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Of Bulls and Bears – Margin Impact from Changing Yield Curves

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After the blog published on April 21, 2016, we have received a number of comments regarding why we were silent on the industry “conventional wisdom” that a wider yield curve can provide stronger net interest margin, and that a narrower yield curve can squeeze the margin. This can be true, but often is not. All else being equal, a wider yield curve would produce stronger margins. However, real life seldom results in an “all else being equal” outcome. Business, and the economic climate, are not static. There are constant changes to the regulatory, economic, and competitive landscape that can (and does) change consumer behavior – and the changes in consumer behavior result in changes and shifts in credit union financial structures.

Bear Flattener

If we were to apply “conventional wisdom” to the most recent “bear flattener,” which occurred from 2004 to the end of 2005, real world results are not what would be expected. In June 2004, the industry net interest margin was 3.26%. In June 2006, the industry margin had barely moved down, reaching 3.20%. This barely quantifiable movement in margin happened when the yield curve moved from roughly 350 basis points (bps) to about 20 bps – a reduction in steepness by more than 300 bps.

Using the “all else being equal” argument, margins may have been squeezed more. However, there was a mitigating factor that helped to preserve the margin – the loan-to-asset ratio for the industry increased more than 5% over that same time frame. The increase in the loan-to-asset ratio helped to offset margin pressures that could have been realized if “all else being equal” loan demand had not increased.

Bear Steepener

Applying the same conventional wisdom to a recent “bear steepener,” which occurred from 2012 to 2013 long-term rates increased more than 100 bps, translating to a yield curve that is roughly 100 bps wider than it was December 2012. However, net interest margin for the industry dropped from 2.94% to 2.80%. Comparing the end of 2012 to the end of 2015, the yield curve has been consistently steeper and loan-to-asset ratios jumped 7% (to 65%), but the margin of 2.86% has not rebounded to the 2012 level.

Now, some may argue that there were so many other variables and moving pieces in the broader economic climate, “all else being equal” or using an “apples to apples” comparison, margins should have increased. That may be the case. The same arguments are brought up in relation to static income simulation. Breaking it down into the fundamental components, everyone realizes that real life isn’t static – things change, member demands and consumer behaviors shift, and the competitive landscape has a significant impact on credit union earnings and risk profiles. The entire reason for the thought that wider yield curves bring stronger margins is a lack of change in the composition of assets and liabilities in static income simulation. This is antiquated thinking that has resulted in potentially misleading “conventional wisdom.”

Conventional Wisdom can be Misleading

As an industry, we have seen yield curves widen (steepen) and yield curves narrow (flatten), loan-to-asset ratios increase and loan-to-asset ratios decrease, with inconclusive correlations between changes in the yield curve in relationship to actual bottom-line net interest margins. Credit union management teams, boards of directors, and even regulators should be concerned with an assumption of static replacement regardless of the change in the environment, as it is often misleading. For decades we have been modeling a huge range of yield curves and environments, and this experience has taught us the importance of modeling how members may respond differently in these environments. Additionally, it has demonstrated that better business decisions can be made by first understanding the potential profitability (or losses) from the existing structure, prior to layering on guesses about what the new business may be able to do in all of the different environments.

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Of Bulls and Bears – Twisting the Yield Curve Is More Than Just a Stress Test

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If you’re a financial institution, you need to understand how changes in market rates could affect your financial well-being. That’s what A/LM analysis is for. Traditional A/LM analysis has revolved around simple, instantaneous, and parallel shifts in rates. But in reality, rates have rarely shifted in parallel (not to mention instantaneously). As an example, using the interest rate environment and yield curve at the end of March, an instant and parallel change in rates would result in the below rates:

twisting the yield curve, c. myers. credit union,

Each of the rates increases 300 basis points (bps) and the relationship between the short- and long-term rates does not change. While the above approach does represent a change in interest rates, there is no change in the yield curve. In the +300 bps change in rates, the spread between the 3 month and the 10-year yield is 1.57% – which is exactly the same as it was on March 31. An effective interest rate risk management program must include an analysis of the impact to earnings and net worth caused by a shift in the relationship between short- and long-term rates. This is referred to as twisting the yield curve. As that relationship changes, it results in yield curves that are either flatter (meaning the difference between short- and long-term rates decreases) or steeper (meaning the difference between short- and long-term rates increases). And, depending on the financial structure, flatter and steeper yield curves may produce very different financial effects.

“Bullish” Twists

The yield curve is said to twist in a bullish manner when the Federal Reserve is expected to lower interest rates.

A bull flattener is characterized by long-term rates decreasing more than short-term rates. This yield curve shift can cause disproportionate reaction across a credit union’s balance sheet, typically influencing longer-term assets or liabilities more than short-term assets or non-maturity deposits. For example, cost of funds may not change much (as the short-term rates tend to influence cost of funds on non-maturity deposits), but longer-term assets like mortgages may experience an increase in prepayment speeds (as decreases in long-term rates typically correlate with decreases in mortgage rates and more refinance activity). A good historical example of a bull flattener is the movement in Treasury rates experienced in 2011, when long-term rates dropped roughly 150 bps, moving from 3.36% at the start of the year to 1.89% at the end of the year. Short-term rates moved 13 bps, dropping from 0.15% to 0.02% over the same period.

Bull Flattener, c. myers, yield curve twists

A bull steepener, on the other hand, is characterized by short-term rates falling faster than long-term rates. The most recent bull steepener occurred from the middle of 2007 to the end of 2008, when the yield curve shifted from a slightly inverted/flat curve as short-term rates dropped roughly 500 bps and long-term rates dropped only about 250 bps over that 18-month timeframe.

“Bearish” Twists

The yield curve is said to twist in a bearish fashion when there is an expectation that the Federal Reserve will increase interest rates.

A bear flattener is characterized by short-term rates rising faster than long-term rates. This yield curve twist tends to increase non-maturity deposit rates, without a significant corresponding increase in long-term rates. This can cause pressure on net interest margins, and can often cause non-maturity deposit migration (movements from non-maturity shares into more expensive short- and intermediate-term certificates of deposits). The most recent bear flattener occurred from the middle of 2004 to the end of 2005, when long-term rates moved nominally, but short-term rates increased over 300bps during that 18-month period.

bear flattener, twisting yield curve, c. myers, credit unions

Conversely, a bear steepener is characterized by long-term rates increasing faster than short-term rates. This yield curve twist tends to slow down existing asset prepayments, and not influence non-maturity deposit behavior. The most recent example of a bear steepener occurred from the middle of 2012 through the end of 2013, when short-term rates hardly moved but long-term rates moved in excess of 100 bps.

Twisting the Yield Curve Is More Than Just a Stress Test

The examples above represent a fraction of the possible effects of yield curve changes. A myriad of factors play into how a bull flattener, bear steepener, or any yield curve change will affect the earnings and net worth of a given financial structure. Member behavior factors – members exercising their options to refinance loans or shift deposits between non-maturity deposits and certificates – can have significant impact when the yield curve changes. Understanding the impact to profitability in a wide range of rate environments and yield curves, and the resulting impact to net worth, should not be simply a stress test – it should be a matter of course in any effective interest rate risk management program.

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Evaluating Investment Proposals With Enhanced Due Diligence

Understanding the impact that new business decisions can have on a credit union’s risk profile is central to effective asset/liability management, and is even addressed in NCUA’s recently issued Interest Rate Risk Questionnaire.  This is especially appropriate when evaluating proposals from investment brokers seeking to “rebalance” or “strategically realign” a credit union’s investment portfolio.
Many of our clients have received proposals from their brokers to sell investments they currently own for a gain and replace those sold with comparable investments (albeit at lower yields).  Accompanying these proposals are broker-provided due diligence information packets that show the current portfolio price risk compared to the proposed portfolio price risk in a +300, WAM for the current portfolio and proposed portfolio in a +300 and other industry-standard measures of risk.  While many of these proposals can offer an acceptable balance between risk and return given an individual credit union’s unique circumstances and appetite for risk, some proposals can be downright disastrous, resulting in significant interest rate risk with even the slightest change in interest rate environment.
To appropriately safeguard against making a decision that is inconsistent with a credit union’s normal practice, or board-directed appetite for risk, a certain measure of independent due diligence is highly recommended.  For example, ask your broker to provide the same reports with a shock higher than the traditional +300 (+500 is recommended—before rates plummeted to today’s low levels, short-term rates were roughly 5% for a sustained period).  You should also ask your broker to twist the yield curve (non-parallel shock).
Nearly every broker-provided proposal generates an increase in net worth dollars, and a corresponding increase in net worth ratio.  The key in realizing the potential risks of executing on a proposal is understanding how the amount of net worth not at risk changes, and in what interest rate environments this becomes a negative change.  Understanding margin changes today, as well as changes in price risk in a +300, can be valuable tools.  However, testing the potential impact on net worth is critical when evaluating the risk in a business decision, and this level of testing is typically not included with any standard broker-provided due diligence.
Remember, in NCUA’s Final Rule on Interest Rate Risk Management, NCUA states “net worth is the reserve of funds available to absorb the risks of a credit union, and it is therefore the best measure against which to gauge the credit union’s risk exposure.”  Ensuring that decision-makers have the appropriate information to drive effective decision-making is an integral part of ensuring that an interest rate risk program is effective, and is incorporated in the risk management process of high-performing credit unions.
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Record Low 10-Year Treasury Rates and Net Interest Margin

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On September 22nd, the 10-year Treasury Rate touched another historic low with a yield close to 1.7%.  This is a critical measure, as many credit union assets are priced off of the longer end of the yield curve.  There are many factors contributing to the low yield, including:

  • The Fed’s decision to sell some shorter-term debt and buy longer-term debt
  • The weak economy
  • The continued flight to safety (American debt looks relatively safe on a global scale)
  • The Fed’s stated intention to keep short-term rates low into the middle of 2013

So what does this all mean to a credit union’s net interest margin? All else being equal, credit union loan and investment yields will continue to decline while rates are low and the economy flounders.  Additionally, the ability to maintain the net interest margin becomes increasingly unlikely the longer we are in this low rate environment.  Deposit rates will hit a “floor” at some point.  Even if a credit union has room to lower deposit rates—and thus minimize the loss of asset yield today—that credit union will, by default, still be adding interest rate risk to the balance sheet.  Additionally, most credit union assets are fixed rate, and these low-yielding, fixed-rate assets will likely stay on the books for a while.  As a result of all these factors, credit union margins will be further squeezed and the potential for interest rate risk will increase.

Does your credit union have the ability to absorb more interest rate risk going forward?  Can your institution remain profitable 12 months from now if current trends continue? Now is a good time to try and figure this out, and take mitigating actions if deemed necessary.

Source: US 10-yr Treasury yield falls to lowest on record, The Associated Press, 9/9/11

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Observations On A Steep Yield Curve

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The Treasury yield curve is rarely as steep as it is today.  The spread between the 3-month and 10-year has recently exceeded 350 basis points.  In more certain times, steep yield curves are beneficial to credit unions because the rates paid on non-maturity deposits are influenced by the short end of the curve and the rates charged on many loans are influenced by the long end of the curve.

When managing risk, we suggest you consider what could happen if the yield curve environment:

  • Remains steep
  • Steepens
  • Flattens by short-term rates increasing (as it did following the last recession)
  • Flattens by long-term rates declining

As you consider these environments, be sure to reflect on how different yield curves might impact member behavior.  For example, a flatter yield curve could be accompanied by lower non-maturity deposit balances as the competition for deposits increases.  Loan demand could also be impacted depending on the reasons for different yield curves.