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Chapter Ten

Chapter Ten. The Investment Function in Banking and Financial Services Management. Functions of a Bank’s Security Portfolio. Stabilize the Bank’s Income Over a Business Cycle Offset Credit Risk Exposure Provide Geographic Diversification Provide Backup Source of Liquidity

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Chapter Ten

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  1. Chapter Ten The Investment Function in Banking and Financial Services Management

  2. Functions of a Bank’s Security Portfolio • Stabilize the Bank’s Income Over a Business 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

  3. Written Investment Policy:Regulator Guidelines • The Quality or Degree of Default Risk Exposure the Institution is Willing to Accept • The Desired Maturity Range and Degree of Marketability Sought for All Securities • The Goals Sought for its Investment Portfolio • The Degree of Portfolio Diversification the Institution Wishes to Achieve with its Investment Portfolio

  4. Money Market Instruments Used by 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

  5. Capital Market Instruments Used by a Bank (Mostly for Income) • Treasury Notes and Bonds Over One Year to Maturity • Municipal Notes and Bonds • Corporate Notes and Bonds • Asset Backed Securities

  6. Other More Recent Investment Instruments • Structured Notes – packaged investments assembled by security dealers that offer customers flexible yields. • Securitized Assets – loans placed in a pool and securities issued against that pool • Stripped Securities – principal and interest separated and each sold as a separate zero coupon security

  7. Dominant Investments Held By Banks–preferred securities • Obligations of the U.S. Government and Government Agencies • State and Local Government Obligations

  8. Expected Rate of Return Tax Exposure Interest Rate Risk Credit Risk Business Risk Liquidity Risk Call Risk Prepayment Risk Inflation Risk Pledging Requirements Factors Affecting the Choice of Securities

  9. Expected Rate of Return Yield to Maturity Holding Period Return

  10. YTM Problem • A govt. bond is expected to mature in two years and has a current price of $950. What is the bond’s YTM if the par value is 1000 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

  11. Tax Exposure • The Tax Status of State and Local Government Bonds • Bank Qualified Bonds • The Portfolio Shifting Tool

  12. Interest Rate Risk • Rising Interest Rates Lowers the Value of Previously Issued Bonds • Longest –Term Bonds Suffer the Greatest Losses • Many Interest Rate Risk Tools Including Futures, Options, and Swaps Exist Today

  13. Investment Grade Moody’sS&P Aaa AAA Aa AA A A Baa BBB Speculative Grade Moody’sS&P Ba BB B B Caa CCC Ca CC C C Default Risk

  14. Business Risk • Risk that the Economy of the Market Area they Serve May Turn Down • Security Portfolio Can Offset This Risk • Securities Can be Purchased From Outside Market Area Served

  15. Liquidity 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 Most Liquid

  16. Call Risk • Corporations and Some Governments Reserve the Right to Retire the Securities in Advance of Their Maturity • Generally Called When Interest Rates Have Fallen • Investor Must Find New Security – Often with a Lower Return

  17. Prepayment 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 Meet Loan Payments and Asset is Sold

  18. Inflation Risk • Purchasing Power from a Security or Loan May be Eroded by Rising Prices • Recently Developed Inflation Risk Hedge – Treasury Inflation Protected Securities • Both Coupon Payments and Principal Adjusted Annually for Inflation Based on Consumer Price Index

  19. Pledging Requirements • Depository Institutions Cannot Accept Federal, State and Local Government Deposits Unless Acceptable Collateral is Pledged • Generally Treasury Securities, Government Agency Securities and Selected Municipal Securities Can Be Used as Collateral

  20. Investment 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

  21. Maturity Management Tools • 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 the Cash Flows • Can Be Used to Insulate the Securities From Interest Rate Changes

  22. Maturity strategy problem • BACONE National Bank has structured its investment portfolio, which extends out to four-year maturities, so that it holds about $11 million each in one-year, two-year, three-year and four-year securities. In contrast, Dunham National Bank and Trust holds $36 million in one and two-year securities and about $30 million in 8- to 10-year maturities. What investment maturity strategy is each bank following? Why do you believe that each of these banks has adopted the particular strategy it has reflected in the maturity structure of its portfolio?

  23. Maturity strategy answer • Bacone National Bank has structured its investment portfolio to include $11 million equally in each of four one-year maturity intervals. This is clearly a spaced maturity or ladder policy. In contrast, Dunham National Bank holds $36 million in one and two-year securities and about $30 million in 8 and 10-year maturities, which is clearly a barbell strategy. Dunham National Bank pursues its strategy to provide both liquidity (from the short maturities) and high income (from the long maturities), while Bacone National is a small bank that needs a simple-to-execute strategy.

  24. After tax yield on a qualified municipal security • What is the net after-tax return on a qualified municipal security whose nominal gross return is 6 percent, the cost of borrowed funds is 5 percent, and the bank is in the 35 percent tax bracket? • Net After-Tax Return = (.06 - .05) + (0.35 x 0.80 x .05) = 0.024 or 2.4%

  25. After 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 35 percent federal income tax bracket. What is the bond's after-tax gross yield? What after tax rate of return must a prospective loan generate to be competitive with the corporate bond? Does a loan have some advantages for a lending institution that a corporate bond would not have? • After-tax Gross Yield on Corporate Bond = 8.98 %( 1 - 0.35) = 5.84%.

  26. Loan advantage • A prospective loan must generate a comparable yield to that of the bond to be competitive. However, granting a loan to a corporation may have the added advantage of bringing in additional service business for the bank that merely purchasing a corporate bond would not do. In this case the bank would accept a somewhat lower yield on the loan compared to the bond in anticipation of getting more total revenue from the loan relationship due to the sale of other bank services

  27. Bond sale calculations • Spiro Savings Bank currently holds a government bond valued on the day of its purchase at $5 million, with a promised interest yield (Coupon) of 6-percent, whose current market value is $3.9 million. Comparable quality bonds are available today for a promised yield of 8 percent. What are the advantages to Spiro Savings from selling the government bond bearing a 6 percent promised yield and buying some 8 percent bonds?

  28. answer • 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 loss of $1.1 million from the bond's book value, but the after-tax loss would be only $1.1 million * (1-0.35) or $0.715 million.

  29. What is tax swapping • A tax swap involves exchanging one type of investment security for another when it is advantageous to do so in reducing the bank's current or future tax exposure. For example, the bank may sell investment securities at a loss to offset high taxable income on loans or to replace taxable securities with tax-exempt securities.

  30. Tax swap continued • Portfolio switching which involves selling certain securities out of a bank's portfolio, often at a loss, and replacing them with other securities, is usually carried out to gain additional current income, add to future income, or to minimize a bank's current or future tax liability. For example, the bank may shift its holdings of investment securities by selling off selected lower-yielding securities at a loss, and substituting higher-yielding securities in order to offset large amounts of loan income.

  31. Securities for collateral requirements • When a bank borrows from the discount window of its district Federal Reserve bank, it must pledge either federal government securities or other collateral acceptable to the Fed. Typically, banks will use U.S. Treasury securities to meet these collateral requirements. If the bank raises funds through repurchase agreements (RPs), banks must pledge securities, typically U.S. Treasury and federal agency issues, as collateral in order to borrow at the low RP interest rate.

  32. Why Banks face pledging requirements • Pledging requirements are in place to safeguard the deposit of public funds. The first $100,000 of public deposits is covered by federal deposit insurance; the rest must be backed up by bank holdings of U.S. Treasury and federal agency securities valued at their par values.

  33. What factors affect decisions on holding different maturities • In choosing among various maturities of short-term and long-term securities to hold, the financial institution needs to carefully consider the use of two key maturity management tools - the yield curve and duration. These two tools help management understand more fully the consequences and potential impact on earnings and risk of any particular maturity mix of securities they choose.

  34. How can yield curve and duration help in the decision to sell or buy • Yield curves possibly provide a forecast of the future course of short-term rates, telling us what the current average expectation is in the market. The yield curve also provides an indication of equilibrium yields at varying maturities and, therefore, gives an indication if there are any significantly under priced or over priced securities. Finally, the yield curve's shape gives the bank's investment officer a measure of the yield trade-off - that is, how much yield will change, on average, if a security portfolio is shortened or lengthened in maturity.

  35. --- continued from previous slide • Duration tells a bank about the price volatility of its earning assets and liabilities due to changes in interest rates. Higher values of duration imply greater risk to the value of assets and liabilities held by a bank. For example, a loan or security with a duration of 4 years stands to lose twice as much in terms of value for the same change in interest rates as a loan or security with a duration of 2 years.

  36. Calculate bond duration and percent change in bond price • A bond currently selling for $950 based on a par value of $1,000 and promises $100 in interest for three years before being retired. Yields to maturity on comparable-quality securities are 12 percent. What is the bond’s duration? Suppose interest rates in the market fall to 10 percent. What will be the approximate percent change in the bond’s price?

  37. ---continued CF PV@12% WT of each CF • 1 $100 $89.30 (89.30* 1)= 89.30 • 2 $100 79.70 (79.70* 2)=159.40 • 3 $1100 783.20 (783.20* 3)=2349.6 • total = 2598.3 • Duration = 2598.3/950 = 2.7351

  38. continued • The bond's duration is 2.7351 years. If interest in the market falls to 10 percent, the approximate percentage change in the bond's price will be: • Percentage Change in Price = {-D x Change in I /(1+I)} x 100 • {-2.7351 x -.02/1+.12} x100 = 4.884 percent

  39. Net after tax yield on bank qualified bonds • Tiger National Bank regularly purchases municipal bonds issued by small rural school districts in its region of the state. At the moment, the bank is considering purchasing an $8 million general obligation issue from the Youngstown school district, the only bond issue that district plans this year. The bonds, which mature in 15 years, carry a nominal annual rate of return of 7.75%. Tiger, which is in the top corporate tax bracket of 35 percent, must pay an average interest rate of 7.38% to borrow the funds needed to purchase the municipals. Would you recommend purchasing these bonds? • a) Calculate the net after tax return on this bank qualified municipal security. What is the tax advantage for being a qualified bond?

  40. Answer to Net ATR problem • Because these bonds were issued by a small governmental unit issuing less than $10 million in securities annually, the interest cost the bank has to pay to acquire the funds needed to buy these bonds is tax deductible. 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 other investments of comparable risk on an after-tax basis. However, the tax-exempt status of the income coupled with the tax-deductibility of the interest expense make these bonds a very attractive alternative.

  41. TEY solution • b) What is the tax equivalent yield for this bank qualified municipal security? • TEY =7.75 +2.066/1-.35 = 15.10%

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