Selling Bonds at a Steep Loss Is Not Always a Good Idea

Over the past seven years, most banks have not delivered competitive performance to their shareholders. Since mid-2018, the KBW Nasdaq regional banking index has delivered a cumulative 26% total return, while high-performing JPMorgan Chase & Co. delivered a whopping 240%.

It’s not just a regional bank problem; according to data from Bloomberg, there are 202 publicly traded banks between $1 billion and $20 billion in assets, of which, over this period, 54 have delivered negative annualized total returns. An additional 118 have delivered below 10%, and only 30 have provided more than 10%. The sub-zero group has accumulated a 34% cumulative growth in tangible book value per share (TBVPS) in contrast to the high-performing group’s 127%. It is important to note that the cumulative tangible growth numbers above are unadjusted for losses that might be hidden in banks’ held-to-maturity portfolio. If adjusted, the relative comparison would be even more profound. TBVPS growth is highly correlated with shareholder performance.

To address suboptimal profitability metrics lingering in 2025, many boards are authorizing management teams to sell low-coupon mortgage-backed securities (MBS) at steep losses to then restructure for improved book yields and income. While selling U.S. Treasury bonds or other short bullet cash flows at losses can be productive and wise, selling these specific discount mortgage assets is likely imprudent. Particularly if banks then acquire new assets with the same overlooked risks that got them into this situation in the first place.

The motivation is clear: profitability improvement. The income statement is usually the best metric for future TBVPS growth, and selling lower in exchange for higher book yields will help improve profitability metrics but might not result in higher growth in future TBVPS. In fact, it’s possible that the decision to reposition in today’s environment could set up far lower growth in TBVPS in certain future interest rate scenarios. Even more concerning, those scenarios happen to be the ones industry participants expect will happen.

The current drag on long-term bank returns stems partially from decisions made in 2021, when liquidity was abundant, and the consensus was rates would remain below 1% until 2024. Banks needed income to make 2022 budgets look acceptable. Most did not properly respect the potential for multiple future interest rate scenarios and piled into things like 20-year, 2% MBS, with a five-year average life and 50 basis points (bps) more book income than the five-year treasury. Performance Trust is among the few on record in 2021 urging against this decision as respect for multiple future scenarios made it clear that the MBS choice was exposed to significant option risk in rates up and rates down, in comparison to the treasury.

From 2021 to 2025, rates went up by roughly 250 bps. That five-year treasury bond from 2021 is now a one-year treasury maturing in 2026, with a two-point loss. The five-year average life MBS, four years later, has extended to a 6.3-year average life, with a loss of 13 points, according to data from Bloomberg.

In 2021, we were striving to fix 2022 profitability, while in 2025, the same mindset around 2026 is driving many repositioning decisions. In search of the highest replacement yields, many will be drawn to the 2025 version of the same assets that created this problem in 2021, par-priced coupon MBS with significant option risk.

In contrast, by holding on to the discount MBS purchased in 2021, you will avoid a reduction in regulatory capital, and our analysis suggests that across a range of rate scenarios, the accumulated other comprehensive income (AOCI) accretion combined with the low book yields that come with holding the asset have the potential to deliver better TBVPS growth than chasing higher replacement book yields that won’t have any AOCI accretion and are saddled with risks if rates fall or rise.

For the same reason we advised against par-priced MBS in 2021, we advise against investing in current coupon MBS today, such as the 20-year 5% or 30-year 5.5%, as these will be attractive only if rates remain largely unchanged for the coming few years.

There is a good chance loss selling MBS will be on your board’s next agenda. Certain assets should be marked as clear to be sold; others, like discount MBS, should usually be kept, especially if the asset being considered for replacement carries the same types of risks that created today’s issues back in 2021. Repositioning can be wise, but it can be difficult to evaluate the decision unless we examine it through a lens that provides clarity around multiple future interest rate scenario growth in TBVPS.

Performance Trust has been advising community banks for 30 years and is a registered broker/dealer, member of FINRA/SIPC. This is intended for educational and informational purposes only and is not intended to be legal, tax, financial, or accounting advice or a recommended course of action in any given situation. This is not an offer or solicitation to purchase or sell securities. The Information is subject to change without notice.