The bruises that banks' bond investments have suffered over the past year will heal a bit as the industry starts reporting its first quarter earnings on Friday.
That's because long-term interest rates have dropped this year as worries over the economic outlook mount, prompting investors to flee to the relative safety of bonds and driving up their prices. It's a welcome reprieve for many banks, which suffered when the value of their bonds fell last year as interest rates rose, and are now seeing those values partially recover.
The slight improvement in banks' bond portfolios normally wouldn't attract much attention, but it comes weeks after Silicon Valley Bank failed partly because its "unrealized" losses were so big that many of its depositors panicked.
Very few banks
With their bonds slightly less in the red, those banks may think about getting rid of low-yielding, long-term bonds, even if that means absorbing a hit, analysts said. The benefit is that the banks will get more cash or use the sales proceeds to restructure their balance sheet, including by reinvesting in short-term securities that offer a healthy yield as the Federal Reserve keeps raising rates.
"The tactical decision that many bank management teams will have is: 'Do we take advantage of this rally in the bond market and sell some portion of our bonds?'" said Jeff Davis, managing director at the financial advisory firm Mercer Capital.
Doing so may be tricky. After all, Silicon Valley Bank's
The Fed has also drastically reduced any need to sell bonds, launching a
But some banks may still see advantages to selling some bonds and restructuring their portfolios, Davis and other analysts said. They can use the freed-up cash to invest in securities with shorter durations instead of being stuck with longer-term bonds, many of which pay little, since banks bought them at a time when interest rates were low.
"You sort of kill two birds with one stone if you're willing to take the loss," Davis said. "You get immediate liquidity, and then two: You can restructure and … if you reinvest, shorten up the duration and probably get a higher yield than the longer-duration stuff that you just sold."
How many banks will exercise this option is uncertain. Many of them may want to hold off until the dust settles after Silicon Valley Bank's failure and the interest rate outlook clears up. Bankers generally don't feel "any sense of urgency that they need to sell" their bonds, said Ethan Heisler, senior advisor at the ratings agency KBRA.
The unrealized losses have taken a toll on some banks' balance sheets, though the losses are theoretical as long as the banks hang onto the bonds until they mature. Banks' regulatory capital metrics remain healthy, but capital levels "are much thinner" when unrealized losses from their bond portfolios are factored in, according to David Feaster, an analyst at Raymond James.
Selling underperforming bonds "would lock in losses and permanently reduce capital," rather than allowing the banks to take a temporary capital hit, Feaster wrote in a note to clients. Even so, he added, some bankers are evaluating replacing low-yielding securities with higher-yielding ones as a way to boost their earnings.
The time it would take to earn back the upfront capital losses is "too long at this point for most, but we would not be surprised to see a handful consider this," Feaster wrote.
In the months ahead of Silicon Valley Bank's failure, banks were already shifting their securities portfolios a bit more toward shorter-term securities, according to an
That shift may accelerate in the future, long after the initial fallout from last month's crisis. Other banks' deposit bases are far more stable than Silicon Valley Bank's was, but bankers are nonetheless reevaluating how to measure how long their deposits will stick around, KBRA's Heisler said.
Banks are adjusting their models to reflect deposits leaving a bit sooner than they previously expected, Heisler said. There is much uncertainty about what the right time frame might be, but the shorter assumptions on the deposit side of the balance sheet mean that banks will make similar adjustments on the asset side to avoid a big mismatch.
"Because my deposits are going to be shorter, my bond portfolio necessarily also has to be shorter," Heisler said, noting that banks can opt to replace expiring long-term bonds with shorter-term securities, a strategy that avoids bond sales.
Morgan Stanley analyst Betsy Graseck made a similar argument in a research note Tuesday, focusing specifically on the duration of banks' non-interest-bearing deposits, including commercial clients' checking accounts. Those types of deposits are the "gold in bank balance sheets," Graseck wrote, since banks don't have to pay interest on them, and they tend to be "sticky" since it's time-consuming for depositors to switch accounts.
Many of Silicon Valley Bank's deposits were non-interest bearing, and the "quick, en masse deposit exit calls into question many of the assumptions used to determine the duration of this type of deposit," Graseck wrote.
Banks will "likely need to review or re-justify" their current assumptions for how long their deposits will stay, Graseck wrote. She also noted that regulators may indirectly push all banks with more than $100 billion of assets to hold securities with shorter durations by applying the full liquidity coverage ratio to those banks.
"Shorter-duration liabilities will directly translate to increasing shorter-duration assets like cash and shorter-term Treasuries," Graseck wrote.
That shift would have a ripple effect on other markets, her colleagues wrote, including reduced demand from banks for mortgage-backed securities, lower exposures to municipal bonds and smaller demand for collateralized loan obligations.
