Pub. 5 2014 Issue 2

www.wvbankers.org 8 West Virginia Banker Strategic Bond Swaps: Optimizing Risk and Reward in Investments P rudent management of a community bank investment portfolio requires an approach that starts with strategic analysis of the balance sheet, and then moves to tactical decision-making. 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 ac- tively 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 “buy-and- 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 commit- tees 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 $1mm 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%, yet the market yield is now 3%... a difference of 1%. If we do the multiplication, $1mm X 1% 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 uncer- tainty 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 stand- point, Uncle Sam will pick up 34% of the loss (assuming a fully taxable bank) so that an institution can reduce tax expense in a good year so they don’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 expo- sure. Duration adjustment is a textbook asset/liability management strategy for banks that are too asset (or liability) sensi- tive and need to extend (or shorten) the net duration of their assets. Relative Value Swap: At any given point in time, some sectors of the bond market offer better value than others. Moreover, the relative advantage of the different sectors (as measured by their yield spread relationships) is constantly changing. Mortgage-backed securities versus mu- nicipals, callables versus MBS… all of these relationships should be monitored as  Strategic Bond Swaps — continued on page 10 By Jeffrey F. Caughron, Associate Partner, The Baker Group LP