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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