Independent Banker - November 2022 - 35

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Equal amounts of short- and long-term
investments ... will work out fine, if either a) the
curve inverts further; b) the curve begins to
steepen; or c) the curve remains flat.
been, inverted. Tax-free munis appeal
to many buyers, including individuals.
In fact, most of that sector is owned
by retail investors, whose needs (and
marginal tax brackets) are diff erent
than your bank's. Retail demand sets
the yield curve for all muni buyers,
and mom and pop tend to load up on
short bonds, which keeps short yields
under wraps.
to, depositories, have wholly
diff erent investment objectives and
risk tolerances. Long investment
yields, the proxy for which are 10year
bonds, are more aff ected by
infl ation expectations.
Every Fed fund hike should, in
theory at least, give longer buyers
some added comfort that infl ation
will be well behaved. In a year like
2022, which has seen three full
percentage points in rate hikes on the
short end, we're almost certain to see
the curve fl atten, and possibly invert.
As investor sentiment by a number
of measures now expects infl ation to
remain off its peak from earlier this
year, the fi nal component for a curve
inversion has entered the mix.
Here's the dilemma: If an inverted
yield curve is a reliable predictor of
an impending recession, and interest
rates both short and long are going to
fall soon, where should investors place
their bets today? In theory, it should
be on the long end, which leaves
money on the table-today.
MBS, too
As we dig into the less-is-more
narrative of upside-down curves,
we can now add mortgage-backed
securities (MBS) to the list, which is
highly unusual. It is a rare condition
indeed when shorter MBS out-yield
longer ones, and this has to do with
prepayment expectations. As home
mortgage rates have doubled this
year, anyone with an existing loan
is going to sit tight and pay only
the minimum amount of principal
each month.
QUICK STAT
28
The number of times the two- to
10-year segment spread has
inverted since 1900.
Source: Reuters
That means the lower rate pools will
be longer in duration, and also lesser
in yield, than more current ones. To
put a pencil to it, a FNMA 15-year
pool with a 4% stated rate will yield
about 4% at the moment, whereas a
15-year 3% pool will produce about
a 3.5% return. When we add that the
4% MBS is expected to be nearly a
year shorter in average life, one can
see why the " up in coupon " trade
makes full economic sense in 2022.
Muni curve still steep
I need to mention that a sector that is
quite important to community banks
is not now, nor has it ever recently
As of October 2022, the investmentgrade
muni curve was positively
sloped by about 70 basis points
(0.70%) for C corps, and even more
for S corps. This is proof that the
municipal sector has a mind of its
own. It is the least aff ected, for better
or worse, by Fed activity.
Here's a thought
So what do we make of all of this
inversion business? The yield curve
is on a 40-year winning streak of
predicting slowdowns. It's also clear
that short yields have gotten to
levels that can make some money
for community banks, whose deposit
costs have remained quite low. So
how about this as a suggestion: a
barbell structure.
Equal amounts of short- and longterm
investments (you get to defi ne
those limits) will work out fi ne, if
either a) the curve inverts further; b)
the curve begins to steepen; or c) the
curve remains fl at. And I'd say there's
a good chance of one of those results
occurring. So my advice (no surprise
here!) is to invest at diff erent parts
of the curve, in a variety of products.
And you can leave the tumult of the
yield curve's shape to the pundits. 
Jim Reber, CPA, CFA (jreber@
icbasecurities.com), is president
and CEO of ICBA Securities, ICBA's
institutional, fixed-income brokerdealer
for community banks
independentbanker.org Q 35
http://www.independentbanker.org
Independent Banker - November 2022

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