approach institutions, generally those with less than $250 billion in assets, to opt out of that provision.

HTM portfolios have grown by 106.4% since the LCR surfaced in proposed form in the fall of 2013, while growing considerably more since the Basel III rules were first proposed. Conversely, banks' AFS portfolios have risen 4.5% since the fall of 2013.

RMBS remain by far the largest portion of securities in banks' HTM portfolios and have grown in recent quarters, rising to 59.7% of all bonds in those portfolios in the third quarter from 59.3% in the linked quarter and 58.1% a year earlier.

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To analyze available-for-sale securities portfolios of banks and thrifts in an Excel template, click here.

Click here to view a video tutorial on how to use SNL's tools for CAMELS Analysis.

Bank holding companies report information about held-to-maturity and available-for-sale securities on FR Y-9C Schedule HC-B, which can be accessed under the Regulatory Financials section of a company's Briefing Book page on the SNL website or in SNLxl.