Car dashboards have changed a lot over the years. The dashboards on most cars built in the 1960s and 1970s had a speedometer, tachometer, and voltmeter, along with fuel, temperature, oil, and water pressure gauges. Modern dashboards have done away with many of these, replacing them with a digital speedometer and infotainment controls. Both vintage and modern car dashboards have one thing in common, though: they provide important indicators to the driver about the car’s performance. Indicators are also vital to the financial markets. One of the most closely watched economic indicators among community financial institutions (CFIs) is the spread between 2Y and 10Y Treasury notes. Also referred to as the yield curve, this indicator provides valuable information about the broad economy and interest rates.Normally, the yield curve slopes upward, with long-term rates higher than short-term rates due to their higher risk. But until last September, when the Federal Reserve started lowering interest rates, the yield curve was inverted for nearly two years. During this time, long-term interest rates fell below short-term rates. Yields Reflect Market ExpectationsThere’s a reason why the yield curve is so closely watched: the yield on the 2Y Treasury note reflects market expectations for the Fed’s policy decisions, while the 10Y Treasury note’s yield reflects expectations for inflation and long-term economic growth. According to historical data, the yield curve has peaked at an average of about 270bp over the past three interest rate cycles (or since 1990). During periods when the yield curve steepened, this was driven largely by sharp reductions in short-term interest rates, which often occur near recessions.An inverted yield curve is challenging for CFIs because it puts pressure on profitability. Thus, a steepening yield curve is welcome news for portfolio managers looking ahead to the rest of this year.
The Yield Curve and CFI PortfoliosGiven the current interest rate environment, many CFIs are probably wondering whether the current rate cycle will mimic those of the past. The answer will have a big impact on strategic portfolio decisions CFIs make this year. If it does, history has shown that the best strategy is to extend durations, reduce premium exposure, and add call protection. However, if the rate cycle deviates from historical norms, the strategy will shift to one of three scenarios:
The Yield Curve and CFI PortfoliosGiven the current interest rate environment, many CFIs are probably wondering whether the current rate cycle will mimic those of the past. The answer will have a big impact on strategic portfolio decisions CFIs make this year. If it does, history has shown that the best strategy is to extend durations, reduce premium exposure, and add call protection. However, if the rate cycle deviates from historical norms, the strategy will shift to one of three scenarios:
- A bull steepener, or downward bias, in which short-term interest rates decline more than long-term rates. If the interest rate decline in the current cycle is lower than historical bull steepener cycles, the best strategy might be to invest in deeply discounted bonds. These include mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs) that feature coupons below current market levels. Alternatively, you could invest in instruments with strong call protection, such as agency bullets, agency CMBS, and municipal and corporate bonds.
- A bear steepener, or upward bias, in which long-term interest rates rise more than short-term rates. Few investments benefit from rising long-term rates, which makes a bear steepener market challenging. Look for investments that will suffer the least harm while reinvesting your cash flow.
- A mixed steepener in which short-term interest rates decline while long-term rates rise. In a mixed steepener market, the best investments will depend on how sharply interest rates move in either direction. This scenario will usually favor investments with maturities that fall around the yield curve’s fulcrum point. You can reinvest prepayments and calls on higher-yielding bonds further out on the yield curve with incoming cash flow.
Be sure to look at the structure and performance of your existing investments as you consider new holdings and repositioning strategies for your portfolio this year.Protection from Rate Risk — and Support for Your BorrowersOne way to protect your CFI from interest rate risk is with a loan-level hedging solution. With over 25 years of experience in hedging, PCBB works with CFIs to mitigate this interest rate risk. We find traditional approaches, such as swaps, can be effective but often come with regulatory, accounting, and collateral burdens. However, there are some hedged loan solutions, including PCBB’s Borrower’s Loan Protection® (BLP®), that allow CFIs to give borrowers the long-term, fixed-rate payment structure they want, while benefitting from a floating rate over the loan’s full term.For your institution, focus on a hedging solution that offers the following benefits:
- Protection against rising or volatile rates without adding balance sheet risk
- Additional fee income
- The ability to offer hedging terms as long as 30 years, providing a competitive edge in commercial lending markets
For your borrowers, focus on a hedging solution that prioritizes the following perks:
- Lock in predictable, fixed-rate debt service
- More confidence in long-term planning without worrying about rate shocks
- A straightforward structure — one fixed periodic payment to your institution
After two years of yield curve inversion, most CFIs are happy to see a steepening yield curve. Pairing smart portfolio management with a loan-level hedging program ensures that not only is your balance sheet protected, but also your borrowers’ needs are met, turning rate volatility into an opportunity for growth.
