Put Unrealized Losses to Good Use

By Jim Reber, President and CEO of ICBA Securities

This just in: community bank investment portfolios have lost value in 2018. The rest of this column contains good news. At least, it does for those community bank portfolio managers who are interested in improving future earnings, creating a more diversified collection of bonds, tweaking their risk profile and, yes, deferring income. I hope that includes you.

Before we get into the numbers, and at the risk of being Master of the Obvious, I want to mention that all of the decline in value this year is for the purest of reasons: rising interest rates. In the recent past (i.e. the last decade), there have been certain securities whose prices had plummeted because either credit quality had deteriorated or spreads had widened. Two of the more notable examples of this are the cratering of Fannie Mae/Freddie Mac Preferred Stock in the aftermath of their being placed in receivership in 2008, and a couple of episodes of disruption in the muni market. Does Meredith Whitney on “60 Minutes” ring a bell?

Where we are

Even though we’re now a full three years into this rising rate cycle, bond prices have been quite stable until just recently. The Fed first hiked overnight rates in December 2015 after warning that it might for several meetings. By the end of that year, the typical community bank had a modest unrealized loss of about 30 basis points (0.30 percent).

Fast forward two years, to December 2017, and those losses, on average, were still only 50 basis points. The cause of the relative price stability was two-fold. First, the Fed was moving quite slowly, as there were only four rate hikes in that two-year period. Second, credit spreads on most of the bonds banks owned tightened during that period. As the economy improves, the required incremental yields over those of benchmark Treasuries normally shrink, and such was the case here too.

Today, those losses on average are approaching 3 percent. That means a $100 million portfolio is $300,000 underwater. Many community banks have not a single bond that’s owned at an unrealized gain. If I’m describing your portfolio, you’re in good company. This also represents an opportunity.

Build for the future

If you ask your tax accountant if income deferral is a sound tax-planning and cash flow strategy, you should first set your stopwatch to see how long it takes to receive a “yes.” Selling some underwater bonds, which some might term “dogs,” and buying other securities that have higher market yields will push income into future periods. It will also delay some payment of income tax to Uncle Sam.

So far this year, the banking industry’s earnings are about 20 percent ahead of last year. That’s due to both a still-improving lending environment and (as you may have heard) tax reform. Chances are that your institution could selectively sell some bonds this year and still meet its earnings goals, with all future years also benefiting.

Look both ways

As you investigate your opportunities, a few bond-swap reminders are in order. First, economically, the best bonds to sell are the ones with the lowest current market yields. Examples of these could be short bullet agencies or “pre-refunded” munis. Your brokers could use the term “take-out yield” as a synonym for market yield.

Also, and this may be academic at this point, it’s very difficult to make the math work by taking a gain on a tax-free bond. However, it can be beneficial to buy tax-free securities to replace bonds sold at a loss. Your broker can demonstrate the economics of this “tax swap” strategy.

Finally, from a timing standpoint, it’s wise to act sooner rather than later as yearend approaches. The liquidity in the bond market often starts to evaporate by mid-December, so you’ll want to stay ahead of that likelihood. And, if it’s more advantageous to take some losses in the next calendar year, think about pulling the trigger by mid-January. Having nearly an entire year to start making up the realized losses will help the 2019 results.

There are plenty of reasons to think about taking some losses now, and this column contains just a few of them. Your broker-dealers can help you and your management team identify which “dogs” can be converted into “winners” for future periods.

Contact Jim Reber via email or at (800) 422-6442.

7900 International Drive, Suite 685,

Bloomington, MN 55425

Phone: 651.687.9080

Fax: 651.687.9387

info@icbm.org

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