Bank bond portfolios remained deeply underwater in 2023, reducing banks’ access to liquidity when deposits became far more precious.
Rising interest rates have once again inflicted a decrement on the valuation of bank bond portfolios, coinciding with a period when major banks confront alterations in regulations compelling them to acknowledge notional losses in the computation of their regulatory capital.
Accumulated Other Comprehensive Income (AOCI), an encompassing metric encompassing fluctuations in the market worth of securities held for future sale, experienced a decline of $18.31 billion in a sequential manner during the second quarter, culminating in a net negative value of $301.63 billion across the entire industry. This decline markedly contributed to a collective reduction in tangible common equity amounting to $11.00 billion.
As per the Basel III endgame proposition, AOCI will factor into the regulatory capital equation for all banks possessing assets exceeding $100 billion, supplementing the already established status quo for globally systemically important banks.
These institutions adversely impacted by this alteration have proffered estimates delineating the duration required for their bonds to recuperate to their nominal value (“pull to par”), grounded in considerations of bond maturities and prevailing market anticipations regarding interest rate fluctuations. Furthermore, a subset of these institutions has outlined strategic blueprints to expeditiously fortify their capital positions, including measures such as the suspension of share buyback programs.
The broad impact of sinking Bank Bond
Over the second quarter, the average rates for Treasury securities spanning maturities ranging from two to seven years experienced a noteworthy uptick of 61 basis points. This upward movement in rates, which occurs in opposition to the movement of bond values, played a pivotal role in causing a reduction in the overall worth of the bond holdings held by banks.
In the initial quarter, the average rates within these maturities had taken a contrary route, diminishing by 38 basis points. These rates had then remained relatively stable during the fourth quarter of the previous year, 2022. During these periods, the Accumulated Other Comprehensive Income (AOCI) had displayed some improvement, even though it was still in negative territory. The ramifications of heightened interest rates on the fair valuation of banks’ balance sheets have been a central factor contributing to the turbulence experienced this year. This situation has even prompted certain depositors to withdraw their funds, leaving a subset of banks with limited alternatives to address these outflows.
Although the majority of the banking industry has managed to navigate these pressures adeptly, the influence of reduced bank bond values has had a widespread impact. Notably, 3,833 banks exhibited a decline in AOCI from one quarter to the next during the second quarter, in contrast to only 360 banks that showcased an enhancement. In such circumstances, earnings have the potential to offset the deterioration in bond values. Looking at adjusted tangible common equity, a metric encompassing loss reserves with adjustments for nonperforming and overdue loans, 2,537 banks displayed sequential improvement, while 1,992 banks faced sequential deterioration.
As the calendar moved into the third quarter, the trend persisted, with average Treasury rates for the maturities above experiencing a further uptick of 28 basis points by August 25th.
Bank Bond Portfolios – Prolonged Recovery
The process of reversing the negative Accumulated Other Comprehensive Income (AOCI) figures at numerous banks is anticipated to extend over the years.
A case in point is KeyCorp, which has estimated that around 44% of its adverse AOCI will gradually dissipate by the conclusion of 2024. This reduction is projected to increase to 55% by the conclusion of 2025, contingent upon prevailing market forecasts regarding interest rates.
Similarly, Truist Financial Corp. has outlined a plan to curtail its negative AOCI by 36%, diminishing it from $13.4 billion to $8.6 billion, by the culmination of 2026. In its financial report for the second quarter, the bank’s Chief Financial Officer articulated the bank’s confidence in generating adequate capital through earnings. This capital generation is expected to counterbalance the remaining projected impact of the accumulated other comprehensive loss on its Common Equity Tier 1 (CET1) ratio during this timeframe.
Fifth Third Bancorp has set its sights on achieving a 50% reduction in its negative AOCI by the conclusion of 2025. Notably, the bank implemented a suspension of share repurchases in the second quarter as part of its strategic approach.
Discussing this approach during a June conference, CFO James Leonard of Fifth Third indicated that the bank might opt to abbreviate the duration of its bond portfolio. Conversely, the bank might consider increasing the duration of its loan portfolio to mitigate the potential risks associated with a decline in interest rates.