Chapter TenChapter Ten

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Chapter Ten

The Investment Function in Bankingand Financial Services ManagementThe Investment Function in Bankingand Financial Services Management

Functions of a Bank’s SecurityPortfolio

Functions of a Bank’s SecurityPortfolio

• Stabilize the Bank’s Income Over aBusiness Cycle

• Offset Credit Risk Exposure• Provide Geographic Diversification• Provide Backup Source of Liquidity• Reduce Tax Exposure• Serve as Collateral for Govt. Deposits• Hedge Against Interest Rate Risk

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• Stabilize the Bank’s Income Over aBusiness Cycle

• Offset Credit Risk Exposure• Provide Geographic Diversification• Provide Backup Source of Liquidity• Reduce Tax Exposure• Serve as Collateral for Govt. Deposits• Hedge Against Interest Rate Risk

Money Market Instruments Usedby a Bank (Mostly for Liquidity)Money Market Instruments Usedby a Bank (Mostly for Liquidity)

• Treasury Bills• Short-Term Treasury Notes and Bonds• Federal Agency Securities• Certificates of Deposit• Eurocurrency Deposits• Banker’s Acceptances• Commercial Paper• Short-Term Municipal Obligations

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• Treasury Bills• Short-Term Treasury Notes and Bonds• Federal Agency Securities• Certificates of Deposit• Eurocurrency Deposits• Banker’s Acceptances• Commercial Paper• Short-Term Municipal Obligations

Capital Market Instruments Usedby a Bank (Mostly for Income)

Capital Market Instruments Usedby a Bank (Mostly for Income)

• Treasury Notes and Bonds Over OneYear to Maturity

• Municipal Notes and Bonds• Corporate Notes and Bonds• Asset Backed Securities

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• Treasury Notes and Bonds Over OneYear to Maturity

• Municipal Notes and Bonds• Corporate Notes and Bonds• Asset Backed Securities

Other More Recent InvestmentInstruments

Other More Recent InvestmentInstruments

• Structured Notes – packaged investmentsassembled by security dealers that offercustomers flexible yields.

• Securitized Assets – loans placed in a pooland securities issued against that pool

• Stripped Securities – principal and interestseparated and each sold as a separate zerocoupon security

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• Structured Notes – packaged investmentsassembled by security dealers that offercustomers flexible yields.

• Securitized Assets – loans placed in a pooland securities issued against that pool

• Stripped Securities – principal and interestseparated and each sold as a separate zerocoupon security

Dominant Investments Held ByBanks–preferred securities

Dominant Investments Held ByBanks–preferred securities

• Obligations of the U.S. Government andGovernment Agencies

• State and Local Government Obligations

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• Obligations of the U.S. Government andGovernment Agencies

• State and Local Government Obligations

Factors Affecting the Choice ofSecurities

Factors Affecting the Choice ofSecurities

• Expected Rate ofReturn

• Tax Exposure• Interest Rate Risk• Credit Risk• Business Risk

• Liquidity Risk• Call Risk• Prepayment Risk• Inflation Risk• Pledging

Requirements10-7

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• Expected Rate ofReturn

• Tax Exposure• Interest Rate Risk• Credit Risk• Business Risk

• Liquidity Risk• Call Risk• Prepayment Risk• Inflation Risk• Pledging

Requirements

Expected Rate of ReturnExpected Rate of Return

Yield to Maturity

Holding Period Returnsecurity theof valueface theisFVwhere

andsecurityon thepaymentscouponannual theareCPwhere

YTM)(1

FV

YTM)(1

CPPV

nn

1t

tBond

n

t

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Yield to Maturity

Holding Period Returnsecurity theof valueface theisFVwhere

andsecurityon thepaymentscouponannual theareCPwhere

YTM)(1

FV

YTM)(1

CPPV

nn

1t

tBond

n

t

heldissecurity theyearsofnumber theisHPwhere

andforsoldbecansecurity theprice theisPwhere

HPR)(1

P

HPR)(1

CPPV

HP

1tHP

t

YTM ProblemYTM Problem

• A govt. bond is expected to mature in twoyears and has a current price of $950.What is the bond’s YTM if the par value is1000 and the coupon rate is 10%.

• YTM = 12.99%=• If the bond is sold after 1 year for $970

what is the holding period yield.• YTM = 12.63

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• A govt. bond is expected to mature in twoyears and has a current price of $950.What is the bond’s YTM if the par value is1000 and the coupon rate is 10%.

• YTM = 12.99%=• If the bond is sold after 1 year for $970

what is the holding period yield.• YTM = 12.63

Tax ExposureTax Exposure

• The Tax Status of State and LocalGovernment Bonds

• Bank Qualified Bonds• The Portfolio Shifting Tool

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• The Tax Status of State and LocalGovernment Bonds

• Bank Qualified Bonds• The Portfolio Shifting Tool

Interest Rate RiskInterest Rate Risk

• Rising Interest Rates Lowers the Value ofPreviously Issued Bonds

• Longest –Term Bonds Suffer the GreatestLosses

• Many Interest Rate Risk Tools IncludingFutures, Options, and Swaps Exist Today

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• Rising Interest Rates Lowers the Value ofPreviously Issued Bonds

• Longest –Term Bonds Suffer the GreatestLosses

• Many Interest Rate Risk Tools IncludingFutures, Options, and Swaps Exist Today

Default RiskDefault Risk

Investment Grade

Moody’s S&PAaa AAAAa AAA ABaa BBB

Speculative Grade

Moody’s S&PBa BBB BCaa CCCCa CCC C

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Investment Grade

Moody’s S&PAaa AAAAa AAA ABaa BBB

Speculative Grade

Moody’s S&PBa BBB BCaa CCCCa CCC C

Business RiskBusiness Risk

• Risk that the Economy of the Market Areathey Serve May Turn Down

• Security Portfolio Can Offset This Risk• Securities Can be Purchased From Outside

Market Area Served

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• Risk that the Economy of the Market Areathey Serve May Turn Down

• Security Portfolio Can Offset This Risk• Securities Can be Purchased From Outside

Market Area Served

Liquidity RiskLiquidity Risk

• Breadth and Depth of Secondary Market– Number of Trades on an Given Day– Volume of Trades on Any Given Day

• Treasury Securities are Generally the MostLiquid

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• Breadth and Depth of Secondary Market– Number of Trades on an Given Day– Volume of Trades on Any Given Day

• Treasury Securities are Generally the MostLiquid

Call RiskCall Risk

• Corporations and Some GovernmentsReserve the Right to Retire the Securitiesin Advance of Their Maturity

• Generally Called When Interest RatesHave Fallen

• Investor Must Find New Security – Oftenwith a Lower Return

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• Corporations and Some GovernmentsReserve the Right to Retire the Securitiesin Advance of Their Maturity

• Generally Called When Interest RatesHave Fallen

• Investor Must Find New Security – Oftenwith a Lower Return

Prepayment RiskPrepayment Risk

• Specific to Asset-Backed Securities• Most Consumer Mortgages and Loans

Can Be Paid Off Early• Caused by Loan Refinancing Which

Accelerate When Interest Rates Fall• Caused by Asset Turnover When

Borrowers Move or are Not Able to MeetLoan Payments and Asset is Sold

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• Specific to Asset-Backed Securities• Most Consumer Mortgages and Loans

Can Be Paid Off Early• Caused by Loan Refinancing Which

Accelerate When Interest Rates Fall• Caused by Asset Turnover When

Borrowers Move or are Not Able to MeetLoan Payments and Asset is Sold

Inflation RiskInflation Risk

• Purchasing Power from a Security or LoanMay be Eroded by Rising Prices

• Recently Developed Inflation Risk Hedge– Treasury Inflation Protected Securities

• Both Coupon Payments and PrincipalAdjusted Annually for Inflation Based onConsumer Price Index

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• Purchasing Power from a Security or LoanMay be Eroded by Rising Prices

• Recently Developed Inflation Risk Hedge– Treasury Inflation Protected Securities

• Both Coupon Payments and PrincipalAdjusted Annually for Inflation Based onConsumer Price Index

Pledging RequirementsPledging Requirements

• Depository Institutions Cannot AcceptFederal, State and Local GovernmentDeposits Unless Acceptable Collateral isPledged

• Generally Treasury Securities,Government Agency Securities andSelected Municipal Securities Can Be Usedas Collateral

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• Depository Institutions Cannot AcceptFederal, State and Local GovernmentDeposits Unless Acceptable Collateral isPledged

• Generally Treasury Securities,Government Agency Securities andSelected Municipal Securities Can Be Usedas Collateral

Investment Maturity StrategiesInvestment Maturity Strategies

• The Ladder or Spaced-Maturity Policy• The Front-End Load Maturity Policy• The Back-End Load Maturity Policy• The Barbell Strategy• The Rate Expectation Approach

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• The Ladder or Spaced-Maturity Policy• The Front-End Load Maturity Policy• The Back-End Load Maturity Policy• The Barbell Strategy• The Rate Expectation Approach

Maturity Management ToolsMaturity Management Tools• The Yield Curve

– Picture of How Market Interest Rates DifferAcross Differing Maturities

– Constructed Most Easily with Treasury Securities– Provides Information About the Risk Return

Trade-Off• Duration

– Present Value Weighted Average Maturity of theCash Flows

– Can Be Used to Insulate the Securities FromInterest Rate Changes

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• The Yield Curve– Picture of How Market Interest Rates Differ

Across Differing Maturities– Constructed Most Easily with Treasury Securities– Provides Information About the Risk Return

Trade-Off• Duration

– Present Value Weighted Average Maturity of theCash Flows

– Can Be Used to Insulate the Securities FromInterest Rate Changes

Maturity strategy problemMaturity strategy problem

• BACONE National Bank has structured itsinvestment portfolio, which extends out to four-year maturities, so that it holds about $11 millioneach in one-year, two-year, three-year and four-year securities. In contrast, Dunham NationalBank and Trust holds $36 million in one andtwo-year securities and about $30 million in 8- to10-year maturities. What investment maturitystrategy is each bank following? Why do youbelieve that each of these banks has adopted theparticular strategy it has reflected in thematurity structure of its portfolio?

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• BACONE National Bank has structured itsinvestment portfolio, which extends out to four-year maturities, so that it holds about $11 millioneach in one-year, two-year, three-year and four-year securities. In contrast, Dunham NationalBank and Trust holds $36 million in one andtwo-year securities and about $30 million in 8- to10-year maturities. What investment maturitystrategy is each bank following? Why do youbelieve that each of these banks has adopted theparticular strategy it has reflected in thematurity structure of its portfolio?

Maturity strategy answerMaturity strategy answer• Bacone National Bank has structured its investment

portfolio to include $11 million equally in each offour one-year maturity intervals. This is clearly aspaced maturity or ladder policy. In contrast,Dunham National Bank holds $36 million in oneand two-year securities and about $30 million in 8and 10-year maturities, which is clearly a barbellstrategy. Dunham National Bank pursues itsstrategy to provide both liquidity (from the shortmaturities) and high income (from the longmaturities), while Bacone National is a small bankthat needs a simple-to-execute strategy.

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• Bacone National Bank has structured its investmentportfolio to include $11 million equally in each offour one-year maturity intervals. This is clearly aspaced maturity or ladder policy. In contrast,Dunham National Bank holds $36 million in oneand two-year securities and about $30 million in 8and 10-year maturities, which is clearly a barbellstrategy. Dunham National Bank pursues itsstrategy to provide both liquidity (from the shortmaturities) and high income (from the longmaturities), while Bacone National is a small bankthat needs a simple-to-execute strategy.

After tax yield on a qualifiedmunicipal security

After tax yield on a qualifiedmunicipal security

• What is the net after-tax return on aqualified municipal security whosenominal gross return is 6 percent, the costof borrowed funds is 5 percent, and thebank is in the 35 percent tax bracket?

• Net After-Tax Return = (.06 - .05) + (0.35 x0.80 x .05) = 0.024 or 2.4%

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• What is the net after-tax return on aqualified municipal security whosenominal gross return is 6 percent, the costof borrowed funds is 5 percent, and thebank is in the 35 percent tax bracket?

• Net After-Tax Return = (.06 - .05) + (0.35 x0.80 x .05) = 0.024 or 2.4%

After tax gross yieldAfter tax gross yield• Suppose a corporate bond investment officer

would like to purchase a bond that has a before-tax yield of 8.98 percent and the bank is in the 35percent federal income tax bracket. What is thebond's after-tax gross yield? What after tax rateof return must a prospective loan generate to becompetitive with the corporate bond? Does aloan have some advantages for a lendinginstitution that a corporate bond would nothave?

• After-tax Gross Yield on Corporate Bond =8.98 %( 1 - 0.35) = 5.84%.

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• Suppose a corporate bond investment officerwould like to purchase a bond that has a before-tax yield of 8.98 percent and the bank is in the 35percent federal income tax bracket. What is thebond's after-tax gross yield? What after tax rateof return must a prospective loan generate to becompetitive with the corporate bond? Does aloan have some advantages for a lendinginstitution that a corporate bond would nothave?

• After-tax Gross Yield on Corporate Bond =8.98 %( 1 - 0.35) = 5.84%.

Loan advantageLoan advantage• A prospective loan must generate a comparable

yield to that of the bond to be competitive.However, granting a loan to a corporation mayhave the added advantage of bringing inadditional service business for the bank thatmerely purchasing a corporate bond would notdo. In this case the bank would accept asomewhat lower yield on the loan compared tothe bond in anticipation of getting more totalrevenue from the loan relationship due to thesale of other bank services

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• A prospective loan must generate a comparableyield to that of the bond to be competitive.However, granting a loan to a corporation mayhave the added advantage of bringing inadditional service business for the bank thatmerely purchasing a corporate bond would notdo. In this case the bank would accept asomewhat lower yield on the loan compared tothe bond in anticipation of getting more totalrevenue from the loan relationship due to thesale of other bank services

Bond sale calculationsBond sale calculations

• Spiro Savings Bank currently holds agovernment bond valued on the day of itspurchase at $5 million, with a promised interestyield (Coupon) of 6-percent, whose currentmarket value is $3.9 million. Comparablequality bonds are available today for a promisedyield of 8 percent. What are the advantages toSpiro Savings from selling the government bondbearing a 6 percent promised yield and buyingsome 8 percent bonds?

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• Spiro Savings Bank currently holds agovernment bond valued on the day of itspurchase at $5 million, with a promised interestyield (Coupon) of 6-percent, whose currentmarket value is $3.9 million. Comparablequality bonds are available today for a promisedyield of 8 percent. What are the advantages toSpiro Savings from selling the government bondbearing a 6 percent promised yield and buyingsome 8 percent bonds?

AnswerAnswer

• In this instance the bank could sell the 6-percent bonds, buy the 8 percent bonds,and experience an extra 2 percent in yield.The bank would experience a capital lossof $1.1 million from the bond's book value,but the after-tax loss would be only $1.1million * (1-0.35) or $0.715 million.

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• In this instance the bank could sell the 6-percent bonds, buy the 8 percent bonds,and experience an extra 2 percent in yield.The bank would experience a capital lossof $1.1 million from the bond's book value,but the after-tax loss would be only $1.1million * (1-0.35) or $0.715 million.

What is Tax SwappingWhat is Tax Swapping

• A tax swap involves exchanging one typeof investment security for another when itis advantageous to do so in reducing thebank's current or future tax exposure. Forexample, the bank may sell investmentsecurities at a loss to offset high taxableincome on loans or to replace taxablesecurities with tax-exempt securities.

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• A tax swap involves exchanging one typeof investment security for another when itis advantageous to do so in reducing thebank's current or future tax exposure. Forexample, the bank may sell investmentsecurities at a loss to offset high taxableincome on loans or to replace taxablesecurities with tax-exempt securities.

Tax Swap ContinuedTax Swap Continued• Portfolio switching which involves selling

certain securities out of a bank's portfolio, oftenat a loss, and replacing them with othersecurities, is usually carried out to gainadditional current income, add to future income,or to minimize a bank's current or future taxliability. For example, the bank may shift itsholdings of investment securities by selling offselected lower-yielding securities at a loss, andsubstituting higher-yielding securities in orderto offset large amounts of loan income.

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• Portfolio switching which involves sellingcertain securities out of a bank's portfolio, oftenat a loss, and replacing them with othersecurities, is usually carried out to gainadditional current income, add to future income,or to minimize a bank's current or future taxliability. For example, the bank may shift itsholdings of investment securities by selling offselected lower-yielding securities at a loss, andsubstituting higher-yielding securities in orderto offset large amounts of loan income.

Securities for CollateralRequirements

Securities for CollateralRequirements

• When a bank borrows from the discountwindow of its district Federal Reserve bank, itmust pledge either federal governmentsecurities or other collateral acceptable to theFed. Typically, banks will use U.S. Treasurysecurities to meet these collateral requirements.If the bank raises funds through repurchaseagreements (RPs), banks must pledge securities,typically U.S. Treasury and federal agencyissues, as collateral in order to borrow at the lowRP interest rate.

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• When a bank borrows from the discountwindow of its district Federal Reserve bank, itmust pledge either federal governmentsecurities or other collateral acceptable to theFed. Typically, banks will use U.S. Treasurysecurities to meet these collateral requirements.If the bank raises funds through repurchaseagreements (RPs), banks must pledge securities,typically U.S. Treasury and federal agencyissues, as collateral in order to borrow at the lowRP interest rate.

Why Banks Face PledgingRequirements

Why Banks Face PledgingRequirements

• Pledging requirements are in place tosafeguard the deposit of public funds.The first $100,000 of public deposits iscovered by federal deposit insurance; therest must be backed up by bank holdingsof U.S. Treasury and federal agencysecurities valued at their par values.

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• Pledging requirements are in place tosafeguard the deposit of public funds.The first $100,000 of public deposits iscovered by federal deposit insurance; therest must be backed up by bank holdingsof U.S. Treasury and federal agencysecurities valued at their par values.

What Factors Affect Decisions onHolding Different Maturities

What Factors Affect Decisions onHolding Different Maturities

• In choosing among various maturities ofshort-term and long-term securities tohold, the financial institution needs tocarefully consider the use of two keymaturity management tools - the yieldcurve and duration. These two tools helpmanagement understand more fully theconsequences and potential impact onearnings and risk of any particularmaturity mix of securities they choose.

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• In choosing among various maturities ofshort-term and long-term securities tohold, the financial institution needs tocarefully consider the use of two keymaturity management tools - the yieldcurve and duration. These two tools helpmanagement understand more fully theconsequences and potential impact onearnings and risk of any particularmaturity mix of securities they choose.

How can yield curve and durationhelp in the decision to sell or buy

How can yield curve and durationhelp in the decision to sell or buy

• Yield curves possibly provide a forecast of the futurecourse of short-term rates, telling us what the currentaverage expectation is in the market. The yieldcurve also provides an indication of equilibriumyields at varying maturities and, therefore, gives anindication if there are any significantly under pricedor over priced securities. Finally, the yield curve'sshape gives the bank's investment officer a measureof the yield trade-off - that is, how much yield willchange, on average, if a security portfolio isshortened or lengthened in maturity.

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• Yield curves possibly provide a forecast of the futurecourse of short-term rates, telling us what the currentaverage expectation is in the market. The yieldcurve also provides an indication of equilibriumyields at varying maturities and, therefore, gives anindication if there are any significantly under pricedor over priced securities. Finally, the yield curve'sshape gives the bank's investment officer a measureof the yield trade-off - that is, how much yield willchange, on average, if a security portfolio isshortened or lengthened in maturity.

--- continued from previous slide--- continued from previous slide

• Duration tells a bank about the pricevolatility of its earning assets andliabilities due to changes in interest rates.Higher values of duration imply greaterrisk to the value of assets and liabilitiesheld by a bank. For example, a loan orsecurity with a duration of 4 years standsto lose twice as much in terms of value forthe same change in interest rates as a loanor security with a duration of 2 years.

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• Duration tells a bank about the pricevolatility of its earning assets andliabilities due to changes in interest rates.Higher values of duration imply greaterrisk to the value of assets and liabilitiesheld by a bank. For example, a loan orsecurity with a duration of 4 years standsto lose twice as much in terms of value forthe same change in interest rates as a loanor security with a duration of 2 years.

Calculate bond duration andpercent change in bond priceCalculate bond duration andpercent change in bond price

• A bond currently selling for $950 based ona par value of $1,000 and promises $100 ininterest for three years before beingretired. Yields to maturity on comparable-quality securities are 12 percent. What isthe bond’s duration? Suppose interestrates in the market fall to 10 percent.What will be the approximate percentchange in the bond’s price?

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• A bond currently selling for $950 based ona par value of $1,000 and promises $100 ininterest for three years before beingretired. Yields to maturity on comparable-quality securities are 12 percent. What isthe bond’s duration? Suppose interestrates in the market fall to 10 percent.What will be the approximate percentchange in the bond’s price?

---continued---continued

CF PV@12% WT of each CF1 $100 $89.30 (89.30* 1)= 89.302 $100 79.70 (79.70* 2)=159.403 $1100 783.20 (783.20* 3)=2349.6

total = 2598.3

Duration = 2598.3/950 = 2.7351

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CF PV@12% WT of each CF1 $100 $89.30 (89.30* 1)= 89.302 $100 79.70 (79.70* 2)=159.403 $1100 783.20 (783.20* 3)=2349.6

total = 2598.3

Duration = 2598.3/950 = 2.7351

continuedcontinued

• The bond's duration is 2.7351 years. Ifinterest in the market falls to 10 percent,the approximate percentage change in thebond's price will be:

• Percentage Change in Price = {-D xChange in I /(1+I)} x 100

• {-2.7351 x -.02/1+.12} x100 = 4.884 percent

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• The bond's duration is 2.7351 years. Ifinterest in the market falls to 10 percent,the approximate percentage change in thebond's price will be:

• Percentage Change in Price = {-D xChange in I /(1+I)} x 100

• {-2.7351 x -.02/1+.12} x100 = 4.884 percent

Net after tax yield on bankqualified bonds

Net after tax yield on bankqualified bonds

• Tiger National Bank regularly purchases municipalbonds issued by small rural school districts in its regionof the state. At the moment, the bank is consideringpurchasing an $8 million general obligation issue fromthe Youngstown school district, the only bond issue thatdistrict plans this year. The bonds, which mature in 15years, carry a nominal annual rate of return of 7.75%.Tiger, which is in the top corporate tax bracket of 35percent, must pay an average interest rate of 7.38% toborrow the funds needed to purchase the municipals.Would you recommend purchasing these bonds?

• a) Calculate the net after tax return on this bankqualified municipal security. What is the tax advantagefor being a qualified bond?

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• Tiger National Bank regularly purchases municipalbonds issued by small rural school districts in its regionof the state. At the moment, the bank is consideringpurchasing an $8 million general obligation issue fromthe Youngstown school district, the only bond issue thatdistrict plans this year. The bonds, which mature in 15years, carry a nominal annual rate of return of 7.75%.Tiger, which is in the top corporate tax bracket of 35percent, must pay an average interest rate of 7.38% toborrow the funds needed to purchase the municipals.Would you recommend purchasing these bonds?

• a) Calculate the net after tax return on this bankqualified municipal security. What is the tax advantagefor being a qualified bond?

Answer to Net ATR problemAnswer to Net ATR problem• Because these bonds were issued by a small

governmental unit issuing less than $10 million insecurities annually, the interest cost the bank has to payto acquire the funds needed to buy these bonds is taxdeductible. Therefore, their net after-tax return is:Net A.T.R = (7.75% - 7.38%) + (0.80 x 0.35 x 7.38%)

= 7.75% -7.38% + 2.066%= 2.436%

• This net yield figure should be compared with otherinvestments of comparable risk on an after-tax basis.However, the tax-exempt status of the income coupledwith the tax-deductibility of the interest expense makethese bonds a very attractive alternative.

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• Because these bonds were issued by a smallgovernmental unit issuing less than $10 million insecurities annually, the interest cost the bank has to payto acquire the funds needed to buy these bonds is taxdeductible. Therefore, their net after-tax return is:Net A.T.R = (7.75% - 7.38%) + (0.80 x 0.35 x 7.38%)

= 7.75% -7.38% + 2.066%= 2.436%

• This net yield figure should be compared with otherinvestments of comparable risk on an after-tax basis.However, the tax-exempt status of the income coupledwith the tax-deductibility of the interest expense makethese bonds a very attractive alternative.

TEY solutionTEY solution

• b) What is the tax equivalent yield for thisbank qualified municipal security?

• TEY =7.75 +2.066/1-.35 = 15.10%

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