Page 36 - August 22, 2024 Bulletin

BUSINESS PARTNERfeature article

Dale Sheller
Associate Partner
Director of Financial Strategies Group
The Baker Group

Words of Wisdom –

Investing for the Next Rate Cycle

The last several years have been nothing but an ever-changing, portfolio must also satisfy the institution’s liquidity, interest
dynamic environment for financial institutions to operate in. rate risk and safety of principal, and pledging needs. The
First, the pandemic induced the recession of 2020, followed by portfolio isn’t a vehicle for speculating and making large bets
historic low interest rates across the entire yield curve. Second, on the direction of interest rates.
the historically low interest environment quickly turned into the
most aggressive tightening cycle from the Fed since the 1980s. 2. There is no free lunch in the bond markets. When
Liquidity levels and interest rates swung in many directions investing in bonds, you’re always making trade-offs between
over the course of the last few years. As senior management and risk and reward. Yield and risk move hand in hand.
investment portfolio managers look back over the decisions Typically, if you are comparing two different bonds that
(or indecision) they made regarding the investment portfolio, look similar in risk, but one has a lower price and therefore
many wish they would have done a handful of things differently. higher yield, there is some difference in the amount
Typically, most portfolio mistakes are made at or near the trough of liquidity, credit, or interest rate risk. Sometimes the
or peak during any given rate cycle. As of the date of writing this difference in risk is clear and sometimes it can be hiding a
article, it is all but a foregone conclusion that the Fed will cut little bit.
rates in September. We have already seen the bond market yields
fall in the last few weeks in anticipation of impending interest 3. Interest rate risk is a two-sided coin. I teach several
rate cuts. The following are words of wisdom for investing banking schools where I like to ask this trick question:
during the next cycle of falling rates. Which has more interest rate risk, a 3-month Treasury bill or
a 10-year Treasury bond? Most of the students tend to pick
1. A community financial institution’s bond portfolio is the 10-year Treasury bond because it has a longer maturity
not a hedge fund. I’ll go ahead and use a baseball reference: and therefore longer duration than a 3-month Treasury
We aren’t always trying to hit homeruns with our bond bill. They both have interest rate risk, but different types.
purchases; rather, we are typically looking for singles and The reinvestment risk of a 3-month Treasury bill is higher
doubles. The portfolio doesn’t live in isolation as it is part than a 10-year Treasury bond due to its maturing every 3
of a broader balance sheet with loans and deposits. Excess months with the investor subject to market rate movements
return or earnings are always a goal of the investment over that 3-month period. The 10-year has more long-term
portfolio but may not always be the primary objective. The interest rate risk or price risk. If the 10-year Treasury bond is

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