Banks Have Been Unloading Bonds at a Loss. Is That a Good Thing?

Just as the industry saw unrealized losses in securities portfolios stabilize last year, the fourth quarter changed all that, putting renewed pressure on banks in the year ahead and raising fresh concerns about valuations, mergers and whether institutions will be forced to sell securities at a loss.

Bond yields have been on a bumpy ride. As bond yields rise, bond values fall, sometimes leaving banks with unrealized losses on the balance sheet from previously purchased bonds.

Unrealized losses on securities increased by 32.5% from the third quarter and 1% from a year earlier, to $482.4 billion on Dec. 31, according to data recently reported by the Federal Deposit Insurance Corp. The agency noted that longer-term interest rates, in particular the 30-year mortgage and10-year Treasury rates, increased significantly during the quarter, decreasing the value of securities on banks’ books.

As of March 17, the 10-year Treasury reversed course again, dropping to 4.29%, but rates are still higher than they were at the end of the third quarter.

The stakes are high, and bank executives and boards must decide whether to hold onto these assets as they slowly mature or cut their losses and remove a worrisome asset from their balance sheet.

Though bankers have historically resisted selling securities at a loss, preferring to hold them until maturity, this mindset has somewhat shifted in the past year, according to investment bankers. For over a year now, banks have been shedding securities to create earnings stability and flexibility down the road.

“The reality for a long time was that recording big securities losses was a dogmatic no-no,” says Brian Leibfried, head of bank insights at investment bank Performance Trust Capital Partners.

“There was a mantra to wait for the assets to mature, but if you do that, you will under-earn for a long, long time,” Leibfried adds. “Once the dogma was broken down, people became more willing to get rid of assets that no longer served a purpose. We’re seeing more people cut loose.”

Interest Rate Surge Reshapes Portfolios
At the start of the third quarter, the outlook seemed more favorable. Interest rates began declining, and unrealized losses were starting to ease. However, the fourth quarter changed the landscape again as the 5-year U.S. Treasury yield increased by 83 basis points, ending the year at 4.43%, while the 10-year Treasury yield rose by 81 basis points to 4.61%.

“Those are massive moves,” says Scott Hildenbrand, head of financial strategies at investment bank Piper Sandler, who closely monitors the 5-year Treasury due to its alignment with the duration of most bonds on bank balance sheets. “A lot of assets are still susceptible to higher rates, which can lead to bigger losses.”

The change seemed to overshadow efforts by several banks to go ahead and move underperforming securities off their balance sheets. “The fourth-quarter spike in rates was too big of a move for the industry, even subtracting those that had already moved assets off the balance sheet,” Leibfried adds.

The increase in unrealized losses has forced more banks to reconsider their portfolio strategies for 2025, convincing some that unloading securities now is preferable to waiting for a sustainable improvement in rates.

In recent months, the average securities restructuring has covered only a fifth of a bank’s total portfolio, as management teams aimed to recapture their losses over a short period. Now, more banks are willing to extend earn-back periods to take a more aggressive approach to cleanup.

Several banks, including $43 billion Associated Banc-Corp in Green Bay, Wisconsin, $3.7 billion Bank of Marin Bancorp in Novato, California, and $7.1 billion Heritage Financial Corp. in Olympia, Washington, have already undergone second rounds of securities sales in the past year, with more institutions expected to follow suit.

More Banks Move to Sell Underwater Securities
Although more banks may be open to selling underperforming securities, the decision comes with significant challenges for management teams and boards. While it can improve long-term earnings stability, the near-term financial impact can be painful.

Under regulators’ dividend rules, banks can only pay dividends based on their last four quarters of earnings, says Chip MacDonald, managing director at the law firm MacDonald Partners. While banks can average earnings over that period, a substantial loss still puts pressure on dividend sustainability. Major losses can impact discretionary bonuses, stock buybacks, and may even prompt regulatory consultations.

“These deals aren’t very happy news,” MacDonald says. “The loss has a lingering impact for banks. Nobody likes that.”

Many banks must also determine how to fill the capital hole created by selling securities at a loss. Several institutions have issued common stock to raise capital in conjunction with securities repositioning — a move that is often unpopular due to the risk of diluting existing investors.

Several banks recently sold stock below tangible book value to purge underwater securities, according to data compiled by Performance Trust.

“Financing with equity at or below book value doesn’t make a lot of sense to me,” Leibfried says. “The investors are probably getting good deals — but the banks should be thoughtful and consider other ways of bringing in capital.”

To avoid dilution, some banks have turned to creative capital-raising strategies. Notably, $12 billion First Busey Corp. in Champaign, Illinois, sold Visa Class B shares, while $972 million Bogota Financial Corp. in Teaneck, New Jersey, and $32 billion Fulton Financial Corp. in Lancaster, Pennsylvania, offset financial losses by executing sale-leaseback transactions on branch properties.

“The decision to shed securities is complicated and ultimately depends on the composition of the entire balance sheet,” Leibfried says. “Two banks could have the same durations, but the buy-or-hold decision could depend on what types of securities they have.”

Unrealized Losses Complicate M&A Deals
The impact of unrealized losses on bank valuations and growth strategies is complex. Securities portfolios matter for M&A activity, where regulatory scrutiny is more pronounced, and in cash deals, where unrealized losses lead to a decline in tangible common equity.

“A buyer with a big unrealized loss might find it harder to do a cash deal for a seller who also has big unrealized losses,” Leibfried says.

Hildenbrand agreed, adding that even stock-based deals may take longer to materialize as both parties navigate portfolio valuations.

“M&A was about to explode as rates fell in the third quarter,” Hildenbrand says. “All of a sudden, you’re having to reexamine the marks at a time when a lot of banks don’t have the equity. It just makes a deal harder to do.”

More banks may look to offload securities before pursuing a buyer. Just like selling a house, conventional wisdom suggests the bank appears more attractive if it addresses balance sheet issues before an acquisition.

“You make sure the roof is right, you clean out the garage — you do all the things you need to do to get it ready,” Hildenbrand says.

While interest rates have eased slightly in early 2025, the long-term outlook remains uncertain. Some banks are choosing to act now, selling securities to gain clarity and control over their financial trajectory.

Any bank considering a major portfolio restructuring should proactively engage with regulators, MacDonald says. “That’s a must — it will give your regulators more confidence in what you’re doing and why.”

Bank Director’s Bank Services Program has more on this topic for members.