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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% 9 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 16 Baker Client MBS Holdings by Coupon 17 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% 18 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. 19 MBS Products: What Works When Rates Rise AND Fall? Bank of America Merrill Lynch 20 CMOs Offer Many Different Cash Flow Options 21 Banks Hold a Small % of Munis Outstanding Source: SIFMA Holders of US Municipal Securities 2015 22 Higher Yields Were Short Lived Under Bush Tax Cuts 23 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%. 24 TEY Impact 25 Historically, Munis Experience 60% of the Price Volatility to Treasuries 26 Muni and Treasury Yields: 2003 – 2007 During the last tightening cycle of 2003-2007, 10yr Munis sold off 34% less than 10yr Treasuries 27 The Trump Jump’s Sell-Off Since the Brexit Lows of July 2016, 10yr Munis sold off 27% less than 10yr Treasuries 28 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. 29 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%) 31 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 32 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% 34 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 36 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 37 Investment Portfolio Management: Characteristics of High Performance 38 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 39 NMD Analysis: Estimating Deposit Betas using Call Report 40 NMD Analysis: Estimating Potential Surge Balances Any Town Bank – Anywhere, USA 41 42