ViewPoint: Interest Rate Yields
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Spotlight: Interest Rate Yields
The Quest for Yield in a Low-Rate, High-Volatility Environment
August 2011 opened with a bang and has turned out to be a wild time in financial markets. The last-minute debt ceiling decision, Standard & Poor's credit downgrade of U.S. debt, and the Federal Reserve's decision to publicize its intent to keep short-term interest rates low into mid-2013 were some especially noteworthy events.
Extreme volatility in the financial markets occurred, with a sharp stock market correction followed by large daily stock market gyrations. In spite of the U.S. debt downgrade, U.S. Treasuries experienced a flight to quality, which increased prices (thus decreasing yields) as stock market volatility increased. Put another way, prices of the downgraded assets increased—a market reaction that took some participants by surprise. Just when it appeared rates could not go much lower, rates across the yield curve dropped. All of these events are happening against the backdrop of global economic concerns, especially in Europe, renewed fear over banking conditions, and talk of a double-dip recession. These are complex and challenging times for the markets and for financial institutions.
Earnings pressure and profitability challenges
Risk and return: Interest rate risk implications
Net yields can be increased by purchasing assets with maturities further out on the curve, by purchasing assets with optionality such as callable or prepayable securities, or by increasing credit risk. Credit risk can be added in a number of ways, such as entering new markets or lowering underwriting standards to pick up additional interest spread.
An interagency advisory on interest rate risk, SR 10-1, dated January 11, 2010, highlights the need for active oversight and a comprehensive risk management process that effectively measures, monitors, and controls interest rate risk. SR 10-1 is especially relevant given the increase in the number of reported instances of yield-enhancing strategies such as the lengthening of duration in loan and investment portfolios, purchasing structured securities (which have complex embedded options), and seeking alternative loan products. Though offering higher promised returns, each of these strategies can elevate a firm's risk profile, and some strategies are more complex with additional risks that are difficult to quantify.
Some bankers have been approached recently by third parties promoting various yield-improvement strategies. One such strategy includes asset swaps where problem loans or other real-estate-owned properties are sold at par simultaneously with the purchase of high-yielding assets that pose significant credit risk. For any balance sheet strategy, banking supervisors expect a firm's management and board of directors to completely understand the full spectrum of risks a strategy may produce and how these risks may affect the firm.
All in all, expect the unexpected
This article was written by John Kolb, an assistant vice president in the supervision and regulation department at the Atlanta Fed's Birmingham Branch.