Robert Segal

The Federal Open Market Committee (FOMC) in July decided to maintain the target range for federal funds at 0.25 percent to 0.50 percent following a meeting in Washington. The committee upgraded its assessment of the economy, stating that near-term risks have diminished while labor utilization has shown “some increase,” though inflation remains too low.

The Fed said the labor market improved since the June gathering. The committee was concerned that the economy only added 38,000 net new jobs in May. The solid rebound for June (292,000 new jobs) and July (255,000 new jobs) seems to have given the group encouragement that the May report was an aberration.

The minutes from the July 26-27 meeting suggested a rate increase is a possibility as early as September, though the Fed isn’t likely to commit until a consensus can be reached about the outlook for growth.  Several officials weren’t prepared to consider a rate increase as long as inflation remains below the 2 percent target. Others, believing the U.S. is close to full employment, thought a move would soon be warranted.  “Members judged it appropriate to continue to leave their policy options open and maintain the flexibility to adjust the stance of policy based on incoming information,” the minutes said.

Dennis Lockhart, president of the Atlanta Fed, said recently he wouldn’t rule out a September hike.  “Most of the fundamentals underpinning growth of consumption are pretty solid,” Lockhart said. “Early indications of third-quarter GDP growth suggest a rebound,” he added. “I don’t believe momentum has stalled.”

At this time, markets place the chance of a rate increase by year-end at 60 percent, down slightly from 65 percent after the Fed’s April 27 meeting. This compares with only 10 percent, however, at the end of June. The yield on the benchmark 10-year Treasury note traded recently at 1.6 percent, compared with 1.85 percent at the end of May.

In its latest banking profile, the FDIC said community banks reported net interest income of $17.5 billion during first quarter 2016, up $1.3 billion (8.2 percent) from the prior year. Net interest margin of 3.56 percent was up 2 basis points from the year earlier, as asset yields increased 2 basis points and funding costs were unchanged. Going forward, however, margins are projected to trend downward as asset yields are under pressure while funding costs remain near floors.

Active Investments May Pay Off

In this environment, some institutions may wish to consider a more active investment style. A number of organizations limit their investment allocation to a few areas in which they are comfortable, such as mortgage securities or agencies. With this approach, however, the institution may be sacrificing income as well as increasing balance sheet risk.

In fact, portfolio managers at many banks have been busy realigning their investment distributions. With the decline in rates in recent quarters, portfolio cash flow has spiked and according to industry reports, the destination for this cash has largely been municipal and other non-agency bullet securities.

This shift should not come as a surprise, as organizations continue to struggle with margin challenges in the face of a flatter yield curve. Depositories choose these types of securities to provide additional yield and position the portfolio more appropriately for the current rate environment. The predictable cash flow feature makes them an attractive alternative even with the longer duration.

Investment sectors often become overvalued. Investors concerned about rising rates have flocked to short-duration mortgages and floating-rate notes, driving up prices and pushing down yields. At the same time, the market tends to punish entire sectors during times of stress. In these cases, investment officers should consider selling the “rich” securities and moving into the undervalued ones.

Earlier this year, corporate bond spreads widened dramatically as energy prices fell and the stock market plunged. This affected most corporate issuers regardless of credit quality. Apple Inc., for example, issued five-year notes at a spread of 100 basis points to Treasuries, about double the normal spread. This happened in spite of Apple’s strong balance sheet, consistent profitability and ample liquidity. Investors moving out of short-duration mortgage securities and into high quality corporate bonds at this time could have realized higher levels of current income and more stable portfolio cash flow characteristics. While corporate bonds are not appropriate for all investors, the same strategy can be utilized with other securities that offer favorable total return potential.

Maintaining flexibility for managing the investment portfolio can reduce overall rate sensitivity through a range of tactical and strategic transactions. An active manager tends to spread exposures to a variety of higher-returning sectors, while moving out of market segments that become expensive. Successful active management also entails a willingness to think independently in terms of position and sector weightings. When properly implemented, active management strategies can lessen an institution’s exposure to declining margins, helping to offset the impact of a challenging investment landscape.

Robert B. Segal is president of Atlantic Capital Strategies Inc., an investment advisor located in Bedford.
He can be reached at bob@atlanticcapitalstrategies.com.