How to avoid large bond losses: The Stoplight Bond Strategy

Let’s start with a review of key financial terms we learned over the past five years of historic bond market volatility: QT is quantitative tightening, QE is quantitative easing, ZIRP means the Fed’s zero rate interest rate policy, HTM means securities held to maturity, and AFS is securities held available for sale. Lastly, AOCI means Accumulated Other Comprehensive Income, or in other words, the dollar amount of bond loss in your bank’s portfolio. Please read on. .The chart above from the FDIC’s website illustrates the tidal wave swing in record security gains to record losses during and after the covid pandemic. We had never seen bond market swings of this magnitude, ever, and hopefully will never see them again... or another pandemic.Sometime in the early 1980s, when I was a banker, I found myself stopped at an intersection in Des Moines. As I was sitting in my car, the stoplight gave me an idea, or maybe even an epiphany. When should a bank buy longer bonds and when should it buy shorter ones? Red means stop, yellow means proceed with caution and green, of course, means floor it. Maybe I am on to something. Shouldn’t there be rules to follow?Dollar cost averaging is a technique used by successful stock and bond investors for many decades and Buffett is a major advocate. Warren takes his lead from the legendary investor, Ben Graham, of whom I am a groupie. It is based on the mathematical process of systematically lowering your cost basis (thus increasing your future yield/return) whenever you can, while not overreacting to market turmoil or emotion. Math, over emotion, is Buffett’s and Graham’s mantra. Stay calm and keep investing. .When overnight Fed Funds were trading at 0.15 percent during covid and loan demand froze, it was very tempting and very humanlike to stretch for yield. Banks needed income, I got it, and the Fed kept signaling “lower interest rates for longer.”The Fed purchased a record $9 trillion in bonds during QE to save the U.S. economy, driving interest rates nearly to zero and stocks through the roof. This was the goal of QE, and it worked.I knew that when T-Bill yields actually went negative, we had to take action — perhaps on a one-time only basis — to harvest bond gains, reinvest in very short bond maturities and be very patient. Where you are rewarded the least, you usually eventually benefit the most. You can trust that rule, and vice versa. The best time for banks to purchase bonds has always been when they can’t, and the worst time is when they are forced to buy because of slack loan demand, and the consequent abundant liquidity like during covid-19. Reaching long term for yield when yields are very low is often called the “bond trap.” It is not all our fault, but it is very much a formidable challenge of bond investing for banks.The Stoplight Strategy encourages countercyclical, dollar cost averaging, and uses tax swaps to defer taxes and improve future earnings. Unlike the FDIC chart above, our consulting clients today have very small AOCI losses, approximately one-third of the chart above. Their average portfolio yield today is 3.23 percent, with a 3.3 percent bond loss and duration of 3.47 years as of May. We booked very large bond gains, especially from overpriced mortgage-backed securities that the Fed targeted in QE to help lower mortgage rates and jumpstart housing.I am an advocate of “total” return as you may recall and the very small difference between a 3.23 percent book yield and a 3.3 percent bond loss ... is finally about to turn positive. This is the best overall measure of your portfolio’s success, and you can run these numbers hypothetically for your portfolio for comparison if you wish.Our clients used AFS accounting exclusively and therefore were able to tax swap their lowest yields with Uncle Sam’s help to lock in higher future bond income while adding duration during QT, as 4-5 percent yields were and still are very accretive.The typical Midwest bank’s average bond portfolio yield is currently about 2.75 percent, with an average maturity of about 5.5 years. You can see the average bond portfolio loss in the FDIC table on the previous page at about 10 percent.And finally, back to the traffic intersection as the stoplight appears to be green now ... but likely changing to yellow or red over the next year given what we know now.Floor it. Jeff Goble is president of Goble Consulting Group, LLC, in Mission Hills, Kan., and has published two books on investing, including “More Yield, Less Risk … Better Sleep!” He wrote more than 150 columns for Bank News Magazine, now BankBeat.He may be reached at Jeff@GobleConsultingGroup.com.