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Examining Loans vs. Bonds in Today's Market

By Aaron Stoffer, Relationship Magager

Simply put, banks are in the business of taking in deposits and making loans.  Our brick and mortar locations and staff work to serve our communities for this purpose.  So, it would make sense that anytime we can make a loan, regardless of competitive pressure on rate, we make it, right?  Well, the answer to this question is really “it depends”.  When examining the profitability of both making a loan or purchasing a bond, there can be times when a bond might add more to the bottom line.  Let’s take a look…
The example below came from a recent ALCO meeting.  When discussing the loan pipeline and pricing, the lenders mentioned that competition and remaining abundance of cash in the market is slowing the upward momentum in rates among commercial loans.  Currently, rates are somewhere in the upper 4.00 percent range for a 7-year term loan with a 20-year amortization. While this might seem like a great rate given we have just come from rates in the low 3.00 percent range, this rate is almost 200 basis points below where the swaps market would price this structure. However, 4.00 percent is still a decent return if we can make a better profit from a good credit loan versus purchasing an investment.  This is where we can share an example and examine the math.  Let’s review an investment option, a 30 year 4 percent mortgage back security that is an amortizing asset like the loan being considered.  This table below shows a brief summary and the simple math when placing the two side by side.  

When we look at profitability on a loan, we must include our allocation to the allowance, capital, overhead, plus an assumption of a one percent origination fee collected.  On the investment, there isn’t an allocation for the allowance, capital is at 20 percent of the loan allocation, overhead is substantially lower for investments (remember the point above), and there isn’t any additional fee income.  The cost of funds for both are the same, because we are using deposits. The breakeven rate on the loan where you are getting the same profit assuming no credit risk is 5.25 percent.  

This analysis isn’t done to tell anyone to stop making loans and focus only on investments. This analysis is to help everyone focus on the profitability in your balance sheet and pricing of assets.  If you are able to get a loan rate that creates more profit for the bank, then that should be your choice.  If you are in a competitive negotiation with a customer, knowing your options before committing your resources will help you make the best decision for your shareholders.  

If you have questions on this analysis, or how to do this using our Loan Builder tool on our website, please reach out to, or your investment representative.


This information is intended for institutional investors only. The material provided in this document/presentation is for informational purposes only and is intended solely for private use. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instruments.

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