What is happening to your clients as a result of rising interest rates?
Jared: Prior to May, our bank clients were siting with unrealized gains in their portfolios. Those gains quickly turned to losses as rates rose over 100 basis points.
Matt: Many banks have significant exposure to mortgage-backed securities in their investment portfolio; these securities are particularly sensitive to changes in interest rates. Mortgages tend to get hit worse in rising interest rate environments due to the options embedded in mortgage backed securities. Our clients are asking, ‘How can we diversify our portfolio to better prepare for rising interest rates down the road?’ Many banks are considering the use of non-callable, investment-grade corporate securities in their portfolios.
Jared: The challenge with adding credit in the securities portfolio, whether it is corporate or municipal exposure, is that Dodd-Frank Section 939A prevents banks from relying solely on the rating agencies when determining the credit quality of the issuer. So the securities that can help a bank diversify interest rate risk can be more labor intensive to acquire and monitor.
How do you fit in?
Jared: BlackRock launched a suite of term maturity exchange-traded funds (ETFs) that are designed to address this exact issue. These products allow banks to gain exposure to a diversified pool of non-callable, investment-grade corporate credits. Each investor is provided an analytics package designed to facilitate pre-purchase analysis and ongoing monitoring of the credits held in the [pool]. And the funds liquidate on a pre-determined date, so they can be used as liability management tools.
What are the risks?
Matt: The U.S. corporate credit market is in excess of $6 trillion. However, many banks have not previously utilized corporate credit in their securities portfolios, so bank management has to feel comfortable with it from an investment and regulatory perspective. They need to make sure that they can do proper due diligence on the bonds that they are investing in. This is the real challenge for many banks; they just don’t have sufficient resources to gather the data to analyze individual corporate issuers.
Do you have to look at bonds in relation to the loan portfolio?
Jared: We are strong advocates for diversification. We believe banks should monitor their exposure to issuers across their loan and securities portfolios. We provide detailed analytics to ensure that banks can accurately track this exposure.
What has history taught us about rising interest rates?
Matt: Investors tend to be reactive. Markets can move fairly suddenly in unpredictable ways and there are unforeseen correlations between assets. It is important to have the right strategy in place before the market moves.
How do regulators view your service or that of others doing due diligence on these securities?
Jared: The regulators, rightfully so, want to make sure the banks have a solid understanding of their risk. In regards to the investment portfolio, they want to be certain that the banks understand the probability of default of the securities they purchase. They are sympathetic to the fact that many banks are resource-constrained. As a result, the regulators support using independent, reliable and qualified third parties to research and document specific investment securities, so long as it can be understood and evaluated by the bank.