Managing the Investment Portfolio

Transcription

1 Managing the Investment Portfolio GSBC Executive Development Institute April 26, 2015 Portfolio Purpose & Objectives Tale of Two Balance Sheets o Components of Core Balance Sheet Originated loans Retail deposits Composition driven by market demand and conditions o Components of Managed Balance Sheet Investments Loan purchases & sales Wholesale funding Derivatives & hedging Composition driven by management strategic decision making When you combine the two balance sheets, you achieve your target balance sheet 1

2 Managing Both Investment Portfolios o Today Portfolio Focus is on present needs and market conditions Current yield and income Existing interest rate and liquidity risks Problem: It s a limited view, no more than a snapshot of a point in time o Future Portfolio Focus is on needs and objectives beyond the present Considers effect of changes in market conditions How do changes affect investment price, yield and duration? Example: Total return Interest Rate Risk (IRR) Management Risk incurred by a financial institution when the maturities of its assets and liabilities are mismatched Change in interest rates results in change in value of assets/liabilities or net income Mismatch between assets/liabilities results in the balance sheet having some type of sensitivity 2

3 Role of Investment Portfolio o Investment holdings can act as offset to loan characteristics o Positions can be established quickly and efficiently (loans can take time to grow) o Once built, positions can be run off as new loans take their place Liquidity Risk Management The risk that a bank will be unable to obtain funding to fund asset growth or to meet liability demands without experiencing large losses o Can be a sudden surge of liability withdrawals or a sudden lack of funding sources o Can occur due to a surge in asset growth, e.g. credit line usage o Can be institution-specific or systemic o Liquidity risk generally blooms into a crisis as a result of another risk factor, e.g. credit risk, interest rate risk, etc. o Can ultimately evolve from a liquidity problem into a solvency problem Role of Investment Portfolio o Liquidity is getting more regulatory scrutiny due to inherent IRR (rates rise, bond values fall) o Can be used for raising cash through asset sales o More important role: managing cash flow o Principal cash flows can be used to pay for loan growth or to offset liability reductions o Portfolio liquidity can be affected by use of less liquid investments, i.e. not Treasuries or agency bonds 3

4 Investment Terms & Concepts A bond s price is the current (present) value of all cash flows (interest and principal) over its lifetime Par Value Coupon o Also known as notional or face value o The amount that the issuer agrees to repay by the maturity date, or the amount of the bond that you are purchasing (but not necessarily the amount you will pay for the investment) o The interest rate that the issuer pays the investor o Usually semi-annual payments, but can vary o Do not confuse the coupon rate with the yield!! Term to Maturity o The number of years over which the issuer agrees to pay interest to the investor, until the principal is paid on the maturity date 4

5 Bond Pricing & Quotes Par equals the face value of the bond; in pricing, par equals 100 Bond pricing is quoted as a percentage of par Bond Discounts & Premiums o Discount = bond is trading at a price below par o Premium = bond is trading at a price above par Bond Yield o Yield to Maturity (YTM) = Internal rate of return (IRR) earned by an investor who purchases a bond at a given price, if: The bond is held to maturity All income earned is reinvested at the same rate as the YTM All interest and principal payments are made on schedule o If any of the assumptions do not hold, the YTM will vary o Yield to maturity Current yield o Yield to maturity Coupon rate Investment Risks Credit Risk o Default Risk the bond issuer fails to meet its obligations of timely interest and principal payments to the investor o Downgrade Risk a reduction in credit rating results in price decline to reflect higher risk and yield o Credit Spread Risk the yield spread between Treasuries and other bonds widens, resulting in a price decline Interest Rate Risk (IRR) o IRR is defined as the sensitivity of a fixed income security s price caused by a change in interest rates o Duration: the Primary Risk Measure for IRR A sensitivity measure that determines the percentage degree of change in price given a ±100bp move in interest rates Duration is a weighted average of all cash flows (interest & principal) received over the life of a bond Can be used to compare securities with different characteristics (maturity terms, coupons, cash flows, etc.) 5

6 In addition to individual securities, duration can also be used to measure the overall interest rate risk of an investment portfolio o Factors that can affect IRR Liquidity Risk Maturity Coupon Rate Embedded Options o The risk that an investor will have to sell a bond at a much lower price than its indicated true value, OR o The inability to sell a security (worst case) Prepayment Risk (a/k/a Optionality ) o The risk that your principal investment is returned to you sooner than the stated final maturity o Also referred to as optionality o Callable bond cash flows are uncertain o Mortgage prepayments are unknown o Problem: calls and prepayments are more likely to occur during periods of lower interest rates and steep yield curves o Another problem: price appreciation is limited due to effect of negative convexity Extension Risk o This is prepayment risk s ugly cousin (at least right now)... o Some fixed income securities (MBS, CMO) have variable principal cash flows o A material slowdown in principal payments can cause the life and duration to lengthen o Pricing and volatility will adjust to new conditions o This is a bigger issue when rates are rising 6

7 Fixed Income Securities Treasuries o Most liquid investment choice o Risk-free investment Agencies & Government Sponsored Entities (GSEs) o Issued by Federal agencies & government-sponsored enterprises (GSEs) o Only GNMA is backed by the full faith and credit of the U. S. government o While Fannie Mae & Freddie Mac are under Federal conservatorship, their bonds are NOT explicitly government-backed o As a result, investors do have some potential for credit risk o Some agency securities (FHLB, FFCB, TVA) are exempt from state taxation o Agency issues can be bullets or callables, and can be bought at issue (new) or in the secondary market Dealing with Embedded Options o What is an option? Gives the buyer the right to take some action within a specified timeframe Gives the seller the obligation to respond upon the option s exercise by the buyer o Two types of options: Calls, Puts (for our purposes, we re only considering calls) o Non-Callable Bond (Bullet) Bond has a firm maturity date o Callable Bond (Bond with Embedded Call Option) Issuer has the right to retire the bond at a specified time prior to the bond s maturity date o As an investor, you are the option seller, meaning you are obligated to honor the call when it is exercised Q: Since you re selling an option, where s the option premium? A: You get paid for this in the form of a higher coupon. o Agency Call Structures Continuous (American) Once call date is past, bond can be called at any time until maturity Discrete (Bermuda) After call date, bond is callable on a predetermined schedule (quarterly, semi-annually, annually) One-Time (European) Bond can only be called on call date Canary Call (Step Up) Bond is callable on a predetermined schedule during the first step, then must be called or converts to a bullet step-up bond o Factors Affecting Call Options 7

8 Interest rates (current and forward) Coupon rate Time to maturity Step-Up Agency Bonds o Agency bond with a variable coupon rate o Coupon steps up in rate based on a predetermined schedule o Bonds are usually callable (European/Canary, Bermuda, Continuous) o Why Should We Want Step-Ups? Protection against rising interest rates First step coupon is higher than comparable short-term investments Potential for higher coupons later in the life of the investment Overall yield is usually higher than alternative bonds So the investor wins, the issuer wins, the broker wins... What???!! 8

9 9

10 Municipal Bonds o Issued by state, county and local governments, as well as other public entities o Why invest? Tax-exempt income! o Must be bank-qualified (or bank-eligible) o Given tax-exempt status, credit unions do not benefit from investment in munis o Tax considerations, e.g. AMT, could limit investment opportunities o Bullet and callable structures are available o Some credit risk, but lower historical default rates than corporate bonds o Municipal Bond Types General Obligation Backed by the taxing and further borrowing power of the issuing municipality (limited and unlimited) Revenue Issued to finance public works, such as: Water & sewer systems Turnpikes Colleges & universities Hospitals Airports And supported by revenues of the associated project 10

11 Corporate Bonds o Issued by private corporations o Priority over common and preferred shareholders o May be secured or unsecured o Full exposure to credit risk o Credit rating reflects credit risk (and coupon) o Bullets & callables available The Need for Increased Bond Due Diligence o Section 939A of the Dodd-Frank Act requires that bank investments meet minimum credit quality standards independent of ratings assigned by national rating agencies o As of January 1, financial institutions were expected to ensure that investments held meet an investment grade standard o FDIC and OCC have incorporated the standards into their final rules and guidance on permissible investments o Banks can no longer rely solely on credit ratings to assess whether an investment is investment grade o Pre- and post-purchase analysis is required; banks need to demonstrate that issuer presents low risk of default and is likely to make full and timely repayment of principal and interest 11

12 Mortgage-Backed Securities o Security created through pooling and backing of residential mortgages o Issued by Federal agencies (GNMA, FNMA, FHLMC) or private entities (non-agency or private label ) o Types of MBS Passthrough securities Collateralized mortgage obligations (CMOs) Commercial Mortgage-Backed Securities (CMBS) multi-family properties Includes DUS, K-bonds, project loans Home Equity Conversion Mortgages (HECMs) Reverse mortgages 12

13 o MBS Structures Fixed Rate (30-, 20-, 15-, 10-year) Adjustable Rate (ARMs) Short reset (rate adjusts annually) Hybrid ARMS o Fixed rate period followed by annual ARM structure for remaining life of mortgage o 3/1, 5/1, 7/1, 10/1 structures Collateralized Mortgage Obligations (CMOs) o The biggest risk for MBS pass-through securities is prepayment risk o What if there were a way to control of mitigate that risk? o There is... 13

14 Commercial MBS o Mortgage pools composed of multi-family properties o Examples: Apartments, condos, student housing, senior housing o Issued by Fannie Mae (DUS and ACEs) and Freddie Mac (Freddie-Ks) (also private label) o Fixed rate o Single or multi-pools o Balloon maturity (acts like a bond) o Yield maintenance call protection (passed to investor) SBA Pools o Pools made up of small business loans o Backed by SBA (full faith & credit, 0% risk weighted) o Uncapped floating rate security (tied to Prime) some fixed pools are issued o Monthly or quarterly rate reset o Most pools trade at very high premiums (due to coupon) o Prepayment risk is biggest risk due to premiums 14

15 15