Bank Investments - PowerPoint PPT Presentation

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Bank Investments

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  1. Bank Investments

  2. Bank Investments • G & K Chp. 7 • Review Economic Environment (Loans) • Types of investment securities • Evaluating investment risk • Investment strategies

  3. Securities • U.S. government and agency securities • (Agencies: FNMA, FHLMC, GNMA, FCA, SBA) Mortgage-backed securities (MBSs) and collateralized mortgage obligations (CMOs) are dominant in this investment category (prepayment risk). • Municipal bonds • General obligation bonds (GOs) and revenue bonds • Taxes • Corporate bonds

  4. Muni Taxes • Tax formula for munis: YTMm/(1-T) - (1.0 x Average cost of funds x T)/(1-T) = YTMTE where T = bank tax rate, the factor 1.0 is for 100% of interest expenses are not deductible from taxes (i.e., 0.20 for bank qualified munis), and average cost of funds is based on IRS rules, and YTMTE = a tax equivalent yield for comparison to taxable bonds. Example: given T = 0.34, 1.0 is used, average cost of fund = 7%, and YTMm= 8%, we have 0.08/(1 - 0.34) - [(1.0 x 0.07 x 0.34)/(1 - 0.34)] = 0.0852 or 8.52%

  5. Securities Risk • Interest Rate risk • Security Specific risk

  6. Interest Rate risk • Duration • Coupon Rate, YTM inverse to Duration • Maturity directly related to Duration • Assumes Parallel Shifts in YTMs !!! • Convexity (Second Derivative of Price) • Notice that price change prediction gets worse • Positive and Negative Convexity

  7. Security Specific risk • Bond Ratings • Investment grade bonds (top 4 credit ratings) AAA (Aaa)  BBB (Baa) • Junk bonds (lower rated bonds) BB (Ba)  C; Default: DDD, DD, D • Estimates of the probability of default • Bondholder losses in default not captured by credit ratings

  8. Investment strategies • Passive investment strategies • Aggressive investment strategies

  9. Passive Investment Strategies • Space-maturity approach (ladder approach) Spread available investment funds evenly across a specified number of periods within the bank’s investment horizon. Simple and low transactions costs, but passive with respect to interest rate conditions and liquidity is sacrificed to some extent. • Split-maturity approach (barbell approach) Greater quantities of short-term and long-term securities are held. This strategy balances liquidity and higher income.

  10. Ladder Approach $10 $10 $10 $10 $10 Barbell Approach $20 $20 $10 1 yr 2 yrs 3 yrs 4 yrs 5 yrs Maturities of Securities Passive Investment Strategies

  11. Aggressive Investment Strategies • Yield curve strategies • Playing the yield curve • Riding the yield curve • Bond-swapping strategies • Tax swap • Substitution, or price, swap • Yield-pickup, or coupon, swap • Spread, or quality, swap • Portfolio shift