Pub. 4 2013 Issue 1

www.wvbankers.org 10 As we transition into a new year, bank investment officers should take time to assess the big picture and think about strategic direction for the bond portfolio. A glance in the rear view mirror is instructive. W e know that 2012 was punctu- ated by a great deal of politics and a continuation of sloth-like economic growth. Banks were also notified of the potential body blow of Basel III. Through it all, the word of the year for financial markets was “uncertainty.” For most of 2012 we were uncertain of who would be in the White House after the first week of November. Once the election was decided, we focused our uncertainty on the pending “fiscal cliff” of substantial spending cuts and tax increases, which collectively would lop off a significant chunk of GDP growth. That particular uncertainty is still lingering, but it’s fair to as- sume some degree of fiscal drag on the economy regardless of any agreement. The bottom line is that we can expect continued sluggish growth, low interest rates, and another challenging year for bank investments. A Method for Active Management Prudent portfolio management begins with strategic analysis of the balance sheet, including trends in growth and mix as well as broad interest rate risk exposures. From there we can move to tactical decision-making, relative value analysis, and the security selection process. This sort of top-down method provides a framework for active man- agement of investments by rebalancing and restructuring the portfolio in order to achieve the optimal risk/reward profile for the market conditions that exist at the time. The time has long passed when banks could pursue a “buy-and-hold” strategy for bonds. A passive man- agement 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 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. Types of Bond Swaps Duration Adjustment Swap: Many portfolios have seen a natural short- ening of average life and/or a decline in duration as the low rate environ- ment persists. A duration-adjustment swap may involve moving out on the yield curve to take advantage of higher yields or in order to maintain proper balance between asset and liability duration. Historically, com- munity banks maintain fairly high balances of non-maturity deposits, which are relatively high duration liabilities. This must be kept in mind when determining the proper dura- tion of assets including investments. It is the relative difference between effective duration of assets and li- abilities that ultimately determines the volatility of a bank’s economic value of equity. Duration swaps are a classic asset/liability management strategy for banks that are too asset Bond Portfolio Strategies for 2013: Looking Back and Thinking Ahead By Jeffrey F. Caughron, Associate Partner, The Baker Group LP