Bankers should consider the shape of the yield curve when structuring and pricing loans to maximize return and reduce risk. The shape of the yield curve can also help lenders understand borrowers’ needs and better position the bank against competitors. Having a working knowledge about yield curve shape and history will help move the conversation away from price while setting your relationship managers up to have a more in-depth, trusted advisor conversation.
Definition of The Yield Curve
A yield curve plots interest rates with different maturity dates but for the same credit quality counterparty. While swap and Treasury yields are the most frequently reported yield curves, a yield curve can be constructed for any credit counterparty. In this article, we will utilize the US Treasury curve to explain our lending strategy. The advantage of using a yield curve is that it allows lenders to compare different loans (different credit qualities) against a benchmark. Bankers can then price loans off the benchmark (using the yield curve to adjust for the tenor of commitment). However, the shape of the yield curve is also a predictor of economic output and growth, and potentially credit quality, interest rate risk, and a powerful marketing tool.
The shape of the yield curve is a strong factor affecting credit risk, interest rate risk, and sales/marketing approach to commercial loans. The graph below shows six yield curves from 1999 to the present. Comparing different shapes, levels, and prevailing economic environments is very telling in how banks position their credit products.
We will isolate each period and consider the germane signs from the shape and position of the yield curve on credit risk, interest rate risk, and commercial loan marketing. In December 1999, the US economy had experienced almost ten years of positive growth, and outside of the Y2K scare, lenders and borrowers were upbeat about the state of the US economic markets. However, interest rates were high based on the then-current historical standards and certainly in the current context. Higher interest rates resulted in lower cash flow coverage.
Further, the term premium (the cost to the borrower for five or 10yrs vs. float) was significant – over 100 bps. Borrowers could be convinced to float because of the cost of the term premium. Any reduction in interest rates helped both lenders and borrowers in added cost savings. Banks could position commercial loans as floating, and short term fixed and attract borrowers. However, the table below outlines how the shape and level of the yield curve for each period altered lender and borrower motivation and changed interest and credit risks and also altered sales opportunities for banks.
Every banker, particularly relationship managers, should understand the history and ramifications of yield curve level and shape. After all, the yield curve is the single largest factor in determining both risk and profitability in a bank next to credit. No matter if you are in marketing, the branch, risk, operations or in front of borrowers, being conversant in yields, will give you a competitive advantage. Interest rates are a bank’s stock and trade. By observing the yield curve, bankers can better assess risks caused by interest rate movements and credit migration. The yield curve also creates unique marketing and sales opportunities for community banks.
In the present environment, interest rates are at historically low levels, and while the yield curve is flat, a recession is not predicted by the market or most economists. The challenge for banks is finding quality credits, accepting lower yields in return for lower risk, and addressing demand from borrowers for rate certainty given the lack of a term premium.
Submitted by Chris Nichols on July 09, 2019