Seven things you forgot about higher interest rates

Short and intermediate Treasury yields rose sharply in 2022 to the highest levels in 15 years. One clear impact to depository institutions was higher unrealized losses on their AFS portfolios, but at the same time, reinvestment yields were significantly higher as well. However, higher rates have an impact on other fixed income concepts beyond just the bond’s stated yield to maturity (that too is impacted by higher discount rate assumptions). Some bankers and portfolio managers have only known the ultra-low rates of the post-crisis era thanks to a heavy Fed presence, but in this article, we summarize several bond concepts impacted by the absolute level of rates.

1. Compounding Matters More

Higher interest rates shine a light on the impact of compounding. When rates are low, as they were for much of the post-crisis era, differences between compounded and non-compounded rates are de minimis. But now that Fed Funds is north of 4% the difference is much more meaningful.

Additionally, the frequency of compounding becomes more meaningful as rates rise. When rates are at 2%, the difference between a rate that is compounded daily and one that is compounded semi-annually is only 1 basis point (bp), but with rates at 5% that difference is 7 bps. This is a critical concept to understand when evaluating interest rate swaps, where counterparties have the option of deciding on such conventions.

2. Yield to Maturity and Reinvestment Assumptions

A key assumption in a yield to maturity (YTM) calculation is that all periodic cashflows are reinvested at the security’s purchase YTM. However, when yields move sharply in either direction, realized holding period returns can deviate notably from original YTM estimates due to different reinvestment rates. This effect is amplified in the current environment given the sharp increase in market rates in a relatively short timeframe.

3. Durations are Lower on Non-Callable Assets as Rates Rise

Fixed income portfolio managers rely on duration estimates to measure a bond’s price sensitivity to interest rates. However, the relationship between price and yield is not linear, but rather a convex curve. The curvature, typically referred to as convexity, highlights how changes in yields can influence duration. When underlying interest rates increase, the duration of non-callable bonds declines and can pose challenges for longer liabilities structures that require a higher price volatility to offset. The reverse holds true for the opposite scenario: as yields decrease, the duration of a bond or portfolio will extend.

4. ROE Hurdle Rates for Asset Returns are Higher

Traditional asset profitability models (ROE/RAROC) share a unique feature that keeps them tied to modern notions of expected equity returns and equity risk premiums. Financial theory tells us that expected equity returns must be higher when risk-free rates rise since investors need to be appropriately compensated over their risk-free alternatives. If the risk-free opportunity cost rises, assuming equity risk premiums stay constant, so should the required return on equity.

Because all assets are capitalized on the balance at a certain capital target, an asset’s return incorporates the funding benefit of equity. As interest rates rise, expected equity returns rise and the funding benefit of equity to capitalized assets becomes increasingly valuable. Because an asset’s target ROE, or hurdle rate of return, incorporates the funding benefit of equity, those hurdle rates must also follow higher. If the target ROE stays static when interest rates are increasing, asset spreads will increasingly tighten, thereby underpricing risk exposure.

5. Shorter Payment Delays are Worth More

A variety of payment delays exist in the bond market, and how quickly an investor receives principal back matters more when rates are higher. This should make intuitive sense as the opportunity cost of receiving principal back is lower when rates are lower and is higher when rates are higher.

6. No Need for Settlement Fail Charges

In the wake of the Great Financial Crisis when the Fed lowered the fed funds rate to the zero bound, sellers had less incentive to deliver bonds on time because cash returns were so low. In response, the Treasury Market Practices Group headed by the New York Federal Reserve introduced charges for delayed delivery of sold securities, specifically for Treasuries, Agency debt, and Agency mortgage-backed securities (MBS). For Treasuries and Agency debt, the penalty is 2% minus the fed funds rate, and for MBS, the penalty is 3% minus the fed funds rate. In other words, when the fed funds rate moves above 2-3%, fail charges no longer apply because there is appropriate incentive for sellers to deliver bonds and receive proceeds from the sale when prevailing reinvestment rates are much higher.

7. Higher Value on Death Puts in Brokered CDs, Munis and Corporates

Higher rates have increased the value of the estate option, colloquially known as the death put, that is a common feature in certificates of deposit (CDs) as well as some retail-oriented municipal and corporate bonds. Because issuing depositories must honor these contracts, this can become a rising cost to the institution. The death put allows for full redemption of principal at par, plus accrued interest, in the event of death or declaration of incompetence of the security holder. This is particularly important if the fair value of the asset is eroded by a sharp increase in interest rates, as was the case in 2022.

Interested in additional considerations for your depository in a higher interest rate environment? Contact us today to learn more about how ALM First partners with clients to provide unbiased advice that can enhance your bottom-line performance.

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The content in this article is provided for informational purposes and should not be relied upon as recommendations or financial planning advice. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues. While such information is believed to be reliable, no representation or warranty is made concerning the accuracy of any information presented. Statements herein that reflect projections or expectations of future financial or economic performance are forward-looking statements. Such “forward-looking” statements are based on various assumptions, which assumptions may not prove to be correct. Accordingly, there can be no assurance that such assumptions and statements will accurately predict future events or actual performance. No representation or warranty can be given that the estimates, opinions or assumptions made herein will prove to be accurate. Actual results for any period may or may not approximate such forward-looking statements. No representations or warranties whatsoever are made by ALM First Financial Advisors as to the future profitability of investments recommended by ALM First Financial Advisors.

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