Pub. 7 2016 Issue 4

www.wvbankers.org 20 West Virginia Banker Buy Low, Sell High: Spread Widening in Non-BQ Municipals By Geetika Bansal, Senior Market Strategist, Duncan Williams I n the prevailing low interest rate environment, improving bond portfolio performance and returns has mostly consist- ed of opportunistic investing in sectors where spreads are wide and then reaping both the income and potential gain benefits as securities “roll down the curve” and/or spreads tighten. This speaks to the age-old investing adage of buy low, sell high. Such a buying opportunity currently exists in the non-bank qualified (BQ) municipal sector where spreads are wider compared to recent months, especially relative to BQ municipals. This strategy is particularly attractive for banks that have low cost of funds (COF). The Standard Non-BQ municipal bonds typically have higher yields than BQs. There is no rule stopping banks from purchasing non- BQ municipals, but traditionally, banks have favored BQs because of the larger TEFRA haircut that non-BQs have possessed. The TEFRA haircut calculation incorporates a bank’s COFs. The haircut used to calculate the tax-equivalent yield (TEY) on a BQ municipal is 20% x tax rate x COF, and the calculation on a Non-BQ municipal is 100% x tax rate x COF. Thus, when COFs are high, a non-BQ will have a larger haircut, thereby lowering the final TEY. This can be seen in Example 1 presented below. In 2007, the national bank COFs averaged 3.27%. If we assume that a BQ muni had a pretax yield of 2.00% and a non-BQ was yielding 2.40%, the TEY would be 1.952% on the non-BQ and 2.693% on the BQ. Even though the pre-tax yield is 40 basis points greater (2.40% vs 2.00%), the TEFRA haircut differential (1.11% vs. 0.22%) more than offsets the pre-tax advantage, thus making the BQ security the more attractive investment option. Example 1 - Assuming a 3.27% COF (based on Dec 31, 2007 FDIC data for banks under $10Bln in assets) What’s changed? Two things. 1.Low COF: In the current interest rate environment, depositories’ COFs are at historic lows. Based on FDIC data as of June 30, 2016, the average COFs for banks under $10Bln in assets was 0.41%. With COFs at such a low level, the TEFRA haircut is only modestly different between the two types of investments. In Example 2, we assumed the same bond yields but applied the current COFs level of 0.41% to calculate the TEFRA haircut, resulting in a TEY of 3.425% on the non-BQ versus 2.988% on the BQ. The current low COFs has lowered the haircut substantially, thereby incentivizing investors to position the non-BQ security. Example 2 - Assuming a 0.41% COF, the non-BQ munici- pal is more attractive from a TEY perspective. 2.Spread Widening in Non-BQ Municipals: 2016 has been a historic year for municipal issuance due to robust refinancing of older issues. October month-end witnessed the largest week for municipal issuance year- to-date with over $16Bln coming to market. 10 year AAA municipal yields are typically used as the benchmark versus comparable Treasuries to measure returns. For most of 2016, the 10 year AAA ratio has been in the low 90’s indicating that a 10 year AAA municipal has returned approximately 90% of what a Treasury has. Since mid- summer, this ratio has been steadily increasing and is now close to 100%. In fact, longer municipal maturities have ratios currently above 100%. These returns, combined with increased supply, have put pressure on municipal spreads, creating an attractive entry point for investors. read Widening in Non-BQ Municipals r Market Strategist nterest rate environment, improving bond portfolio performance and returns has pportunistic i vesting in sectors where sp ead are wide and then reaping both the gain benefits as securities “roll down the curve” and/or spreads tighten. This investing adage of buy low, sell high . S ch a buying opportunity currently exists in d (BQ) municipal sector where spreads are wider compared to recent months, BQ municipals. This strategy is particularly attractive for banks that have low cost nds typically have higher yields than BQs. There is no rule stopping banks from unicipals, but traditionally, banks have favored BQs because of the larger TEFRA have possessed. The TEFRA haircut calculation incorporates a bank’s COFs. The ate the tax-equivalent yield (TEY) on a BQ municipal is 20% x tax rate x COF, and on-BQ municipal is 100% x tax rate x COF. Thus, when COFs are high, a non-BQ cut, thereby lowering the fin l TEY. This can be se n in Example 1 presented bank COFs averaged 3.27%. If we assume that a BQ muni had a pretax yield of was yieldi g 2.40%, the TEY would be 1.952% on the non-BQ and 2.693% on the pre-tax yield is 40 basis points greater (2.40% vs 2.00%), the TEFRA haircut 0.22%) more th n offsets the pre-tax dvantage, thus making the BQ security the ment option. a 3.27% COF (based on Dec 31, 2007 FDIC data for banks under $10Bln in assets) BQ Non BQ Tefra Disallowance % 20% 100% x Tax Rate 34.0% 34.0% x Cost of Funds 3.27% 3.27% = Tefra Haircut 0.22% 1.11% Before Tax Yield 2.000% 2.400% - Tefra Haircut 0.22% 1.11% = Book Yield 1.78% 1.29% TEY (Yield/(1-tax rate)) 2.693% 1.952% Yield difference (bps) (74) Flat 1. Low COF: In the current interest rate environment, deposit ries’ COFs are at Based on FDIC data as of June 30, 2016, the average COFs for banks under $1 0.41%. With COFs at such a low level, the TEFRA haircut is only modestly diff two types of investments. In Example 2, we as umed the same bond yields b current COFs level of 0.41% to calculate the TEFRA haircut, resulting in a TEY non-BQ versus 2.988% on the BQ. The current low COFs has lowered the hai thereby incentivizing investors to position the non-BQ security. Example 2 - Assuming a 0.41% COF, th non-BQ municipal is more attractive from a T 2. Spread Widening in Non-BQ Municipals: 2016 has been a historic year for m due to robust refinancing of older is u s. Octob r month-end witnessed the municipal issuance year-to-date with over $16Bln coming to market. 10 year yields are typically used as the benchmark versus comparable Treasuries to m For most of 2016, the 10 year AAA ratio has be n in th low 90’ indicating th municipal has returned approximately 90% of what a Treasury has. Since mid has been steadily increasing and is now close to 100%. In fact, longer munici ratios currently above 100%. These returns, combined with increased supply on municipal spreads, creating an attractive entry poi nt for investors. Concu has actually lagged the investor demand, whereby BQ spreads have tightene BQ Non BQ Tefra Disallowance % 20% 100% x Tax Rate 34.0% 34.0% x Cost of Funds 0.41% 0.41% = Tefra Haircut 0.03% 0.14% Before Tax Yield 2.000% 2.400% - Tefra Haircut 0.03% 0.14% = Book Yield 1.97% 2.26% TEY (Yield/(1-tax rate)) 2.988% 3.425% Yield difference (bps) 44 Flat