Rising Rates and Considerations for Held-to-Maturity Classification

April 21, 2022
Data Point Graph

Inflation data, Federal Open Market Committee (FOMC) rhetoric, and market expectations have pushed treasury rates up significantly across the yield curve, especially across intermediate maturities, where many financial institutions purchase and price assets. Since December 31, 2021, yields across those maturities are up as much as 187bps as can be seen in the table below.

Historical Daily Treasury Par Yield Curve Rates

Source: United States Department of Treasury

For many institutions, this has resulted in large unrealized loss positions in their investment portfolios. For those institutions that have historically had larger investment portfolios, the idea of large swings in unrealized gains and losses may not come as a surprise. However, many institutions have increased their investment portfolios in response to the influx of deposits that have found their way onto bank balance sheets since the beginning of the pandemic. Whatever the path, both are facing steep declines in investment values in the wake of a very rapid rise in market rates.

Over the course of the last few weeks, we have fielded numerous calls from anxious bankers wondering what they should do in reaction to the large losses and the resulting impact on capital. One common theme of those discussions has been the held-to-maturity (HTM) designation and transferring investments from available-for-sale (AFS) to HTM to shield their portfolio and related book capital from experiencing further deterioration. While transferring securities to HTM is a viable option to the aforementioned risks, important considerations should be taken into account prior to making the change.

Book Capital vs. Regulatory Capital

According to Accounting Standards Codification (ASC) 320-10-35, debt securities classified as AFS are required to be measured and reported at fair value. The resulting unrealized gains or losses is excluded from earnings and reported in other comprehensive income until realized, with certain exceptions existing when the AFS is designated as being hedged in a fair value hedge. As a result, the unrealized losses noted above are causing book capital levels to decline and in some cases decline significantly depending upon the size and composition of the institution’s investment portfolio. However, a critical distinction must be made between book capital and regulatory capital.

With the implementation of revised Basel III capital rules on the March 31, 2015 call report, banks were allowed to opt-out of including accumulated comprehensive income (AOCI) as a component of common equity tier 1 (CET1) capital. As such, unrealized losses, which are a component of AOCI, are excluded from regulatory capital calculations.

HTM Designation

As previously discussed, many institutions are looking at moving a portion of their investment portfolio to HTM. This change has important implications that should be considered. But first, let’s discuss what this change would mean from an accounting perspective.

ASC 320-10-35 tells us the following: “For a debt security transferred into the held-to-maturity category from the available-for-sale category, the unrealized holding gain or loss at the date of the transfer shall continue to be reported in a separate component of shareholders' equity, such as accumulated other comprehensive income, but shall be amortized over the remaining life of the security as an adjustment of yield in a manner consistent with the amortization of any premium or discount. The amortization of an unrealized holding gain or loss reported in equity will offset or mitigate the effect on interest income of the amortization of the premium or discount (discussed in the following sentence) for that held-to-maturity security. For a debt security transferred into the held-to-maturity category, the use of fair value may create a premium or discount that, under amortized cost accounting, shall be amortized thereafter as an adjustment of yield pursuant to Subtopic 310-20.”

Important takeaways from this guidance when assessing a decision to transfer AFS investments to HTM:

  • The premium or discount recorded as a yield adjustment is offset by the amortization of the yield adjustment, resulting in offsetting effects on the income statement.
  • The unrealized gain or loss is determined at the date of transfer and remains a component of equity.
  • The unrealized gain or loss is amortized over the remaining life.

It is important to understand that the transfer to HTM does not eliminate the unrealized loss at the time of transfer. That loss remains as a component of equity until the underlying debt security reaches maturity. The resulting transfer to HTM shields the institution from further investment depreciation on the securities transferred. However, it does not eliminate the loss; it freezes it as a component of equity, which may be counter to the initial intentions. Given the transfer date is the determination date of the loss, timing of the transfer can make a significant difference.

Other considerations under the HTM designation:

  • Under the HTM classification, a security cannot be sold except for in a limited number of “safe harbors” otherwise the entire portfolio will be tainted. The resulting impact is a reduction in asset-based on balance sheet liquidity to liability-based liquidity through collateral based borrowing.
  • As market rates change and unrealized loss positions adjust, the institution may not be able to take advantage of strategic opportunities by repositioning HTM securities.
  • While limited, HTM securities with credit exposures fall under the umbrella of Current Expected Credit Losses while AFS debt securities do not.

So Now What?

Each institution faces a different set of circumstances and stakeholders so there is no one size fits all solution. Classifying a portion of the investment portfolio as HTM may be the most prudent alternative for some institutions, but it may present some strategic disadvantages noted above. Regardless of the ultimate decision, certain strategic discussions and assessments should be part of future ALCO meetings.

Liquidity Planning

Liquidity has not been a major risk consideration since the pandemic as many institutions had record increases in their deposit portfolios. However, capital has been strained for some institutions due to balance sheet growth and investment losses have reduced the amount of quickly assessable, asset-based liquidity. With loan demand increasing and uncertainty surrounding the impact of future FOMC actions such as quantitative tightening, institutions should dust off their sources and uses of cash flow and make sure there are no glaring concerns.

Liquidity stress testing including asset growth, deposit run off and a combination of the two should be implemented. The goal should be illustrating the institution’s ability to meet funding needs without needing to sell bonds in a loss position in both normal and stressed scenarios. Consider pledging bonds in loss positions to increase liability-based funding alternatives for liquidity stress events.

Interest Rate Risk (IRR) Management

We are experiencing IRR in real time as of the date of this article. In just over 100 days, rates are up 150bps — while not quite parallel, almost. This is what an institution’s IRR model is supposed to measure. What did your model indicate for rates up 100 and 200bps on December 31, 2021? Were you within your risk limits? Are you still within your risk limits?

If the answers to these questions are yes, then 100 days ago you accepted the position you are in today. The fact is that institutions place IRR bets every day. Your model should help you understand what bets you are placing so you can manage risk appropriately. What will your March 31, 2022, model run tell you? How long before your other assets reprice? How about deposits? You can’t undo the past, but you can be prepared for the future. Your model should help you be prepared.

What Your Balance Sheet Isn’t Telling You

This article is largely focused on unrealized losses in investment portfolios because AFS securities have to be adjusted to market value. What about the loans on the balance sheet? What type of fixed rate terms have you been offering? Better yet, what about the significant non-maturity deposit (NMD) portfolios that still carry a 5-10bps cost of funds?

Institutions aren’t racing to raise deposit rates despite the significant rise in market interest rates. The point being large “gains” reside on the liability side of the balance sheet that don’t get the same attention. A simple illustration would be a five-year Federal Home Loan Bank advance taken out two years ago with a rate of 1.27%. Today, the equivalent three-year advance rate is 3.17% (per For the next three years you get to enjoy an extra 190bps of cost savings (gain). This represents the inverse of what is occurring in the investment portfolio. While it’s easy to focus on losses in the investment portfolio, don’t lose sight of the strategic positions in other areas of the balance sheet such as NMDs.

The uncertainty and volatility of today’s rate markets can be difficult to manage, but a sustained, higher interest rate environment has historically served financial institutions well. Time will tell if the Fed can coordinate a “soft landing” from their accommodative positions.

Contact Eide Bailly today for further assistance with HTM classification.

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