Download 2017 IBA Mega Conference - Indiana Bankers Association

2017 IBA Mega Conference
Breakout Session
Key Takeaways for Successful Bond Portfolio Management
May 4th, 2017
Matt Harris, CFA – Sr. VP, Financial Strategies Group [email protected]
800-937-2257
Economic Conditions & Fed Policy:
2nd Quarter 2017
• US GDP Growth: Stuck at Two
Percent
o 4th Qtr. Annualized GDP = 2.1%
o 4th Qtr. Year-Over-Year GDP = 2.0%
• Job Creation – Warming Up
o
o
o
o
o
April Payrolls Growth = 98K
6mo Avg. Payrolls Growth = 163K
4.5% Unemployment Rate
Labor Force Participation – Still Low
Wage Growth – accelerating
• Consumer Spending / Capital
Investment
o Weak capital spending –uncertainty
o Consumer spending looks brighter
o Inflation perks up… but not too much
• Global Economy
o Populists in Europe: France, Germany
o China: Stepping into the free-trade void
o Trump-Angst and Uncertainty
• Fed Policy:
Another hike… what next?

More to come… and how many?
 Low, but not too slow
2
GDP
3
Rates
“Taper Tantrum”
“Trump Jump”
“Reality Rally”
4
Unemployment Rate & Labor Force Participation
5
Inflation
6
Yield Curve
7
Yield Curves: 2000, 2007, 2017
Above: June 2000
Below: January 2007
This interest rate cycle is unusual: the tightening may result
in an exceptionally flat curve at historically low levels
Current Yield Curve
March 2017 Portfolio Summary
Performance of All Bank Portfolios on Baker Bond
Accounting (BBA)




Avg. Book Yield = 2.74%
Avg. Life = 4.5 years
+300bps Avg. Life = 5.9 years
+300bps Price Risk = 10.64%
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Characteristics of the Top Quartile of Bank Bond Portfolios
High Performing Portfolios Tend To Have:
• Less diversification, more concentration
(in best performing sectors)
• Less Agencies and more Municipals & MBS/CMO
• More stable cashflow (less call/prepay risk)
• Longer Durations
• Larger percentage of assets in bonds
10
A Written Investment Strategy Is An Essential Key To Success
Successful high performance portfolio management begins with a defined plan of action
11
Sector Spread Comparison
2011 – Today: 10yr Municipals (yellow), 5yr Agencies (white), 15yr MBS (orange)
At the tactical level, investment strategy is about finding the best relative value. MBS/CMO continue to
offer better value than Agencies while Munis offer the most at current tax rates. Municipal spreads
widened dramatically as the market digested a Trump win and the possibility of lower tax rates but have
since recovered.
12
Modified Barbell Cash flow
Liquidity
Defensive Cash Flow
Yield
13
Portfolio Sector Cash Flow
14
Projected Cashflow Volatility Comparison: Callables vs MBS
Callable Agency Focus
May 2013
MBS/CMO Focus
May 2013
Callable Agency Focus
June 2013
MBS/CMO Focus
June 2013
15
Coupon Compression = Burnout = Large % of OTM Borrowers
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Baker Client MBS Holdings by Coupon
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Higher Coupon MBS Limit Price Depreciation As Rates Rise
15yr MBS Price Volatility By Coupon
“Taper Tantrum”
When Treasury yields rise and bond prices fall, lower
coupon MBS normally fall much farther than higher
coupons. To remain defensive in the face of a determined
Fed, favor higher coupon MBS with good loan attributes.
“Trump Jump”
Px drop
Nov 7 – Dec 15
15yr 2.0 = 4.2%
15yr 2.5 = 3.6%
15yr 3.0 = 2.9%
15yr 3.5 = 1.9%
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Extension Protection Menu: MBS/CMO
• Low Loan Balance Collateral
o LLB pools have slowed the LEAST over the last 6mos of falling prepayments.
• Purchase loans over Refi loans
o With purchases in 2016 the highest since 2007, there should be more purchase loans in
pools. Large % of refi pools will show more “burnout” and slower speeds as rates rise.
• Roll Down in MBS Terms and Up in Coupon
o Aggregate 10yr terms are now paying faster than 15yrs, 20yrs, and 30yrs!
o The lowest coupons in the stack are showing significant extension risks at current prepay
speeds
• K-Fred Lockout (A2) and/or Current Pay (A1)
o Steady Predictable Cash Flows are crucial in a rising rate environment.
• Modified/Re-Performing Collateral
o Prepay characteristics are very similar to LLB.
o Borrower mentality is very similar to HARP loans.
o The key here is “curing”. Over time, borrowers FICO can “cure”, allowing them to refi
into a conventional loan.
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MBS Products: What Works When Rates Rise AND Fall?
Bank of America Merrill Lynch
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CMOs Offer Many Different Cash Flow Options
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Banks Hold a Small % of Munis Outstanding
Source: SIFMA Holders of US Municipal Securities 2015
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Higher Yields Were Short Lived Under Bush Tax Cuts
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Most Muni Buyers are Individuals with Moderate Tax Burdens
Individuals hold an average 78% of
municipals outstanding
Trump’s Tax Plan aims to lower the
individual tax rate to 33%. However,
the median marginal tax rate for
individual muni holders is already
lower, at 28%.
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TEY Impact
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Historically, Munis Experience 60% of the Price Volatility to
Treasuries
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Muni and Treasury Yields: 2003 – 2007
During the last tightening cycle of 2003-2007,
10yr Munis sold off 34% less than 10yr
Treasuries
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The Trump Jump’s Sell-Off
Since the Brexit Lows of July 2016, 10yr
Munis sold off 27% less than 10yr Treasuries
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The Basics of the TEFRA Disallowance
• The TEFRA disallowance was established in 1982 which
stipulated that institutions who buy Bank Qualified (BQ)
Munis must apply a 20% disallowance of interest expense. For
Sub S institutions (after 3yrs of conversion), there is no TEFRA
disallowance on BQs.
• For Non Bank Qualified (NBQ or “General Market”) Munis, the
disallowance is 100% for both C Corp and Sub S Institutions.
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Non Bank Qualified Spreads Over BQs
• Historically, spreads of NBQ munis over BQs has been about
15-30bps in the 10-15yr part of the yield curve.
• After the election, NBQ spreads over BQs widened to as much
as 100bps.
• The Yield pickup can be significant when interest rates are
low, however the relative value of NBQs over BQs tends to
deteriorate at higher interest rates
• It all boils down to the institution’s cost of funds…
30
BQ vs NBQ Tax Equivalent Yield Calculations
BQ Yield:
NBQ Yield:
Tax Rate:
Cost of Funds:
2.60%
3.05%
34%
0.50%
• BQ TEY
(Yield) – (Tax Rate * Cost of Funds * 20%)
(1 – Tax Rate)
• NBQ TEY
(Yield) – (Tax Rate * Cost of Funds * 100%)
(1- Tax Rate)
• BQ TEY
(2.60%) – (34% * 0.50% * 20%)
(1 – 34%)
=
3.89%
=
4.36%
• NBQ TEY
(3.05%) – (34% * 0.50% * 100%)
(1- 34%)
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Comparing BQ and NBQ Yields
BQ General Obligation LTD
NBQ General Obligation LTD
These two bonds are nearly
identical, the only difference
being the tax status of BQ
vs NBQ. The NBQ
however, picks up 45bps of
nominal yield
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Isn’t There Less Value in NBQs as my Cost of Funds Increase?
• Yes. The question is, how much would my cost of funds need
to increase to show better value in a BQ muni relative to an
NBQ?
• In this example, cost of funds need to average 2.00% or higher
for the BQ TEY to exceed the NBQ TEY
33
Historical Cost of Funds
Average COF Since 1990: 1.90%
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Lower Tax Rates = Better Relative Value for NBQ Munis
Breakeven Cost of
Funds
1.5%
1.5%
2.0%
2.0%
2.5%
4.0%
35
Update on Municipal Defaults
Muni Defaults by Issuer
Jan 1998 - Jan 2017
Muni Issuer Defaults
Jan 1998-Jan 2017
GO
REV
Special Assessment
BQ
COPs
3%
13%
7%
15%
NBQ
8%
Taxable
AMT
13%
64%
77%
Defaults Remain Rare…
But when they do occur, it’s
largely in speculative General
Market (NBQ) Revenue Bonds
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The Baker Group’s Municipal Credits Database Coverage
 Covers Issuers in 2,755 of the 3,007 Counties in the US
 151,563 Cusips and 22,082 Unique Obligors
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Investment Portfolio Management:
Characteristics of High Performance
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Interest Rate Risk Checklist
• Director Education
– Ensure directors have a basic understanding of IRR and the bank’s ALCO processes
– Provide directors with access to educational resources on interest rate risk
– Board minutes should reflect director participation in IRR discussions
• Regular (Quarterly) ALCO Meetings to Review & Discuss Reports
– ALCO minutes should reflect a demonstration of sound processes that quantify risk to earnings &
capital
• Regular (Quarterly) Standard & Non-Standard Stress Tests
–
–
–
–
-100bp, +100bp, +200bp, +300bp, +400bp, Non-Parallel (e.g. +400bp/+100bp Bear Flattener)
Ramped Rate Shifts & Immediate Rate Shocks
12 & 24 Month Horizons
Earnings at Risk & Economic Value of Equity
• Annual Validation
– Obtain most recent Validation Letter for Model (validates the “math” of the model)
– Back-Test your reports over a 12 month period (validates the results)
– Independent Review of ALCO Process (validates the process)
• Annual Assumptions Review
– Use Back-Test to determine if assumptions are generally reasonable
– Periodically perform analysis to ensure assumptions reflect institution’s profile and activities (e.g.
Loan Prepayments, NMD Sensitivities, Open-Close Study, Decay Analysis, Surge Balances, etc.)
– Annual Sensitivity Testing (aka, “assumptions stress test” – e.g. increase NMD betas, shorten NMD
average lives by 50%, run a migration simulation from NMD to CD’s, etc.)
• Annual Review of Investment & ALCO Policies
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NMD Analysis: Estimating Deposit Betas using Call Report
40
NMD Analysis: Estimating Potential Surge Balances
Any Town Bank – Anywhere, USA
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