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Bank Investments. Bank Investments. G & K Chp. 7 Review Economic Environment (Loans) Types of investment securities Evaluating investment risk Investment strategies. Securities. U.S. government and agency securities (Agencies: FNMA, FHLMC, GNMA, FCA, SBA)
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Bank Investments • G & K Chp. 7 • Review Economic Environment (Loans) • Types of investment securities • Evaluating investment risk • Investment strategies
Securities • U.S. government and agency securities • (Agencies: FNMA, FHLMC, GNMA, FCA, SBA) Mortgage-backed securities (MBSs) and collateralized mortgage obligations (CMOs) are dominant in this investment category (prepayment risk). • Municipal bonds • General obligation bonds (GOs) and revenue bonds • Taxes • Corporate bonds
Muni Taxes • Tax formula for munis: YTMm/(1-T) - (1.0 x Average cost of funds x T)/(1-T) = YTMTE where T = bank tax rate, the factor 1.0 is for 100% of interest expenses are not deductible from taxes (i.e., 0.20 for bank qualified munis), and average cost of funds is based on IRS rules, and YTMTE = a tax equivalent yield for comparison to taxable bonds. Example: given T = 0.34, 1.0 is used, average cost of fund = 7%, and YTMm= 8%, we have 0.08/(1 - 0.34) - [(1.0 x 0.07 x 0.34)/(1 - 0.34)] = 0.0852 or 8.52%
Securities Risk • Interest Rate risk • Security Specific risk
Interest Rate risk • Duration • Coupon Rate, YTM inverse to Duration • Maturity directly related to Duration • Assumes Parallel Shifts in YTMs !!! • Convexity (Second Derivative of Price) • Notice that price change prediction gets worse • Positive and Negative Convexity
Security Specific risk • Bond Ratings • Investment grade bonds (top 4 credit ratings) AAA (Aaa) BBB (Baa) • Junk bonds (lower rated bonds) BB (Ba) C; Default: DDD, DD, D • Estimates of the probability of default • Bondholder losses in default not captured by credit ratings
Investment strategies • Passive investment strategies • Aggressive investment strategies
Passive Investment Strategies • Space-maturity approach (ladder approach) Spread available investment funds evenly across a specified number of periods within the bank’s investment horizon. Simple and low transactions costs, but passive with respect to interest rate conditions and liquidity is sacrificed to some extent. • Split-maturity approach (barbell approach) Greater quantities of short-term and long-term securities are held. This strategy balances liquidity and higher income.
Ladder Approach $10 $10 $10 $10 $10 Barbell Approach $20 $20 $10 1 yr 2 yrs 3 yrs 4 yrs 5 yrs Maturities of Securities Passive Investment Strategies
Aggressive Investment Strategies • Yield curve strategies • Playing the yield curve • Riding the yield curve • Bond-swapping strategies • Tax swap • Substitution, or price, swap • Yield-pickup, or coupon, swap • Spread, or quality, swap • Portfolio shift