Independent Banker - December 2020 - 60

punitive to invest in Fed funds when
you're only earning 10 basis points,
but your cost of funds is 60 basis
points or more. "
Another big challenge community
banks are facing is the collapse of the
yield curve. " The spread between twoyear
and 10-year Treasuries is down
to 50 basis points, so there's very
" I believe investment
decisions should be
made within the context
of the balance sheet.
Community bankers
need to ask themselves
if they're doing things
they wouldn't do in more
normal times. "
-Kevin Smith, Vining Sparks
little wiggle room, " Erhardt says. " In
comparison, there was a 200 basispoint
spread after the financial crisis a
decade ago. "
Deploy excess liquidity
All of these factors make managing
an investment portfolio that much
more important for community
banks. It is, after all, one of the few
things a bank can control. " In the
current environment, " Erhardt says,
" the investment portfolio becomes a
larger percentage of a bank's earning
assets. So, the No. 1 priority from an
investment perspective is to deploy
excess liquidity-whether this is
making loans, buying loans or adding
investment securities. "
High-grade municipal bonds have
always been a bedrock investment
for community banks, making up
56 Q ICBA Independent Banker Q December 2020
between a quarter and a third of
the typical community bank bond
portfolio. Erhardt says that munis
currently offer the highest yield and
spread over Treasuries.
Smith agrees but notes that
community banks will need to refocus
on the municipal bond review process
next year due to concerns about some
cities' and states' financial standing.
Tax collections have gone down in
many areas due to the economic
impact of the pandemic.
According to Hancock, some
community banks have become more
willing to assume more credit risk in
the current environment in the search
for higher yields. " For example, some
banks are buying out-of-state munis
or lower-rated munis, " he says. " But
you have to be careful here. Banks
take plenty of risk in their loan
portfolios, which is where I believe
their risk should be because it's where
they get rewarded. "
Erhardt agrees, recommending
that community banks stick with
AAA-rated or AA-rated municipal
bonds. He says the typical community
bank buys tax-exempt municipal
bonds and fills in a cash flow ladder
with amortizing securities like
agency mortgage-backed securities
(MBS) and collateralized mortgage
obligations (CMOs). " These are the
core holdings of a community bank's
portfolio; they make principal and
interest payments each month that
you can redeploy into loans when loan
demand comes back, " he adds.
" When bank earnings are stressed,
there's always the temptation to
take on more risk, " Smith says. " I
believe investment decisions should
be made within the context of the
balance sheet. Community bankers
need to ask themselves if they're
doing things they wouldn't do in more
normal times. "
Bonds provide the flexibility needed
to get the community bank's risk
profile in line with where it should
be, Hancock adds. " If your risk is
declining rates, look for bonds that
Independent Banker - December 2020

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