1)
Why are Treasury bills not considered to be investment securities?
ANSWER: Because they are short-term money market instruments with maturities less
than one year. They are held more for liquidity purposes than for investment income.
2)
How do municipal bonds reduce taxes for a bank?
ANSWER: No federal income taxes are levied on interest income, and state tax is only
applicable if the bond was purchased outside of the investor's home state and a state
income tax exists in the investor's home state. Of course, deductions for munis interest
income in excess of the bank's taxable income could not be used. Also, it should be kept
in mind that, under the Tax Reform Act of 1986, banks are subject to a minimum
corporate tax which may cause some deductions to become unusable. TRA86 also
eliminated interest deductions on funds borrowed by banks to purchase munis, with the
exception that a 80 percent deduction is allowed if the local government issues less than
$10 million in any one year. Tax planning is needed to ensure that munis income
deductions and other deductions (e.g., leasing, depreciation, capital losses on security
sales, etc.) are beneficial in terms of sheltering income from taxes.
3)
Why is investment policy affected by the interest rate cycle?
ANSWER: Volatile interest rates can substantially increase the interest rate risk
associated with holding longer-term investment securities. Also, investment policy
should consider the effects of interest rate movements on earnings. When interest rates
are relatively high and expected to decline in the future, investment in longer-term
securities may be warranted to lock in higher yields and possibly earn a significant capital
gain as interest rates decline. On the other hand, when interest rates are relatively low and
expected to rise in the future, shorter-term maturities of securities may be emphasized to
enable the bank to roll over securities into higher yielding securities as interest rates rise
as well as make loans when needed.
4)
Why do most investment securities have maturities in the range of one-to-five
years?
ANSWER: This increases the flexibility of the bank in managing its investment policy, as
securities with maturities in this range will mature within one business cycle. At different
times in the business cycle, the bank normally will want to restructure the maturities of
the securities portfolio to take advantage of present and expected future interest rate
conditions.
5)
Why do banks generally avoid junk bonds?
ANSWER: Bonds rated lower than investment grade may well be considered unsafe
investments within "prudent man" rules of law. Also, banks may be restricted from
holding significant quantities of junk bonds due to regulatory constraints.
6)
Discuss how default risk affects bond prices.
ANSWER: Default risk raises the interest rate on bonds and therefore lowers the price.
This risk premium increases as the probability of default increases. Risk premia are
affected by the business cycle. In a recession, when default is more likely, default risk
premia increase. At the peak of the business cycle, default risk premia are at a minimum.
7)
Define price risk. How can a bank take advantage of price risk in a relatively high
interest rate period?
ANSWER: Price risk refers to the inverse relationship between the movement in interest
rates and the change in prices of securities. The longer the duration of a bond, the greater
its price risk (i.e., the percentage change in the price of a security can be estimated as the
negative of duration times the expected change in interest rates divided by the quantity
one plus the current level of interest rates).
To take advantage of price risk in a high interest rate period, the bank should lengthen
the duration of its portfolio of securities. This not only provides a relatively high rate of
earnings but allows the bank to take advantage of an opportunity to sell the securities as
interest rates decline in the future and their prices rise (which would provide a sizable
capital gain).
8)
Why do bonds issued in relatively low interest rate periods have low call risk?
ANSWER: As interest rates rise, the prices of bonds will fall. In order to be called, the
bond price normally must rise above the current selling price and "strike" the call price.
9)
Why is call risk an important factor for an investment manager purchasing bonds
in a relatively high interest rate period?
ANSWER: During such times, it can be expected that interest rates will decline in the
future. As they do, the prices of bonds will rise. Beginning from a relatively high level, as
interest rates fall, prices of bonds likely will increase substantially. In this case it is very
likely that the price will "strike" the call price. As soon as the call deferment period has
expired, the bond can be called. This is advantageous to the firm because a new issue of
bonds can be sold at lower interest rates and the resultant funds used to pay off the old
bonds. However, this call risk may cause the yield on the investment portfolio to decline,
as funds are reinvested in lower interest rate securities. A call premium is normally paid
to the bondholder to compensate for this reinvestment risk.
10)
Why might the barbell approach to investment management be preferred to the
ladder approach?
ANSWER: The ladder approach evenly spreads the investments of the bank over time
into different maturity ranges. This approach to investment management sacrifices higher
yields on longer-term securities as well as liquidity in terms of holding shorter-term
liquid securities. The barbell approach overcomes these drawbacks by allocating larger
proportions of the investment portfolio to both shorter-term and longer-term securities.
This balances both earnings and liquidity goals of the bank.
11)
What does "playing the yield curve" mean? How is it different than "riding the
yield curve?"
ANSWER: "Playing the yield curve" involves changing the maturity structure of the
investment portfolio as interest rates change. When interest rate levels are relatively low,
the bank will purchase shorter-term securities. These securities are gradually rolled over
into higher-yielding securities as interest rates rise in the future. When interest rate levels
are peaking out, maturing securities are rolled over into longer-term securities to lock in
high yields as well as to possibly earn a sizable capital gain as interest rates fall in the
near future.
"Riding the yield curve" means to purchase securities with maturities that exceed the
investor's holding period. It is anticipated by the investor that interest rates will not
increase as much as expected. If the yield curve did not change (for example) during the
investor's holding period, and the yield curve were upward sloping, as the maturity of the
securities held by the investor declined over time, their yield would decline in line with
the downward sloping shape of the yield curve. Since their yield would decline, the prices
of the securities would rise. When the time to maturity decreases to the point that it
equals the investor’s holding period, the securities are sold to realize a capital gain.
12)
Briefly discuss four kinds of bond swaps?
ANSWER: A substitution (or price) swap would involve simultaneously buying
securities at one price and then selling them at a higher price. This swap would be due to
some price inefficiency in the market. A tax swap involves buying and selling tax-exempt
and taxable securities. For example, a corporate and a municipal bond could have equal
yields, but the bank might sell the municipal bond and buy the corporate bond because
the capital loss will allow a tax deduction that exceeds the transactions costs of doing the
swap.
A yield-pickup (or coupon) swap involves buying and selling low coupon and high
coupon bonds. This may done for either interest rate risk (duration) or tax reasons.
A portfolio shift swap involves selling lower yield securities and replacing them with
higher yielding securities. This swap is profitable if the tax savings associated with the
capital loss on sale of the lower yielding instruments plus the present value of higher
earnings on new securities exceeds the capital loss on lower yielding securities.
13)
(a) Given a five-year municipal bond yielding 10%, a comparable five-year
corporate bond yielding 15%, a federal income tax rate of 34% facing the bank,
which bond should be preferred by the bank?
(b) Given the following income statement information, calculate the bank's net
income after taxes. Assume a federal tax rate of 34 percent on income. What if
$400 of interest tax deductions are lost due to the municipal bond purchases?
Total interest on securities
Municipal bond interest
Other securities interest
in thousands
$2,000
500
1,500
Total interest on loans
Total operating income
4,000
6,000
Total interest expensea
(4,100)
Total noninterest expense
Total operating expense
a
Allowable interest expenses under TRA86.
(900)
(5,000)
ANSWER:
(a)
The after-tax yield on the corporate bond is 15%(1 - .34) = 9.90%. Assuming that
the municipal bond has no capital gains (i.e., the market price equals the par
value), the munis yield of 10% is a higher than that of the corporate bond. If the
munis yield was comprised of both interest and capital gains earnings, taxes on
the latter gains would lower its after-tax yield. In this case further calculations
would be needed to make a final decision between the two different types of
securities.
(b)
Net income after taxes can be calculated as follows:
Total operating income
$6,000
Total operating expense
Net operating income
(5,000)
1,000
Less municipal bond interest
Taxable income
(500)
500
Less taxes (@ 34 percent)
Taxable income after taxes
Municipal Bond Interest
Total Net Income After Tax
(170)
$330
$500
$830
If $400 of interest tax deductions were lost due to the municipal bond purchases,
taxable income would increase to $900 and taxes would increase to $306. Thus,
net income after taxes would now be $694 (i.e., $1,000 - $306).
14)
A munis bond selling at par has a yield-to-maturity equal to 10%. A bank
investment manager wishes to calculate its tax equivalent yield. Assume that it is
a qualified bond, the bank's tax rate is 34 percent, and the average cost of funds
for the bank is 8 percent. If the munis bond was not qualified, what would be the
answer?
ANSWER:
Equation (10.1) in the text can be used to get:
[0.10/(1-0.34)] - [(0.20 x 0.08 x 0.34)/(1-0.34)] = .1433 or 14.33 percent.
If the bond was not qualified, then 100 percent of the interest would not be deductible,
such that the factor 0.20 above would be changed to 1.0. In this case the tax equivalent
yield is 0.1103 or 11.03 percent.
True/False
1)
2)
Pledging requirements are related to capital management rather than investment
management.
ANSWER: False
Revenue bonds are backed by the "full faith and credit" of the taxing government
unit.
ANSWER: False
3) GOs pay no federal income taxes on interest income.
ANSWER: True
4)
5)
6)
During recessionary periods, the yield spread between low and high quality bonds
tends to increase.
ANSWER: True
When interest rates are high, and the expansionary phase of the economy is
peaking out, this is an ideal time to purchase short-term securities, as opposed to
long-term securities.
ANSWER: False
Empirical evidence has repeatedly shown that future implicit interest rates
calculated from the equation representing the expectations theory of the yield
curve tend to be upwardly biased estimates of actual future rates of interest.
ANSWER: True
7)
The ladder approach to investment management is a passive approach.
ANSWER: True
Multiple Choice
1) Investment securities are held by commercial banks to produce income in the forms
of ___________ and ______________ .
a. interest and dividends
b. dividends and capital gains
c. interest and capital gains
d. interest and tax credits
ANSWER: c
2)
Investment securities are defined as those securities with:
a. high return per unit risk
b. interest rates above market rates
c. maturities greater than 1 year
d. a and c
e. a, b, and c
ANSWER: c
3)
The Glass Steagall Act prohibits banks from holding:
a. corporate bonds
b. corporate stocks
c. municipal securities
d. equity securities
e. none of the above
ANSWER: b and/or d
4)
Treasury notes and bonds:
a. are sold only at a discount
b. are coupon-bearing instruments
c. range in maturities from 1 to 30 years
d. b and c
e. a, b, and c
ANSWER: d
5)
Which of the following securities would tend to offer the highest yield?
a. Treasury bills
b. Treasury notes bonds
c. agency securities
d. general obligation municipal
e. revenue bonds
ANSWER: e
6)
The pretax equivalent rate of return on a 7% municipal bond when the tax rate is
30%, the average cost of funds is 6%, and the bond is "qualified" is:
a. 10%
b. 7.43%
c. 9.49%
d. none of the above
ANSWER: c
7)
The pretax equivalent rate of return on a 7% municipal bond when the tax rate is
30%, the average cost of funds is 6%, and the bond is not "qualified" is:
a. 10%
b. 7.43%
c. 9.49%
d. none of the above
ANSWER: b
8)
Which of the following comprises the largest proportion of investment in
securities portfolios of commercial banks?
a. municipal securities
b. U.S. Treasury and agency securities
c. corporate securities
d. mortgage backed securities
ANSWER: b
9)
Investment grade bonds include bonds that are graded letters of:
a. AAA and AA
b. A and BBB
c. BB and B
d. a and b
e. a, b, and c
ANSWER: d
10)
The value of a $1,000 bond with an 8% yield-to-maturity and duration of 4 years
would decline in value by how much if interest rates rose 2%?
a. $37
b. $74
c. $80
d. $100
e. none of the above
ANSWER: b
11)
The expectations theory of the yield curve assumes that:
a. holding period is irrelevant
b. holding period is relevant
c. risk premiums exist for liquidity
d. supply and demand for securities is very important in long-term and shortterm yields.
ANSWER: a
12)
When interest rates are relatively high, and the expansionary phase of the business
cycle is peaking out, banks should take advantage of the yield curve by:
a. buying short-term securities
b. selling short-term securities
c. buying long-term securities
d. selling long-term securities
ANSWER: c
13)
The higher rate that banks charge for loans with longer terms to maturity is the
result of:
a. risk aversion
b. liquidity preference
c. a normally upward sloping yield curve
d. a and c
e. a, b, and c
ANSWER: e
14)
The long-term bond market is dominated by:
a. life insurance companies and pension funds
b. pension funds and commercial banks
c. commercial banks and the Fed
d. life insurance companies and the Fed
ANSWER: a
15)
The risk associated with NOT being able to sell bonds quickly without loss of
principal is called:
a. credit risk
b. call risk
c. liquidity or marketability risk
d. portfolio risk
ANSWER: c
16)
A corporate bond will most likely be called if it was issued when interest rates
were ____________ and the interest rate have since _______________.
a. high; fallen
b. high; risen
c. low; risen
d. low; fallen
ANSWER: a
17)
The passive portfolio management strategy in which available investment funds
are spread equally over a specified number of periods is known as the:
a. split-maturity approach
b. spaced-maturity approach
c. barbell approach
d. spread-maturity approach
e. none of the above
ANSWER: b
18)
The split-maturity approach to securities management involves buying _________
amounts of short-term securities, ______________ amounts of intermediate-term
securities, and _________________ amounts of long-term securities.
a. large; small; large
b. large; large; large
c. large; small; small
d. small; small; small
ANSWER: a
19)
Aggressive strategies for managing investment portfolios include:
a. bond swapping
b. playing the yield curve
c. portfolio switching
d. a and b
e. a, b, and c
ANSWER: d
20)
The most important aspect of aggressive yield curve strategies is:
a. high liquidity
b. accurate market forecasting
c. taxes
d. risk aversion
ANSWER: b
21)
All of the following are types of bond swaps EXCEPT:
a. municipal swap
b. coupon swap
c. tax swap
d. spread swap
ANSWER: a
22)
The exchange of a low coupon bond for a high coupon bond, or vice versa, is
called a:
a. spread swap
b. quality swap
c. trade-off swap
d. yield pickup swap
ANSWER: d
23)
Banks "cherry pick" securities in their investment portfolio to:
a. obtain tax losses on sales
b. obtain interest income
c. obtain capital gains
d. none of the above
ANSWER: c
24)
Risk-based capital rules cause banks to favor:
a. GO municipal bonds
b. revenue bonds
c. all municipal bonds
d. no municipal bonds
ANSWER: a
25)
Default risk on bonds can be evaluated by using:
a. financial analysis
b. bond ratings
c. estimates of potential losses on bonds
d. a and b
ANSWER: d
26)
Bond ratings do NOT capture:
a. default risk
b. probability of missed interest payments
c. probability of missed principal payments
d. potential losses to bondholders
ANSWER: d