Download Looking Back and Thinking Ahead Looking Back

SPRING 2013
OFFICIAL PUBLICATION OF THE WEST VIRGINIA BANKERS ASSOCIATION
Bond Portfolio Strategies for 2013:
Looking Back
and Thinking
Ahead
Bond Portfolio Strategies for 2013:
Looking Back and
Thinking Ahead
By Jeffrey F. Caughron, Associate Partner, The Baker Group LP
sheet, including trends in growth and
mix as well as broad interest rate risk
exposures. From there we can move to
tactical decision-making, relative value
analysis, and the security selection
process. This sort of top-down method
provides a framework for active management of investments by rebalancing
and restructuring the portfolio in order
to achieve the optimal risk/reward
profile for the market conditions that
exist at the time.
The time has long passed when
banks could pursue a “buy-and-hold”
strategy for bonds. A passive management style can potentially result
in substantial opportunity costs and
underperformance. At least once a
year, portfolio managers or investment
committees should evaluate the overall
posture of the investment portfolio and
make any adjustments that are dictated
by changes in balance sheet mix, tax
considerations, or the risk position of
the bank. The best time to make such
adjustments is at the turn of a year
when the bank can do tax loss swaps
as well as restructure the portfolio for
better efficiency.
Types of Bond Swaps
As we transition into a new year, bank investment officers should take time
to assess the big picture and think about strategic direction for the bond
portfolio. A glance in the rear view mirror is instructive.
W
e know that 2012 was punctuated by a great deal of politics
and a continuation of sloth-like
economic growth. Banks were also
notified of the potential body blow
of Basel III. Through it all, the word
of the year for financial markets was
“uncertainty.”
For most of 2012 we were uncertain
of who would be in the White House
after the first week of November. Once
the election was decided, we focused
our uncertainty on the pending “fiscal
cliff” of substantial spending cuts and
10
tax increases, which collectively would
lop off a significant chunk of GDP
growth. That particular uncertainty
is still lingering, but it’s fair to assume some degree of fiscal drag on the
economy regardless of any agreement.
The bottom line is that we can expect
continued sluggish growth, low interest
rates, and another challenging year for
bank investments.
A Method for Active
Management
Prudent portfolio management begins
with strategic analysis of the balance
Duration Adjustment Swap: Many
portfolios have seen a natural shortening of average life and/or a decline
in duration as the low rate environment persists. A duration-adjustment
swap may involve moving out on
the yield curve to take advantage of
higher yields or in order to maintain
proper balance between asset and
liability duration. Historically, community banks maintain fairly high
balances of non-maturity deposits,
which are relatively high duration
liabilities. This must be kept in mind
when determining the proper duration of assets including investments.
It is the relative difference between
effective duration of assets and liabilities that ultimately determines
the volatility of a bank’s economic
value of equity. Duration swaps are
a classic asset/liability management
strategy for banks that are too asset
www.wvbankers.org
or liability sensitive and need to extend or shorten the net
duration of their assets.
Relative Value Swap: At any given point in time, some
sectors of the bond market offer better value than others.
Moreover, the relative advantage of the different sectors (as measured by their yield spread relationships) is
constantly changing. Mortgage-backed securities versus
municipals, callables versus MBS… all of these relationships should be monitored as markets move. Savvy
portfolio managers will take advantage of the changing
relationships and do swaps that sell what is rich and buy
what is cheap compared to historical averages. As always,
each bank will have a different sector allocation that
is optimal for them given their liquidity and cash f low
needs, tax position, etc. Here again, a big-picture view of
the balance sheet is necessary.
Muni Tax-Loss Swap: Banks should always be looking at
their tax position and working with their accountants to
optimize their after-tax performance. Each bank has its own
unique set of circumstances, but generally the Tax Code allows for a loss on the sale of securities to be deducted for tax
purposes. Moreover, for a taxable bank, the interest income
from reinvestment is allowed to be earned tax free if the
proceeds are used to purchase municipals. The bottom line
is that the bank can recoup a tax-deductible loss with taxfree income. This strategy in particular is best executed at
the turn of the year in order to have an entire twelve months
to recover any loss.
Cash Flow/Liquidity Management Swap: To a very large extent,
investment portfolio management is simply the management
of cash flows. Just as we look at rate sensitivity for the overall
balance sheet, we must also take a macro view of the portfolio
and pay close attention to the positioning of cash flows for
reinvestment. This involves creating and maintaining a schedule of maturities, prepayments, and other sources of principal
return that will optimize the risk and reward of reinvestment
in future months and years, regardless of the direction of interest rates. Cash flows for many securities, callable bonds, and
MBS in particular, are moving targets because of the options
risk. This makes it critical that the profile be monitored and
measured for changes in rates, and adjusted with bond swaps
when necessary. Q
For more information, contact Jeff Caughron at The Baker Group:
800-937-2257, www.GoBaker.com, or email: jcaughron@GoBaker.
com. The Baker Group LP is the sole authorized distributor for the
products and services developed and provided by The Baker Group
Software Solutions, Inc.
The Correspondent Division of CenterState Bank employs
over seventy dedicated correspondent professionals, and
we manage over 590 relaƟonships throughout the
Southeastern United States.
As our customers and their communiƟes expand and grow, CenterState Bank is commiƩed to
delivering innovaƟve products and services that Include:
InternaƟonal Services
Foreign Wire Transfers
S.W.I.F.T. Messaging
Foreign Currency and Travelers Checks
Foreign Check Clearing
Foreign DraŌs
Foreign Exchange Advisory Services
Capital Markets Services
Porƞolio Strategies
Bond AccounƟng and Safekeeping
BondRisk and SwapRisk SoŌware
Treasury Services
x Brokered CDs
x Repurchase Agreements
x Federal Funds AccommodaƟons
x DerivaƟve Instruments
Asset/Liability Management Modeling and ConsulƟng
x Plansmith Bankers GPS - Call Report Model
x FICast Sendero - Instrument-Level Model
Payment SoluƟons
Cash Management
x Converge (On-line Plaƞorm)
x Sweep Account
x Federal Funds Program
Bond School and Customized EducaƟonal FuncƟons
120 Club Oaks Court, Suite 150 y Winston-Salem, NC 27104 y 336.659.7100 y 877.604.8282
www.csbcorrespondent.com
spring 2013
11