3.8.12Tarini Vaidya- Investment Mgt in Banks

7/28/2019 3.8.12Tarini Vaidya- Investment Mgt in Banks

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W E L I N G K A R

Investment management in banks


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Types of investments

Bonds.

MoneyMarketInstruments.

MutualFunds.

ABS/MBS.

Equity.


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Bonds

Fixed income, coupon paying.

Fixed income, zero coupon.

Floating rate bonds, based on a benchmark rate.


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Fixed rate, coupon paying bond

Pre-determined rate of interest, called coupon.

Interest paid out at regular intervals. GoI bonds pay out semi-annually.

No mandatory pay out interval for corporate bonds, can bequarterly, semi-annual or even annual.

Bullet repayment of principal on maturity, or partrepayment of principal at pre-determined dates.

Embedded Put/Call options. Corporate bonds trade at a discount (higher interest

rate) than GoI bonds.


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Zero Coupon Bond (ZCB)

Issued at a discount to face value.

No interest pay outs at periodic intervals.

Principal + interest paid out at maturity.


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Floating Rate Bond (FRB)

No pre-determined coupon rate.

Coupon is fixed periodically, based on a benchmark.

GoI issued FRBs, where coupon was fixed once every

year on a pre-determined date. Benchmarked to the yield on last 3 auctions of 364

day T-bills.

Protect investors in rising interest rate environment.

Difficult to price and revalue.


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Which bond has higher credit risk -ZCB or Coupon paying bond?

ZCB has

higher creditrisk, as therepayment isa balloon /

bulletrepayment atthe end of thetenure.

There are nointermediatecash flows.


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Which bond has re-investment risk ZCB or coupon paying bond?

The coupon

paying bond.

Intermediatecash flowsmust be re-

invested.

What ifinterest rateshave fallen

since thebond wasissued?


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Yield-to-maturity

YTM is the internal rate of return (IRR) earned by aninvestor who buys the bond at todays market price,and holds the bond to maturity.

Discount rate at which the sum of all future cashflows (coupon + principal) are equal to the price ofthe bond today.


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Elements of YTM

Face value of bond.

Coupon (interest rate).

Frequency of interest payment.

Deal date. Maturity date.

Interest calculation basis/day count.

Market price.


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Day count

Number of days between coupon pay-out dates.

30/360 : assumes each month has 30 days, and a yearhad 360 days. Bond basis.

Actual/365 : actual number of days in each month, andeach year has 365 days (no leap year). Money marketbasis.

Actual/actual : actual number of days in each month and

actual number of days in the year. GoI bonds issued on 30/360 day basis.

No specific day count convention for corporate bonds.


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Yield to Maturity/Price

WELINKAR - YTM.xlsx

Price and YTM have an inverse relationship.

Long dated bonds (>1 year) are traded on price basis.

Short term securities (CP,CD, T-bills) are traded on aYTM basis.
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Money Market Instruments

Commercial

paper (CP).

Certificatesof deposit

(CD).

Bills Re-discounting

Scheme(BRDS).


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Commercial paper

Issued by corporate/non-banks.

Used for short term working capital.

Minimum tenure : 7 days

Maximum tenure : < 1 year Issued at discount to face value.

Day count calculation : actual/365, money market.

Investors : banks, mutual funds, FIIs, insurers. Credit rating required before issue of CP.

Traded on YTM basis.


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Certificate of deposit

Issued by banks.

Used to raise short term resources.

Advantage over fixed deposits.

Minimum tenure : 7 days Maximum tenure : < 1 year

Issued at discount to face value.

Day count calculation : actual/365, money market.

Investors : banks, mutual funds, FIIs, insurers. Credit rating required before issue of CD.

Traded on YTM basis.


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Bills re-discounting scheme

Banks discount trade bills for their clients.

Banks can re-discount these with another marketparticipant.

Minimum tenure:15 days, maximum tenure 90 days.

Banks issue BRDS to raise short term funds, which arecheaper than deposits/CDs, as BRDS does not attractstatutory reserve costs.

Banks issue BRDS to reduce Priority Sector Lending

requirements. Banks invest in BRDS to invest short term liquidity, or

buy Priority Sector assets.


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Reserve cost

WELINGKAR - YTM.xlsx
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Priority sector lending

Banks must give 40% of aggregate bank advances to aborrower in the priority sector.

Priority sector : 13.5% to direct agriculture : individual farmers 4.5% to indirect agriculture : warehouses

22% to micro and small scale sector : investment in plant & machinerynot > Rs. 25 lakhs.

Penalty : investment in NABARDs Rural InfrastructureDevelopment Fund (RIDF), which carries a very low interestrate.

Bank advances computed on last Friday of March. Banks resort to lending their assets under BRDS to reduce

advances on computing date. PSL deficit banks buy BRDS ofeligible advances from other banks.


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Securitised paper

Asset backed

securities.

Mortgagebackedsecurities.

Inter-bankparticipation


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Asset Backed Securities (ABS)

Banks bundled various retail loans (car loans, 2-wheeler loans, personal loans) and down sold themto an investor.

Bank received discounted value of all loans upfront. Bank continued to collect EMIs, and pass on the

monthly collections to the investors.

However, because bank had sold down the loan, was

not worried about potential defaults. Investors were cash surplus, or were attracted by the

discounting rate.


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Mortgage Backed Securities (MBS)

Banks bundled various retail housing loans anddown sold them to an investor.

Bank received discounted value of all loans upfront.

Bank continued to collect EMIs, and pass on themonthly collections to the investors.

However, because bank had sold down the loan, wasnot worried about potential defaults.

Investors were cash surplus, or were attracted by thediscounting rate.


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What could go wrong?

Profits were bookedupfront, capital was

released.

Banks no longercared about thecredit quality of the

borrower as they

were not going tohole the loans ontheir books.

Loans were given touncreditworthy

borrowers.

Defaults began, andtook down theholders to

ABS/MBS.


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Mutual funds

Liquid funds

Debt funds

Equity funds


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Equity

Limited

holdings.

Tradingportfolios.

Quick churn.


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Managing investments in banks

Strategies

Portfolios


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Active Passive

Analyse data, predict ratemovements, formulatean interest rate view.

Trade on marketinefficiencies (bank CD

Vs corporate CP)

Analyse each security(ICICI Vs HDFC Bank)

Time market entry andexit.

Control risk.

Balance risk and return. Buy and hold.

Match to duration.

Strategies


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Statutory Portfolio Discretionary Portfolio

Mandatory subvention :Statutory Liquidity Ratio(SLR). Computation.

Eligible investments.

Why mandated?

Evolution : 40% to 23% GoI bonds, T-bills.

Excess SLR.

Corporate bonds.

Commercial Paper.

Certificates of Deposit.

BRDS.

Asset/Mortgage BackedSecurities.

Mutual Funds

Equity.

Banks portfolios


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Statutory Liquidity Ratio

Mandated to protect banking system from liquiditycrisis.

Computed as a % of NDTL.

Computed every Reporting Friday. Investments in : cash, gold, eligible securities

Central GoI bonds and Treasury bills.

State bonds.


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SLR market evolution pre 1992

High SLR requirement (40% of NDTL).

Regulated interest rates : deposit and lending rates.

Lack of transparency in market (no NSE, NDS-OM).

Poor communication systems : telephone, fax.


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How would you manage SLR?

Passivemanagement:

Investment in SLRbonds limitedlargely to statutoryrequirement, not

much excess SLR.

Match to durationof underlyingdeposits.

Interest ratesregulated, so notmuch focus onMTM.


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Strategy analysis

Flat yield curve strategy is ok

Sharply positive yieldcurve scenario strategy does notmaximise returns.

Totally ignores going-concern concept.

No interest rate viewtaken.

Statutory portfolio@ 40% of DTL +passive

management = NOmanagement,erosion ofshareholder value.


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Corporate bond market evolution pre 1992

Lack of transparency in non-SLR market. Co-operative banks have more deposits and lower

loans. Look for investments in non-SLR bonds.

Non-SLR bonds largely cornered by commercialbanks.

Broker-bank relationship.

Brokers sold non-SLR bonds to co-op banks ininteriors at high mark up to fair market price.

Bankers Receipts rampant.

Financial irregularities : 1992 Scam!


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Bond market evolution 1993

Prudential norms for classification of securities RBI introduces classification of securities into HTM, AFS and

HFT categories.

HTM is not marked-to-market.

AFS is MTM quarterly.

HFT is MTM daily.

Only 25% of all investments can be classified asHTM, rest has to be AFS.

Banks forced to account for diminution in portfoliovalue.


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The golden years : 1996 to 2003

Rapid deregulation of Indian financial system resultsin easing interest rates. SLR brought down to 25% ofNDTL, interest rates de-regulated.

S.E Asian crisis, money flows cautiously to India. Dot com boom and bust, 9/11 terror attacks.

US Fed lowers interest rates to jump start USeconomy.

Globally interest rates fall, also in India.


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How would you manage a fixedincome portfolio?

Aggressive

strategy


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SLR bonds Non-SLR bonds

Huge excess SLR ~38% ofNDTL.

Mostly in AFS.

Extend portfolio duration asyield curve is upwardsloping.

Actively manage portfolioreturn by trading income.

SLR seen as another assetclass to generate income.

Banks invest in CPs andcorporate debt to get

positive carry.

Non-SLR bonds carried inAFS portfolio.

Brokers use banks balance

sheets to warehouse bonds.

Active and aggressive strategy


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The golden years

Huge trading and MTM profits generated.

Fixed income teams expanded.

Accommodative monetary policy in US and India.

Huge investments in non-SLR bonds, newinstruments ABS, MBS.


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Strategy analysis

Loss of focus on corebanking business ofbeing a financialintermediary.

Large risk positions,capable of causingP&L swings.

Income from non-

core activities.

Lazy banking.

Statutoryportfolio @ 25%of DTL +

aggressivemanagement =MISmanagement.


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The shock

June 2004, US Fed raises Fed Funds rate after years ofaccommodative monetary policy.

Contagion effect in India : RBI follows suit and tightensmonetary policy.

10 year yield rises from record low of 4.97%.

Banks stuck with huge excess SLR in AFS. MTM losses taint quarterly results. Appeal through FIMMDA to RBI. RBI allows banks to designate entire statutory requirement (25%

NDTL) as HTM.

Also stipulates no new non-SLR can be classified asHTM. Banks fixed income portfolios, largely in AFS category, look

terrible!


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2004 : the turning point

Banks allowed one extra instance to transfer securitiesfrom AFS to HTM, at lower of book or market value.

Banks book some losses.

Over the next few years, SLR portfolio is maintained atclose to statutory requirement, low excess.

Short SLR managed through Repo in.

Banks invest cautiously in non-SLR corporate bonds in a

rising interest rate environment. More activity in ABS/MBS, for profit booking and capital

release.


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2008 : another turning point

August 2007 : US sub-prime surfaces. Dec 2007-Jan 2008 : India unaffected, feel good

persists.

March 2008 : Bear Sterns collapses and is sold to JPMorgan. India inflation rises, oil touches $142/b inJuly.

RBI raises interest rates to fight inflation.

Interest rates rise. Indian bond yields rise. 10 year G-Sec at 9.47% by Q3 FY 2008-09.

Fixed income portfolios look ugly.


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Stop losses

Your are long AAAcorporate bonds.

10 year G-sec yieldhas risen from ~6.50% to 9.50%.

AAA corporatebond spread hasrisen to 225bps.

Your Treasurer andCFO are concerned

about the negativeimpact of MTM onyour holdings.

They ask you to sell.


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Quantitative easing

Contagion spreads from US to Europe, central banksreduce rates significantly.

Sept 2008 : AIG is bailed out by the Fed. Sept 15, 2008 :Lehman Bros files for bankruptcy.

Financial crisis threatens the global market. Many international banks downgraded. Lack of risk appetite, markets in danger of seizing up. RBI follows by reducing the Repo rate. Lack of risk appetite, markets in danger of seizing up. Fed injects liquidity via QE I : Nov 25, 2008 buys $600

bn of toxic assets. With so much liquidity in the markets, rates begin to fall.


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Stop loss

RBI reduces Repo rate from 9% in July 2008 to6.50% by December 2008.

Indian 10 year G-Sec yield falls to 5.24% by Dec

2008 (from 9.47% in Sept 2008). 10 year AAA corporate yields went from ~ 11% to

8.60%


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As the fixed income manager whosestop loss was triggered @ 11%, howdo you feel now?

Stop losses

are anecessary eviland are a partof every

traders life.

Disciplined

trading is thebest policy inthe long run.


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2008-2009

Banks sell directly out of HTM to book profits.

FY 2009-10 : 10 year G-Sec yield moves to 6-6.5%.

FY 2010-11 : domestic inflation, liquidity tightness,

fears of contagion effect of Greece, Eurolanddefaults.

Liquidity tightness in domestic markets.

As the fixed income trader of a bank how would you

manage the duration of your portfolio?


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Banks predict rise in interest rates.

Reduce duration of SLR portfolio to < 3 years, toreduce loss in rising interest rate environment.

What went wrong?

Short end of curve rose by 125 bp, 10 year by 25 bp.

Banks portfolios under water!


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Evolution of investment management

FY 2001 to FY 2004 aggressive management, hugetrading profits, capital accretion.

FY 2004 to FY 2006 fingers burnt, passivemanagement.

Both erode share holder value.


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SLR portfolio

Sensible management Balance risk and reward

Maintain portfolio duration in line with the average durationof the underlying liabilities.

Keep some SLR bonds in AFS, and use this to tweak theportfolio (duration, income).


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Non-SLR portfolio

Sensible management : long dated bonds Balance risk and reward

Churn the portfolio often, so that fresh holdings are at close tomarket rates.

Limit book size to manageable levels.

Pre-sell before bidding for fresh issues.

Buy high rated, liquid paper.


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Conclusion

No textbook approach.

Markets the great teacher.

Statutory portfolio managed prudently.

Discretionary portfolios managed more aggressively. Disciplined trading is key.

3.8.12Tarini Vaidya- Investment Mgt in Banks

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