Over the course of a year or so, the Federal Reserve has raised short-term interest rates more than 475 basis points.
Bankers with a portion of their balance sheet assets invested in fixed income securities are all too aware of the “Finance 101” lesson of the inverse relationship between interest rates and the market value of fixed income securities. While the recent Fed actions certainly have negative implications for parts of the bank’s balance sheet, they also have some positive ones.
For instance, banks with available liquidity have some great buying opportunities currently in the market. In addition to obviously investing in government securities with durations on the short end of the yield curve, the cash value yields on certain types of bank owned life insurance, or BOLI, are currently the highest they have been in at least 15 years.
Regulators allow banks to use BOLI to offset the cost of providing new or existing employee benefits. Part of the way BOLI offsets these employee benefit costs is by providing compelling cash value rates of return, which are generally provided by life insurance carriers that carry high credit quality. Another benefit of BOLI is that most types have cash values vests on a daily basis — the cash value doesn’t reduce in a rising interest rate environment. This eliminates the mark-to-market risk associated with other assets on the bank’s balance sheet, such as fixed income securities or loans.
Other higher yielding, high credit quality opportunities are also currently available in the market. Many of the same high credit quality life insurance carriers that offer BOLI have begun offering, or are creating, a guaranteed investment certificate or GIC. GICs are sometimes referred to as a financial agreement or FA. The GIC works much like a certificate of deposit, where the purchaser deposits money with the offering entity — in this case, the life insurance carrier — and earns interest on the deposited money. Much like a CD, the money must be deposited for a fixed length of time and interest rates vary according to the duration. GICs are nothing new; insurance companies themselves have been investing in them for decades.
Another interesting development over the last few months is the ability for banks to invest in a collateralized loan obligation, or CLO. A CLO is a single security that is backed by a pool of debt. As a floating-rate security, it offers income protection in varying market conditions while also minimizing duration. Additionally, CLOs typically offer higher yields than similarly rated corporate bonds and other structured products. We have also seen CLO portfolios added as investment options of private placement variable universal life BOLI designs to provide a bank with additional benefits. This structure has the advantage of giving bank owners the ability to enhance the yield of assets that are designated as offsetting employee benefit expenses. The advantages of this type of structure are obvious in the current inflationary environment.
So while the actions of the Fed have certainly added challenges to the typical banks’ balance sheet, for those institutions who are well positioned, it has also created numerous opportunities.