36 Hoosier Banker October 2014 DIRECTORS / SENIOR MANAGEMENT Prudent management of a community bank investment portfolio requires an approach that starts with strategic analysis of the balance sheet, and then moves to tactical decisionmaking. This sort of top-down method first requires a look at the bank’s asset/liability posture in order to identify exposures to interest-rate risk. Once this is done, the investment portfolio can then be used as a vehicle for managing that risk. To do this properly, an investment officer must be prepared to actively manage the portfolio by rebalancing and restructuring the bonds to achieve the optimal risk/reward profile for the market conditions that exist at the time. Some banks still pursue a “buyand-hold” strategy for bonds. This 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 of year 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. When considering adjustments to the portfolio, it’s important to clearly outline the pros and cons of selling securities. If a bond is currently on the books at an unrealized loss, remember that selling it now involves simply taking today what is an actual loss of income spread out over time … you either take the loss now or take it later. For example, consider a $1 million agency bullet with a one-year maturity that has a $10,000 unrealized loss. Let’s say the book yield on this bond is 2 percent, yet the market yield is now 3 percent … a difference of 1 percent. If we do the multiplication, $1 million x 1 percent x 1 year, we come up with $10,000, the amount of the unrealized loss. So the choice is to either sell the bond or to hold it – lose $10,000 today or $27 each day for a year. Either way, it adds up to $10,000. If we choose to sell today, we can be certain of the yield we will achieve on the reinvestment of the proceeds. If we wait for maturity, we must accept some uncertainty and risk. Where will rates be in one year? Are we willing to bet rates will be higher? In a sense, waiting for maturity is a bet that rates will be the same or higher than today. Meanwhile, from a tax standpoint, Uncle Sam will pick up 34 percent of the loss (assuming a fully taxable bank), so that an institution can reduce tax expense in a good year so that it doesn’t have to in a bad year. Here are some further ideas on bond swaps: • Duration adjustment swap. The purpose of this swap is simply to move in or out on the yield curve to either take advantage of better relative value, or to alter the position of the portfolio with respect to potential price risk. Right now the yield curve is steep, so some banks may wish to extend duration simply to pick up yield. Others may need to rein in their overall duration to shore up their interest-rate risk exposure. Duration adjustment is a textbook asset/ liability management strategy for banks that are too asset (or liability) sensitive and need to extend (or Strategic Bond Swaps: Optimizing Risk and Reward in Investments About the Author Jeffrey F. Caughron is associate partner with The Baker Group, Oklahoma City, and works as a market analyst and portfolio strategist. He has worked in financial markets and the securities industry for more than 20 years. Caughron’s trading experience includes several years on the Treasury desk for an international bank on Wall Street and subsequent positions trading mortgage-backed securities and other taxable fixed-income products for regional broker/dealers. Additionally he managed a $600 million investment portfolio for a large regional financial institution. Caughron has published numerous articles on risk management topics and frequently is quoted in the financial press. He serves on the faculty of the Midwest School for Community Bankers and the Bank Operations Institute. The author can be reached at 800-937-2257, email: jcaughron@gobaker.com. The Baker Group is a Diamond Associate Member of the Indiana Bankers Association and an IBA Preferred Service Provider.
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