Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning
Managing the Investment
Portfolio
Chapter 13
William Chittenden edited and updated the PowerPoint slides for this edition.
The Investment Portfolio
 Most banks concentrate their asset
management efforts on loans
 Managing
investment securities is
typically a secondary role, especially at
smaller banks
 Historically, small banks have
purchased securities and held them to
maturity
The Investment Portfolio
 Large banks, in contrast, not only buy
securities for their own portfolios, but
they also:
 Manage
a securities trading account
 Manage an underwriting subsidiary
that helps municipalities issue debt in
the money and capital markets
The Investment Portfolio
 Historically, bank regulators have
limited the risk associated with banks
owning securities by generally:
 Prohibiting
banks from purchasing
common stock (for income purposes)
 Limiting debt instruments to
investment grade securities
 Increasingly, banks are pursuing
active strategies in managing
investments in the search for higher
yields
Dealer Operations and the Securities Trading
Account
 When banks purchase securities, they
must indicate the underlying objective
for accounting purposes:
 Held-to-Maturity
 Trading
 Available-for-Sale
Dealer Operations and the Securities Trading
Account
 Held to Maturity
 Securities
purchased with the intent
and ability to hold to final maturity
 Carried at historical (amortized) cost
on the balance sheet
 Unrealized gains and losses have no
impact on the income statement
Dealer Operations and the Securities Trading
Account
 Trading:
 Securities
purchased with the intent to
sell them in the near term
 Carried at market value on the balance
sheet with unrealized gains and losses
included in income
Dealer Operations and the Securities Trading
Account
 Available for Sale:
 Securities
that are not classified as
either held-to-maturity securities or
trading securities
 Carried at market value on the balance
sheet with unrealized gains and losses
included as a component of
stockholders’ equity
Dealer Operations and the Securities Trading
Account
 Banks perform three basic functions
within their trading activities:
 Offer
investment advice and assistance
to customers managing their own
portfolios
 Maintain an inventory of securities for
possible sale to investors

Their willingness to buy and sell
securities is called making a market
 Traders
speculate on short-term interest
rate movements by taking positions in
various securities
Dealer Operations and the Securities Trading
Account
 Banks earn profits from their trading
activities in several ways:
 When
making a market, they price
securities at an expected positive spread

Bid
 Price the dealer is willing to pay

Ask
 Price the dealer is willing to sell
 Traders
can also earn profits if they
correctly anticipate interest rate
movements
Objectives of the Investment Portfolio
 A bank’s investment portfolio differs
markedly from a trading account
 Objectives
of the Investment Portfolio
Safety or preservation of capital
 Liquidity
 Yield
 Credit risk diversification
 Help in manage interest rate risk
exposure
 Assist in meeting pledging requirements

Objectives of the Investment Portfolio
 Accounting for Investment Securities
 FASB
115 requires security holdings to
be divided into three categories
Held-to-Maturity (HTM)
 Trading
 Available-for-Sale

 The
distinction between investment
motives is important because of the
accounting treatment of each
Objectives of the Investment Portfolio
 Accounting for Investment Securities
A
change in interest rates can
dramatically affect the market value of
a security

The difference between market value
and the purchase price equals the
unrealized gain or loss on the security;
assuming a purchase at par:
 Unrealized Gain/Loss =
Market Value – Par Value
Objectives of the Investment Portfolio
 Accounting for Investment Securities
 Assume
interest rates increase and bond
prices fall:

Held-to-Maturity Securities
 There is no impact on either the balance
sheet or income statement

Trading Securities
 The decline in value is reported as a loss on
the income statement

Available-for-Sale Securities
 The decline in value reduces the value of
bank capital
Objectives of the Investment Portfolio
 Safety or Preservation of Capital
A
primary objective of the investment
portfolio is to preserve capital by
purchasing securities when there is only
a small risk of principal loss.
 Regulators encourage this policy by
requiring that banks concentrate their
holdings in investment grade securities,
those rated Baa (BBB) or higher.
Objectives of the Investment Portfolio
 Liquidity
 Commercial banks purchase debt
securities to help meet liquidity
requirements
 Securities with maturities under one year
can be readily sold for cash near par
value and are classified as liquid
investments
 In reality, most securities selling at a
premium can also be quickly converted
to cash, regardless of maturity, because
management is willing to sell them
Investment Portfolio for a Hypothetical
Commercial Bank
 Liquidity
Purchase
Date
Current Date: September 30, 2005
Annual
Book
Coupon
Value
Description
Income
12/15/95
$4,000,000
10/15/95
2,000,000
6/6/99
500,000
10/l/94
1,000,000
$4,000,000 par value U.S.
Treasury note at 11%, due
11/15/08
$2,000,000 par value
Federal National Mortgage
Association bonds at
8.75%, due 10/15/10
$500,000 par value
Allegheny County, PA, Arated general obligations at
5.15%, due 3/l/11
$1,000,000 par value State
of Illinois Aaa-rated
general obligations at 11%,
due 10/1/19
Market
Value
$440,000
$4,099,000
175,000
1,824,000
25,750
482,500
110,000
1,190,000
Objectives of the Investment Portfolio
 Yield
 To
be attractive, investment securities
must pay a reasonable return for the
risks assumed
 The return may come in the form of
price appreciation, periodic coupon
interest, and interest-on-interest
 The return may be fully taxable or
exempt from taxes
Objectives of the Investment Portfolio
 Diversify Credit Risk
 The diversification objective is closely
linked to the safety objective and
difficulties that banks have with
diversifying their loan portfolios
 Too often loans are concentrated in
one industry that reflects the specific
economic conditions of the region
 Investment portfolios give banks the
opportunity to spread credit risk
outside their geographic region and
across different industries
Objectives of the Investment Portfolio
 Help Manage Interest Rate Exposure
 Investment
securities are very flexible
instruments for managing a bank’s
overall interest rate risk exposure
 Banks can select terms that meet their
specific needs without fear of
antagonizing the borrower
 They can readily sell the security if
their needs change
Objectives of the Investment Portfolio
 Pledging Requirements
 By
law, commercial banks must pledge
collateral against certain types of
liabilities.
Banks that borrow via repurchase
agreements essentially pledge part of
their government securities portfolio
against this debt
 Public deposits
 Borrowing from the Federal Reserve
 Borrowing from FHLBs

Composition of the Investment Portfolio
 Money market instruments with short
maturities and durations include:
 Treasury
bills
 Large negotiable CDs
 Bankers acceptances
 Commercial paper
 Repurchase agreements
 Tax anticipation notes.
Composition of the Investment Portfolio
 Capital market instruments with longer
maturities and duration include:
 Long-term
U.S. Treasury securities
 Obligations of U.S. government agencies
 Obligations of state and local
governments and their political
subdivisions labeled municipals
 Mortgage-backed securities backed both
by government and private guarantees
 Corporate bonds
 Foreign bonds
Composition of the Investment Portfolio
A.
All Banks Over Time
Percentage of Total Assets
1975 1980
1985
1990
1995
Billions of dollars
1970
U.S. Treasury securities
Agency securities
Municipal securities
Corporate & foreign securities
Total
Total financial assets (billions of $)
12.1% 9.8% 7.8% 8.3% 5.4% 6.2% 2.9% 1.3%
2.7
3.9
4.1
3.2
8.4
10.4
11.2
12.9
13.6
11.6
10.0
9.7
3.5
2.1
1.8
1.7
0.6
0.9
0.5
1.0
2.7
2.5
4.1
6.6
29.0% 26.2% 22.4% 22.2% 20.0% 21.2% 20.0% 22.5%
$517 $886 $1,482 $2,375 $3,334 $4,488 $6,469 $8,487
B.
2000
Percentage of Total Consolidated Assets, December 31, 2000
Commercial Banks Ranked by Assets
10
11-100
101-1,000
>1,000
Largest
Largest
Largest
Largest
Investment securities
U.S. Treasury securities
0.80%
1.00%
1.00%
0.90%
U.S. Gov't. agency & corporate securities
9.20%
13.00%
17.00%
16.20%
Private mortgage-backed securities
1.10%
2.10%
0.90%
0.20%
Municipal securities
0.60%
1.00%
3.00%
4.70%
Other securities
3.40%
2.90%
2.00%
1.10%
Equities
0.20%
0.20%
0.40%
0.30%
Total investment securities
15.30%
20.20%
24.30%
23.40%
Trading account securities
5.90%
1.10%
0.10%
0.00%
Total
21.20%
21.30%
24.40%
23.40%
2004
Characteristics of Taxable Securities
 Money Market Investments
 Highly
liquid instruments which mature
within one year that are issued by
governments and large corporations
 Very low risk as they are issued by wellknown borrowers and a active
secondary market exists
 Banks purchase money market
instruments in order to meet liquidity
and pledging requirements and earn a
reasonable return
Characteristics of Taxable Securities
 Capital Market Investments
 Consists
of instruments with original
maturities greater than one year
 Banks are restricted to “investment
grade” securities, those rated Baa
(BBB) or above; i.e., no junk bonds
 If banks purchase non-rated securities,
they must perform a credit analysis to
validate that they are of sufficient
quality relative to the promised yield .
Money Market Investments
 Repurchase Agreements (Repos)
A
loan between two parties, with one
typically either a securities dealer or
commercial bank
 The lender or investor buys securities
from the borrower and simultaneously
agrees to sell the securities back at a
later date at an agreed-upon price plus
interest
 Essentially are collateralized federal
funds transactions
Money Market Investments
 Repurchase Agreements (Repos)


The minimum denomination is generally $1
million, with maturities ranging from one day to
one year
The rate on one-day repos is referred to as the
overnight repo rate and is quoted on an add-on
basis assuming a 360-day year


$ Interest = Par Value x Repo Rate x Days/360
Longer-term transactions are referred to as term
repos and the associated rate the term repo rate
Money Market Investments
 Treasury Bills
 Marketable obligations of the U.S.
Treasury that carry original maturities of
one year or less
 They exist only in book-entry form, with
the investor simply holding a dated
receipt
 Investors can purchase bills in
denominations as small as $1,000, but
most transactions involve much larger
amounts
Money Market Investments
 Treasury Bills
 Each
week the Treasury auctions
bills with 13-week and 26-week
maturities

Investors submit either competitive
or noncompetitive bids
 With a competitive bid, the purchaser
indicates the maturity amount of bills
desired and the discount price
offered
 Non-competitive bidders indicate only
how much they want to acquire
Money Market Investments
 Treasury Bills
 Treasury bills are purchased on a discount
basis, so the investor’s income equals price
appreciation
 The Treasury bill discount rate is quoted in
terms of a 360-day year:
FV  P 360
DR 

FV
N

Where




DR = Discount Rate
FV = Face Value
P = Purchase Price
N = Number of Days to Maturity
Money Market Investments
 Treasury Bills Example:


A bank purchases $1 million in face value of
26-week (182-day) bills at $990,390. What is
the discount rate and effective yield?
The discount rate is:
$1,000,000  $990,390 360
DR 

 1.90%
$1,000,000
182

The true (effective) yield is:
$1,000,000  $990,390 
Effective Yield  1 

$990,390

(365/182)
 1  1.956%
Money Market Investments
 Certificates of Deposit
 Dollar-denominated
deposits issued by
U.S. banks in the United States
 Fixed maturities ranging from 7 days to
several years
 Pay yields above Treasury bills.
 Interest is quoted on an add-on basis,
assuming a 360-day year
Money Market Investments
 Eurodollars
 Dollar-denominated
deposits issued by
foreign branches of banks outside the
United States
 The Eurodollar market is less regulated
than the domestic market, so the
perceived riskiness is greater.
Money Market Investments
 Commercial Paper
 Unsecured promissory notes issued by
corporations
 Proceeds are use to finance short-term working
capital needs
 The issuers are typically the highest quality
firms
 Minimum denomination is $10,000
 Maturities range from 3 to 270 days
 Interest rates are fixed and quoted on a
discount basis
 Small banks purchase large amounts of
commercial paper as investments
Money Market Investments
 Bankers Acceptances
A
draft drawn on a bank by firms that
typically are importer or exporters of
goods
 Has a fixed maturity, typically up to nine
months
 Priced as a discount instrument like Tbills
Capital Market Investments
 Treasury Notes and Bonds
 Notes have a maturity of 1 - 10 years
 Bonds have a maturity greater than 10
years
 Most pay semi-annual coupons
 Some are zeros or STRIPS
 Sold via closed auctions
 Rates are quoted on a coupon-bearing
basis with prices expressed in thirtyseconds of a point, $31.25 per $1,000
face value
Capital Market Investments
 Treasury STRIPS



Many banks purchase zero-coupon Treasury
securities as part of their interest rate risk
management strategies
The U.S. Treasury allows any Treasury with an
original maturity of at least 10 years to be
“stripped” into its component interest and
principal pieces and traded via the Federal
Reserve wire transfer system.
Each component interest or principal payment
constitutes a separate zero coupon security
and can be traded separately from the other
payments
Capital Market Investments
 Treasury STRIPS Example
 Consider a 10-year, $1 million par value
Treasury bond that pays 9 percent
coupon interest semiannually ($45,000
every six months)
 This security can be stripped into 20
separate interest payments of $45,000
each and a single $1 million principal
payment, or 21 separate zero coupon
securities.
Capital Market Investments
 U.S. Government Agency Securities
 Composed

of two groups
Members who are formally part of the
federal government
 Federal Housing Administration
 Export-Import Bank
 Government National Mortgage Association
(Ginnie Mae)
Capital Market Investments
 U.S. Government Agency Securities

Composed of two groups

Members who are government-sponsored
agencies
 Federal Home Loan Mortgage Corporation (Freddie
Mac)
 Federal National Mortgage Association (Fannie Mae)
 Student Loan Marketing Association (Sallie Mae)


Default risk is low even though these securities
are not direct obligations of the Treasury; most
investors believe there is a moral obligation.
These issues normally carry a risk premium of
about 10 to 100 basis points.
Federal Status of U.S. Government
Agency Securities
Agency
Full Faith and
Credit of the U.S. Authority to Borrow from the Federal
Government
Treasury
Interest on Bonds
Generally Exempt
from State and
Local Taxes
Farm Credit System
Farm Credit System Financial Assistance
Corporation (FCSFAC)
No
Yes—$260 million revolving line of credit.
Yes
Yes
Yes
Federal Home Loan Banks (FHLB)
No
Yes—FCSFAC began issuing bonds in late 1988.
Yes—the Treasury is authorized to purchase up
to $4 billion of FHLB securities.
Yes—indirect line of credit through the FHLBs.
No
Federal Home Loan Mortgage Corporation
(Freddie Mac)*
Federal National Mortgage Association
(FNMA) (Fannie Mae)*
Financing Corporation (FICO)
Student Loan Marketing Association (Sallie
Mae)
United States Postal Service†
Resolution Funding Corporation (RefCorp)
Farmers Home Administration†(FmHA)
No
No
No
Not since 1/9/82
Guarantee may be
extended if Postal
Service requests
and Treasury
determines this to
be in the public
interest.
No
Yes
Yes—at FNMA request the Treasury may
purchase $2.25 billion of FNMA securities.
No
Yes—at its discretion the Treasury may purchase
$1 billion of Sallie Mae obligations.
Yes—the Postal Service may require the
Treasury to purchase up to $2 billion of its
obligations.
Federal Financing Bank (FFB)
Yes
General Services Administration†(GSA)
Government National Mortgage
Association†(GNMA)
Maritime Administration Guaranteed Ship
Financing Bonds issued after 1972
Small Business Administration (SBA)
Tennessee Valley Authority (TVA)
Washington Metropolitan Area Transit
Authority (WMATA) Bonds
Yes
No
No
Yes—FFB can require the Treasury to purchase
up to $5 billion of its obligations. The Treasury
Secretary is authorized to purchase any amount
of FFB obligations at his or her discretion.
No
Yes
No
Yes
Yes
No
No
No
Yes—up to $150 million.
Yes
No
Yes
No
Yes
Yes
Yes
Yes
No
No
Yes
Yes
No
No, with exceptions
Yes
No, except for states
involved in the
interstate compact
Capital Market Investments
 Callable Agency Bonds
 Securities issued by governmentsponsored enterprises in which the
issuer has the option to call the bonds
prior to final maturity
 Typically, there is a call deferment period
during which the bonds cannot be called
 The issuer offers a higher promised yield
relative to comparable non-callable
bonds
 The present value of this rate differential
essentially represents the call premium
Capital Market Investments
 Callable Agency Bonds
 Banks find these securities attractive
because they initially pay a higher yield
than otherwise similar non-callable
bonds
 The premium reflects call risk

If rates fall sufficiently, the issuer will
redeem the bonds early, refinancing at
lower rates, and the investor gets the
principal back early which must then be
invested at lower yields for the same risk
profile
Capital Market Investments
 Conventional Mortgage-Backed
Securities (MBSs)
 Any
security that evidences an
undivided interest in the ownership of
mortgage loans
 The most common form of MBS is the
pass-through security
 Even though many MBSs have very low
default risk, they exhibit unique interest
rate risk due to prepayment risk

As rates fall, individuals will refinance
Capital Market Investments
 GNMA Pass-Through Securities
 Government
National Mortgage
Association (Ginnie Mae)

Government entity that buys mortgages
for low income housing and guarantees
mortgage-backed securities issued by
private lenders
Structure of the GNMA Mortgage-Backed
Pass-Through Security Issuance Process
Capital Market Investments
 FHLMC

Federal Home Loan Mortgage Corporation
(Freddie Mac)
 FNMA securities

Federal National Mortgage Association (Fannie
Mae)
 Both are:



Private corporations
Operate with an implicit federal guarantee
Buy mortgages financed largely by mortgagebacked securities
Capital Market Investments
 Privately Issued Pass-Through
 Issued
by banks and thrifts, with private
insurance rather than government
guarantee
Prepayment Risk on Mortgage-Backed
Securities
 Borrowers may prepay the
outstanding mortgage principal at any
point in time for any reason
 Prepayments generally occur because
of fundamental demographic trends as
well as movements in interest rates
 Prepayments
typically increase as
interest rates fall and slow as rates
increase
 Forecasting prepayments is not an
exact science
Prepayment Risk on Mortgage-Backed
Securities
 Example:
 Current mortgage rates are 8% and you
buy a MBS paying 8.25%
 Because rates have fallen, you paid a
premium to earn the higher rate
 With rates only .25% lower, it is unlikely
individuals will refinance
 If rates fall 3%, there will be a large
increase in prepayments due to
refinancing
 If the prepayments are fast enough, you
may never recover the premium you paid
The value of the MBS if the
pre-payment rate varies
from 6%
B. The Effect of Relative Coupon on the Prepayment Rate
C. The Effect of Mortgage Age on the Prepayment Rate
3
Pre-payment
experience is
low on new
mortgages,
increases
through five
years then
declines.
2
1
0
-8
-6
-4
-2
0
2
4
6
8
Relative Coupon Rate (Percent)
1.25
Percent per Month
Prepayment risk on mortgage-backed
securities
Percent per Month
Measures the value of
the MBS if the
prepayment rate
remains at 6%
regardless of the level of
mortgage rates.
Pre-payment
rates increase
sharply when
mortgage rates
fall
1.00
.75
.50
.25
0
1
5
10
15
20
25
Mortgage Age (Years)
Unconventional Mortgage-Backed Securities
 Collateralized Mortgage Obligations
(CMOs)
 Security
backed by a pool of mortgages
and structured to fall within an estimated
maturity range (tranche) based on the
timing of allocated interest and principal
payments on the underlying mortgages

Tranche:
 The principal amount related to a specific
class of stated maturities on a collateralized
mortgage obligation. The first class of bonds
has the shortest maturities
Unconventional Mortgage-Backed Securities
 Collateralized Mortgage Obligations
(CMOs)
 CMOs
were introduced to circumvent
some of the prepayment risk associated
with the traditional pass-through
security
 CMOs are essentially bonds
 An originator combines various
mortgage pools to serve as collateral
and creates classes of bonds with
different maturities
Unconventional Mortgage-Backed Securities
 Collateralized Mortgage Obligations
(CMOs)
 The
first class, or tranche, has the
shortest maturity

Interest payments are paid to all classes
of bonds but principal payments are paid
to the first tranche until they have been
paid off
 After
the first tranche is paid, principal
payments are made to the second
tranche, etc
Unconventional Mortgage-Backed Securities
 Types of CMOs

Planned Amortization Class CMO (PAC)




A security that is retired according to a planned
amortization schedule, while payments to other
classes of securities are slowed or accelerated
Least risky of the CMOs
Objective is to ensure that PACs exhibit highly
predictable maturities and cash flows
Z-Tranche


Final class of securities in a CMO, exhibiting the
longest maturity and greatest price volatility
These securities often accrue interest until all
other classes are retired
Unconventional Mortgage-Backed Securities
 CMOs’ Advantages over MBS Pass-
Throughs
 Some
classes (tranches) exhibit less
prepayment risk; some exhibit greater
prepayment risk
 Appeal to investors with different
maturity preferences by segmenting the
securities into maturity classes
Unconventional Mortgage-Backed Securities
 Stripped Mortgage-Backed Securities
 More complicated in terms of structure and
pricing characteristics
 Example:
 Consider a 30 year, 12% fixed-rate mortgage
 There will be 30 x 12 (360) payments (principal plus
interest
 Loan amortization means the principal only payments
are smaller in the beginning:
P1 < P2 < … < P360
 Interest only payments decrease over time:
I1 > I2 > … > I360
Features of Pass-Through, Government, and Corporate Securities
Pass-Throughs
Credit risk
Liquidity
Range of
coupons
(discount to
premium)
Range of
maturities
Treasuries
Generally high grade; range from
High grade to
government guaranteed to A
Government guaranteed. speculative.
(private pass- throughs).
Good for agency issued/guaranteed
Excellent.
Generally limited.
pass-through.
Full range.
Full range.
Medium and long term (fast-paying
and seasoned pools can provide
Full range.
shorter maturities than stated).
Complex prepayment pattern;
can limit through selection Noncallable (except
Call protection investor
variables, such as coupon seasoning, certain 30-year bonds).
and program.
Frequency of
payment
Corporates
Monthly payments of principal and Semiannual interest
interest.
payment.
Stripped Treasuries
Backed by government
securities.
Fair.
Full range for a few Zero coupons (discount
issuers.
securities).
Full range.
Full range.
Generally callable
after initial limited
Noncallable.
period of 5 to 10
years.
Semiannual interest
(except Eurobonds, No payments until
which pay interest
maturity.
annually).
Lower than for bonds of comparable Estimate only for small Minimum average
maturity; can only be estimated due number of callable
life known, otherwise Known with certainty.
Average life
issues;
otherwise,
known
to prepayment risk.
a function of call risk.
with certainty.
of prepayment risk; can Unless callable, a simple Function of call risk; Known with certainty;
Duration/intere Function
only be estimated; can be negative function of yield, coupon, can be negative when no interest rate risk if
st rate risk
and maturity; is known call risk is high.
when prepayment risk is high.
held to maturity.
with certainty.
Cash flow yield based on monthly
Based on semiBond equivalent yield
Based on semiannual
prepayments
and
constant
CPR
annual
coupon
Basis for yield assumption (usually most recent
coupon payments and
payments and 360- based on either 360- or
quotes
three- month historical prepayment 365-day year.
day year of twelve 30- 365-day year depending
on sponsor.
experience).
day months.
Settlement
Once a month.
Any business day.
Any business day.
Any business day.
Asset-Backed Securities
 Conceptually, an asset-backed security is
comparable to a mortgage-backed security
in structure
 The securities are effectively “passthroughs” since principal and interest are
secured by the payments on the specific
loans pledged as security
 Two popular asset-backed securities are:


Collateralized automobile receivables (CARS)
CARDS

Securities backed by credit card loans to
individuals
Other Investments
 Corporate and Foreign Bonds
 At
the end of 2004, banks held $560
billion in corporate and foreign bonds
 Mutual Funds
 Banks
have increased their holdings in
mutual funds to over $25 billion in 2004

Mutual fund investments must be
marked-to-market and can cause
volatility on the values reported on the
bank’s balance sheet
Characteristics of Municipal Securities
 Municipals are exempt from federal income
taxes and generally exempt from state or
local as well
 General obligation

Principal and interest payments are backed
by the full faith, credit, and taxing authority of
the issuer
 Revenue Bonds
 Backed by revenues generated from the
project the bond proceeds are used to
finance
 Industrial Development Bonds
 Expenditures of private corporations
Summary of Terms for a
Municipal School Bond
Due Date Amount Coupon Yield
Sequoia Union High School District
$30,000,000
General Obligation Bonds Election of 2001
Dated: May 1, 2002
Due: July 1, 2003 through July 1, 2031
Callable: July 1, 2011 at 102.0% of par, declining
to par as of July 1, 2013
Winning Bid: Salomon Smith Barney, at
100.0000, True interest cost (TIC) of 5.0189%
Other Managers: Bear, Stearns & Co., Inc., CIBC
World Markets Corp.,
7/1/2003
7/1/2004
7/1/2005
7/1/2006
7/1/2007
7/1/2008
7/1/2009
7/1/2010
7/1/2011
7/1/2012
7/1/2013
7/1/2014
7/1/2015
7/1/2016
7/1/2017
7/1/2018
7/1/2019
7/1/2020
7/1/2021
7/1/2022
7/1/2023
7/1/2024
7/1/2025
7/1/2026
$225,000
$520,000
$545,000
$575,000
$605,000
$635,000
$665,000
$700,000
$735,000
$765,000
$800,000
$835,000
$870,000
$910,000
$950,000
$995,000
$1,045,000
$1,095,000
$1,150,000
$1,210,000
$1,270,000
$1,335,000
$1,405,000
$1,480,000
7/1/2031 $8,650,000
7.00%
7.00%
7.00%
7.00%
7.00%
7.00%
7.00%
4.00%
4.00%
4.13%
4.25%
4.38%
4.50%
4.60%
4.70%
4.80%
4.90%
5.00%
5.00%
5.00%
5.00%
5.00%
5.00%
5.00%
2.00%
2.50%
3.00%
3.25%
3.50%
3.70%
3.80%
3.90%
4.00%
4.13%
4.25%
4.38%
4.50%
4.60%
4.70%
4.80%
4.90%
5.00%
5.00%
5.00%
5.00%
5.00%
5.20%
5.21%
5.13% 5.21%
Characteristics of Municipal Securities
 Money Market Municipals
 Municipal notes provide operating
funds for government units
 Banks buy large amounts of short-term
municipals
 They often work closely with
municipalities in placing these
securities
 Capital Market Municipals
 Includes general obligation bonds and
revenue bonds
Characteristics of Municipal Securities
 Credit Risk in the Municipal Portfolio
 Until
the 1970s, few municipal securities
went into default
 Deteriorating conditions in many large
cities ultimately resulted in defaults by:

New York City (1975), Cleveland (1978),
Washington Public Power & Supply
System (WHOOPS) (1983)
Characteristics of Municipal Securities
 Liquidity Risk


Municipals exhibit substantially lower liquidity
than Treasury or agency securities
The secondary market for municipals is
fundamentally an over-the-counter market


Small, non-rated issues trade infrequently and
at relatively large bid-ask dealer spreads
Large issues of nationally known municipalities,
state agencies, and states trade more actively at
smaller spreads
Characteristics of Municipal Securities
 Liquidity Risk
 Name
recognition is critical, as investors
are more comfortable when they can
identify the issuer with a specific
location
 Insurance also helps by improving the
rating and by association with a known
property and casualty insurer
Characteristics of Municipal Securities
 Municipals are less volatile in price than
Treasury securities


This is generally attributed to the peculiar tax
features of municipals
The municipal market is segmented

On the supply side, municipalities cannot shift
between short- and long-term securities to take
advantage of yield differences because of
constitutional restrictions on balanced
operating budgets
 Thus long-term bonds cannot be substituted for shortterm municipals to finance operating expenses, and
 Capital expenditures are not financed by ST securities
Characteristics of Municipal Securities
 Municipals are less volatile in price than
Treasury securities
 The
municipal market is segmented.
On the demand side, banks once
dominated the market for short-term
municipals
 Today, individuals via tax-exempt money
market mutual funds dominate the short
maturity spectrum

Establishing Investment Policy Guidelines
 Each bank’s asset and liability or risk
management committee is responsible for
establishing investment policy guidelines


These guidelines define the parameters
within which investment decisions help meet
overall return and risk objectives
Because securities are impersonal loans that
are easily bought and sold, they can be used
at the margin to help achieve a bank’s
liquidity, credit risk, and earnings sensitivity
or duration gap targets
Establishing Investment Policy Guidelines
 Investment guidelines identify specific
goals and constraints regarding:
 Return
Objective
 Composition of Investments
 Liquidity Considerations
 Credit Risk Considerations
 Interest Rate Risk Considerations
 Total Return Versus Current Income
Active Investment Strategies
 Portfolio managers can buy or sell
securities to achieve aggregate risk
and return objectives
 Investment strategies can
subsequently play an integral role in
meeting overall asset and liability
management goals
 Unfortunately, not all banks view their
securities portfolio in light of these
opportunities
Active Investment Strategies
 Many smaller banks passively manage
their portfolios using simple buy and
hold strategies
 The purported advantages are that
such a policy requires limited
investment expertise and virtually no
management time; lowers transaction
costs; and provides for predictable
liquidity
Active Investment Strategies
 Other banks actively manage their portfolios
by:



Adjusting maturities
Changing the composition of taxable versus
tax-exempt securities
Swapping securities to meet risk and return
objectives
 Advantage is that active portfolio managers
can earn above-average returns by capturing
pricing discrepancies in the marketplace
 Disadvantages are:


that managers must consistently out predict
the market for the strategies to be successful,
and
high transactions costs
The Maturity or Duration Choice for LongTerm Securities
 The optimal maturity or duration is possibly
the most difficult choice facing portfolio
managers
 It is very difficult to outperform the market
when forecasting interest rates
 Some managers justify passive buy and
hold strategies because of a lack of time
and expertise
 Other managers actively trade securities in
an attempt to earn above average returns
Passive Maturity Strategies
 Laddered (or Staggered) maturity
strategy
 Management
initially specifies a
maximum acceptable maturity and
securities are evenly spaced
throughout maturity
 Securities are held until maturity to
earn the fixed returns
Passive Maturity Strategies
 Barbell Maturity Strategy
 Differentiates
investments between
those purchased for liquidity and those
for income
 Short-term securities are held for
liquidity
 Long-term securities for income
 Also labeled the long and short
strategy
Active Maturity Strategies
 Active portfolio management involves
taking risks to improve total returns by:
 Adjusting
maturities
 Swapping securities
 Periodically liquidating discount
instruments
 To be successful, the bank must avoid
the trap of aggressively buying fixedincome securities at relatively low rates
when loan demand is low and deposits
are high
Active Maturity Strategies
 Riding the Yield Curve


This strategy works best when the yield curve
is upward-sloping and rates are stable.
Three basic steps:



Identify the appropriate investment horizon
Buy a par value security with a maturity longer
than the investment horizon and where the
coupon yield is higher in relationship to the
overall yield curve
Sell the security at the end of the holding period
when time remains before maturity
Riding the Yield Curve Example
Initial conditions and
assumptions:
• 5-year investment Period:
horizon
Year-End
• yield curve is
upward-sloping,
1
2
• 5-year securities
3
yielding 7.6 % and
4
• 10-year securities
5
yielding 8 %.
Total
• Annual coupon
5
interest is reinvested
at 7%.
Buy a 5-Year Security
Coupon
Interest
Buy a 10-Year Security
and Sell It after 5 Years
Reinvestment Coupon Reinvestment
Income at
Interest
Income at
7%
7%
$7,600
$ 8,000
7,600
$ 532
8,000
$ 560
7,600
1,101
8,000
1,159
7,600
1,710
8,000
1,800
7,600
2,362
8,000
2,486
$38,000
$5,705
$40,000
$6,005
Principal at Maturity = $100,000 Price at Sale after 5 years =
$101,615 when rate = 7.6%
Expected Total Return Calculation
 100,000  38,000  5,705 
i5yr  

100,000


 0.0752
1/5
 1 y10yr
1/5


101,615

40,000

6,005



1


 0.0810
100,000


Interest Rates and the Business Cycle
 Expansion
 Increasing Consumer Spending
 Inventory Accumulation
 Rising Loan Demand
 Federal Reserve Begins to Slow Money
Growth
 Peak
 Monetary Restraint
 High Loan Demand
 Little Liquidity
Interest Rates and the Business Cycle
 Contraction
 Falling Consumer Spending
 Inventory Contraction
 Falling Loan Demand
 Federal Reserve Accelerates Money
Growth
 Trough
 Monetary Policy Eases
 Limited Loan Demand
 Excess Liquidity
Interest rates and the Business Cycle
Interest Rates (Percent)
Peak
Short-Term R ates
Long-Term Rates
Contraction
Expansion
Expansion
Trough
Time
 The inverted U.S. yield curve has predicted these recessions:
Date when 1yr > 10 yr rate
April 1968
March 1973
September 1978
September 1980
February 1989
December 2000*
Time until next recession
20 months (Dec. 1969)
8 months (Nov 1973)
16 months (Jan. 1980)
10 months (July 1981)
17 months (July 1990)
3 months (March 2001)
12.3 months average
Passive Strategies Over the Business Cycle
 One popular passive investment strategy
follows from the traditional belief that a
bank’s securities portfolio should consist of
primary reserves and secondary reserves
 This view suggests that banks hold shortterm, highly marketable securities primarily
to meet unanticipated loan demand and
deposit withdrawals
 Once these primary liquidity reserves are
established, banks invest any residual
funds in long-term securities that are less
liquid but offer higher yields
Passive Strategies Over the Business Cycle
 A problem arises because banks
normally have excess liquidity during
contractionary periods when loan
demand is declining and the Fed starts
to pump reserves into the banking
system
 Interest rates are thus relatively low.
Passive Strategies Over the Business Cycle
 Banks employing this strategy add to
their secondary reserve by buying longterm securities near the low point in the
interest rate cycle
 Long-term
rates are typically above
short-term rates, but all rates are
relatively low
 With a buy and hold orientation, these
banks lock themselves into securities
that depreciate in value as interest rates
move higher
Active Strategies Over the Business Cycle
 Many portfolio managers attempt to
time major movements in the level of
interest rates relative to the business
cycle and adjust security maturities
accordingly
 Some try to time interest rate peaks by
following a counter-cyclical
investment strategy defined by
changes in loan demand and the yield
curve’s shape
Active Strategies Over the Business Cycle
 The strategy entails both expanding the
investment portfolio and lengthening
maturities at the top of they business cycle,
when both interest rates and loan demand are
high

Note that the yield curve generally inverts
when rates are at their peak prior to a
recession
 Alternatively, at the bottom of the business
cycle when both interest rates and loan
demand are low, a bank contracts the
portfolio and shorten maturities
The Impact of Interest Rates on the Value of
Securities with Embedded Options
 Issues for Securities with Embedded
Options


Callable agency securities or mortgagebacked securities have embedded options
To value a security with an embedded option,
three questions must be addressed



Is the investor the buyer or seller of the
option?
How and by what amount is the buyer being
compensated for selling the option, or how
much must it pay to buy the option?
When will the option be exercised and what is
the likelihood of exercise?
Price-Yield Relationship for Securities
with Embedded Options
The Roles of Duration and Convexity in
Analyzing Bond Price Volatility
 Recall that the duration for an option-
free security is a weighted average of
the time until the expected cash flows
from a security will be received
P
Duration  - P
i
(1  i)
 i 
P  - Duration 
P

 (1  i) 
The Roles of Duration and Convexity in
Analyzing Bond Price Volatility
Yield %
Price
Price - $10,000 Duration
8
10,524.21
524.21
5.349
9
10,257.89
257.89
5.339
10
10,000.00
0.00
5.329
11
9,750.00
(249.78)
5.320
12
9,508.27
(491.73)
5.310
$ Price
10,524.21
10,507.52
Actual price increase is greater
when interest rates fall for option
free bonds.
10,000.00
Price-yield curve
Tangent line representing the
slope at 10%
8%
10%
Interest Rate %
The Roles of Duration and Convexity in
Analyzing Bond Price Volatility
 From the previous slide, we can see:
 The difference between the actual
price-yield curve and the straight line
representing duration at the point of
tangency equals the error in applying
duration to estimate the change in
bond price at each new yield
 For both rate increases and rate
decreases, the estimated price based
on duration will be below the actual
price
The Roles of Duration and Convexity in
Analyzing Bond Price Volatility
 From the previous slide, we can see:
 Actual
price increases are greater and
price declines less than that suggested
by duration when interest rates fall or
rise, respectively, for option-free bonds
 For small changes in yield the error is
small
 For large changes in yield the error is
large
The Roles of Duration and Convexity in
Analyzing Bond Price Volatility
 Convexity
 The rate of change in duration when
yields change
 It attempts to improve upon duration
as an approximation of price
ΔPrice Due to Convexity  Convexity(i2 )Price
 This
is positive feature for buyers of
bonds because as yields decline, price
appreciation accelerates
The Roles of Duration and Convexity in
Analyzing Bond Price Volatility
 Convexity
 As
yields increase, duration for option
free bonds decreases, once again
reducing the rate at which price declines
 This characteristic is called positive
convexity

The underlying bond becomes more
price sensitive when yields decline and
less price sensitive when yields increase
Impact of Prepayments on Duration and Yield
for Bonds with Options
 Embedded options affect the estimated
duration and convexity of securities
 For example, prepayments will affect the
duration of mortgage-backed securities

Market participants price mortgage-backed
securities by following a 3-step procedure:



Estimate the duration based on an assumed
interest rate environment and prepayment
speed
Identify a zero-coupon Treasury security with
the same (approximate) duration.
The MBS is priced at a mark-up over the
Treasury
Impact of Prepayments on Duration and Yield
for Bonds with Options
 The MBS yield is set equal to the yield
on the same duration Treasury plus a
spread
 The
spread can range from 50 to 300
basis points depending on market
conditions
 The MBS yields reflect the zero-coupon
Treasury yield curve plus a premium
Effective Duration and Effective convexity
 Both are used to estimate a security’s
price sensitivity when the security
contains embedded options
Pi- - Pi
Effective Duration 
P0 (i   i- )
Pi-  Pi  2P *
Effective Convexity 
P * [0.5(i   i- )] 2
Where:
Pi- = price if rates fall
Pi+ = price if rates rise
P0 = initial (current) price
P* = initial price
i+ =initial market rate plus
the increase in rate
i- = initial market rate minus
the decrease in rate
Effective duration and Convexity
 Example:
 Consider
a GNMA pass-through which
has 28-years and 4-months weighted
average maturity
The MBS is initially priced at 102 and
17/32nds to yield 6.912%, at 258 PSA
 At this price and PSA, MBS has an
estimated average life of 5.57 years and
a modified duration of 4.01 years

Effective duration and Convexity
 Example:
 Assume a 1% decline in rates will
accelerate prepayments and lead to a
price of 102 while a 1% increase will slow
prepayments and produce a price of 103
 The effective duration and convexity for
this security are thus:
 Effective GNMA duration
= [102-103]/ 102.53125x(.05921 - .07921)
= -0.4877 years
 Effective GNMA convexity
= [102+103-2 x
(102.53125)]÷102.53125[0.52(.02)2]
= -6.096 years
Positive and Negative Convexity
 Option-free securities exhibit positive
convexity because as rates increase,
the percentage price decline is less
than the percentage price increase
associated with the same rate decline
 Securities with embedded options may
exhibit negative convexity
 The
percentage price increase is less
than the percentage price decrease for
equal negative and positive changes in
rates
Total Return Analysis
 An investor’s actual realized return
should reflect the coupon interest,
reinvestment income, and value of the
security at maturity or sale at the end
of the holding period
 When a security carries embedded
options, these component cash flows
will vary in different interest rate
environments
Total Return Analysis
 If rates fall and borrowers prepay
faster than originally expected:
 Coupon
interest will fall
 Reinvestment income will fall
 The price at sale (end of the holding
period) may rise or fall depending on
the speed of prepayments
Total Return Analysis
 When rates rise
 Borrowers
prepay slower
 Coupon income increases
 Reinvestment income increases
 The price at sale may rise or fall
Total Return Analysis for a Callable FHLB Bond
Total Return Analysis for a Callable FHLB Bond
Option-Adjusted Spread
 The standard calculation of yield to maturity is
inappropriate with prepayment risk
 Option-adjusted spread (OAS) accounts for
factors that potentially affect the likelihood and
frequency of call and prepayments
 Static spread is the yield premium, in percent,
that (when added to Treasury zero coupon
spot rates along the yield curve) equates the
present value of the estimated cash flows for
the security with options equal to the
prevailing price of the matched-maturity
Treasury
Option-Adjusted Spread
 OAS represents the incremental yield earned
by investors from a security with options over
the Treasury spot curve, after accounting for
when and at what price the embedded options
will be exercised.
 OAS analysis is one procedure to estimate
how much an investor is being compensated
for selling an option to the issuer of a security
with options.
 OAS is often calculated as an incremental yield
relative to the LIBOR swap curve.
Option-Adjusted Spread
 The approach starts with estimating
Treasury spot rates (zero coupon
Treasury rates) using a probability
distribution and Monte Carlo simulation,
identifying a large number of possible
interest rate scenarios over the time
period that the security’s cash flows will
appear
Option-Adjusted Spread
 The analysis then assigns probabilities
to various cash flows based on the
different interest rate scenarios

For mortgages, one needs a prepayment
model and for callable bonds, one needs
rules and prices indicating when the
bonds will be called and at what values
Steps in Option-Adjusted Spread Calculation
Rate Volatility Estimates
(Variance)
Current Treasury Curve
(Mean)
Distribution of
Interest Rates
Other Prepayment
Factors
Prepayment Model
Security-Specific
Information: Coupon
Rate, Maturity, etc.
Possible Cash Flows
from Mortgage Security
Market Price of
Mortgage Security
Find Spread over
Treasury Rates Such That
Market Price = Present
Value of Cash Flows
Option-Adjusted
Spread
Shock Rates Up
and Down
Calculate Duration
and Convexity
Option-Adjusted Spread Analysis for a Callable FHLB Bond
Comparative Yields on Taxable versus TaxExempt Securities
 Interest on most municipal securities is
exempt from federal income taxes and,
depending on state law, from state
income taxes
 Some
states exempt all municipal
interest
 Most states selectively exempt interest
from municipals issued in-state but tax
interest on out-of-state issues
 Other states either tax all municipal
interest or do not impose an income tax
Comparative Yields on Taxable versus TaxExempt Securities
 Capital gains on municipals are taxed as
ordinary income under the federal
income tax code
 This
makes discount municipals less
attractive than par municipals because a
portion of the return, the price
appreciation, is fully taxable
 When making investment decisions,
portfolio managers compare expected
risk-adjusted after-tax returns from
alternative investments
Comparative Yields on Taxable versus TaxExempt Securities
 After-Tax and Tax-Equivalent Yields
 Once
the investor has determined the
appropriate maturity and risk security,
the investment decision involves
selecting the security with the highest
after-tax yield
Comparative Yields on Taxable versus TaxExempt Securities
 After-Tax and Tax-Equivalent Yields
 Tax-exempt
and taxable securities can
be compared as:
R

m 
R t (1  t)
where
Rm = pretax yield on a municipal security
Rt
= pretax yield on a taxable security
t
= investor’s marginal federal income tax rate
Comparative Yields on Taxable versus TaxExempt Securities
 After-Tax and Tax-Equivalent Yields
 Example

Let:
Rm = 5.75%
Rt
= 7.50%
Marginal Tax Rate
= 34%
 The investor would choose the municipal
because it pays a higher after tax return:
Rm
Rt
= 5.75% after taxes
= 7.50% (1 - 0.34)
= 4.95% after taxes
Comparative Yields on Taxable versus TaxExempt Securities
 Marginal Tax Rates Implied in the
Taxable - Tax-Exempt Spread
 If
taxable securities and tax-exempt
securities are the same for all other
reasons then:

t* = 1 - (Rm / Rt)
 where
 Rm = pretax yield on a municipal security
 Rt = pretax yield on a taxable security
Comparative Yields on Taxable versus TaxExempt Securities
 Marginal Tax Rates Implied in the
Taxable - Tax-Exempt Spread
 t*
represents the marginal tax rate at
which an investor would be indifferent
between a taxable and a tax-exempt
security equal for all other reasons
 Higher marginal tax rates or high tax
individuals (companies) will prefer taxexempt securities
Comparative Yields on Taxable versus TaxExempt Securities
 Example

Let:
Rm
Rt
= 5.75%
= 7.50%
Marginal Tax Rate = 34%
5.75%
t  1
 23.33%
7.50%
*

An investor would be indifferent between
these two investment alternatives if her
marginal tax rate were 23.33%
Comparative Yields on Taxable versus TaxExempt Securities
 Municipals and State & Local Taxes
 The
analysis is complicated somewhat
when state and local taxes apply to
municipal securities:

m 
Rm (t  t ) R t [1 (t  t m )]
Comparative Yields on Taxable versus TaxExempt Securities
 Municipals and State & Local Taxes
 Many
analysts compare securities on a
pre-tax basis
 To compare municipals on a tax
equivalent basis (pre-tax):
Rm (t  t m )
Tax  Equivalent Yield 
1  (t m  t)
Comparative Yields on Taxable versus TaxExempt Securities
 Deductibility of Interest Expense
 Prior
to 1983, banks could deduct the
full amount of interest paid on
liabilities used to finance the purchase
of muni's
 After 1983 15% was not deductible and
after 1984 20% was not deductible
Comparative Yields on Taxable versus TaxExempt Securities
 Deductibility of Interest Expense
 The
1986 tax reform act made 100% not
deductible except for qualified muni's,
small issue (less than $10 million)
 The loss of interest expense
deductibility is like an implicit tax on
the bank's holding of municipal
securities
Comparative Yields on Taxable versus TaxExempt Securities
 Deductibility of Interest Expense
 To
calculate after tax yields on muni's,
if interest expense is not fully
deductible, calculate the bank’s
effective tax rate on municipals (tm):
tm 
 Pooled 
 %Not  

t
 Interest 

Deductable   Cost 


Rmuni
 State and Local
Comparative Yields on Taxable versus
Tax-Exempt Securities
 Example:
 Assume
t =34%,
 20% Not Deductible
 7.5% Pooled Interest Cost
 Rmuni = 7%.

t muni
(0.34)  (0.20)  (0.075)

 0  6.38%
0.08
at
Rmuni
 8.0  (1 0.0638) 7.49%
Comparison of After-Tax Returns on Taxable and TaxExempt Securities for a Bank as Investor
After-Tax Interest Earned on Taxable versus Exempt Securities
Taxable
$
10,000
10.00%
$
1,000
$
340
$
660
Par Value
Coupon Rate
Annual Coupon interest
Federal income taxes (34%)
After-tax income
Municipal
$ 10,000
8.00%
$
800
$0
$
800
After-Tax Interest Earned Recognizing Partial Deductibility of Interest Expense
Par Value
Coupon Value
Annual coupon interest
Federal income taxes (34%)
Polled interest expense (7.5%)
Lost interest deduction (20%)
Increased tax liability (34%)
Effective after-tax interest income
$
$
$
$
$
$
$
$
10,000
0
1,000
340
750
660
$
$
$
$
$
$
$
$
10,000
0
800
750
150
51
749
After-Tax Interest Earned, Recognizing Partial
Deductibility of Interest Expense: Individual Asset
Factors affecting allowable deduction:
Total interest expense paid
$
Average amount of assets owned
$ 20,000,000
Average amount of tax exempt securities owned:
$
Weighted average cost of financing
1,500,000
800,000
7.50%
Nondeductible interest expense:
Pro rata share of interest expense to carry muni's
Nondeductible interest expense (20%)
Deductible interest expense: $1,500,000 - $12,000 =
4.00%
$
12,000
$
1,488,000
The Impact of the Tax Reform
Act of 1986 (TRA 1986)
 The TRA of 1986 created two classes
of municipals


Qualified
Nonqualified Municipals
 After 1986, banks could no longer
deduct interest expenses associated
with municipal investments, except
for qualified municipal issues
The Impact of the Tax Reform
Act of 1986 (TRA 1986)
 Qualified versus Non-Qualified
Municipals
 Qualified

Municipals
Banks can still deduct 80 percent of the
interest expense associated with the
purchase of certain small issue publicpurpose bonds (bank qualified)
 Nonqualified

Municipals
All municipals that do not meet the
qualified criteria
The Impact of the Tax Reform
Act of 1986 (TRA 1986)
 Qualified versus Non-Qualified
Municipals
 Municipals
issued before August 7,
1986, retain their tax exemption; i.e.,
can still deduct 80 percent of their
associated financing costs
(grandfathered in)
The Impact of the Tax Reform
Act of 1986 (TRA 1986)
 Example:
 Implied tax on a bank’s purchase of
nonqualified municipal securities
(100% lost deduction)
 Assume
 t =34%
 20% not deductible
 7.5% pooled interest cost
 Rmuni = 7%
t muni
(0.34)  (1.00)  (0.075)

 0  31.88%
0.08
at
Rmuni
 8.0  (1 0.3188) 5.45%
Strategies Underlying Security Swaps
 Active portfolio strategies also enable
banks to sell securities prior to maturity
whenever economic conditions dictate
that returns can be earned without a
significant increase in risk
 When a bank sells a security at a loss
prior to maturity, because interest rates
have increased, the loss is a deductible
expense
 At
least a portion of the capital loss is
reduced by the tax-deductibility of the
loss
Evaluation of Security Swaps
Par Value
Market
Value
Remain
Maturity
Semiann
Coupon
YTM
A. Classic Swap Description
Sell US Trea bonds @ 10.50%
Buy FHLMC bons @
12.20%
$2,000,000 $1,926,240
$1,952,056 $1,952,056
3
3
$105,000
$119,075
12.00%
12.20%
B. Swap with Minimal Tax Effects
Sell US Treas bons @ 10.50%
Sell FNMA @
13.80%
Total
Buy FNMA @
13.00%
$2,000,000
$3,000,000
$5,000,000
$5,000,000
3
4
$105,000
$207,000
$312,000
$325,000
$ 13,000
12.00%
13.00%
$1,926,240
$3,073,065
$4,999,305
$5,000,000
1
12.00%
C. Present Value Analysis
Period
0
1
2
3
4
5
6
Treas Cash flow
$1,926,240 ($105,000) ($105,000) ($105,000) ($105,000) ($105,000) ($2,105,000)
Tax savings
$25,816
FHLMC
($1,952,056) $119,075 $119,075 $119,075 $119,075 $119,075 $2,071,132
Difference:
$0
$14,075
$14,075
$14,075
$14,075
$14,075
($33,868)
14,075  47,944  14,075

 $35,380
t
6
1.061
t 1 1.061
6
PV  
Security Swap Example
 Tax Savings:
= (2,000,000 - 1,926,240) * 0.35 = 25,816
 After Tax Proceeds
= 1,926,240 + 25,816 = 1,952,056
 Present Value of the Difference:
14,075  47,944  14,075
PV  

 $35,380
t
6
1.061
t 1 1.061
6
Strategies Underlying Security Swaps
 In general, banks can effectively
improve their portfolios by:
 Upgrading
bond credit quality by
shifting into high-grade instruments
when quality yield spreads are low
 Lengthening maturities when yields
are expected to level off or decline
 Obtaining greater call protection when
management expects rates to fall
Strategies Underlying Security Swaps
 In general, banks can effectively
improve their portfolios by:
 Improving
diversification when
management expects economic
conditions to deteriorate
 Generally increasing current yields by
taking advantage of the tax savings
 Shifting into taxable securities from
municipals when management expects
losses
Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning
Managing the Investment
Portfolio
Chapter 13
William Chittenden edited and updated the PowerPoint slides for this edition.