Pub. 7 2016 Issue 4

Winter 2016 21 West Virginia Banker Concurrently, BQ issuance has actually lagged the investor demand, whereby BQ spreads have tightened versus their non-BQ counterparts. This had led to an even wider spread between non-BQ and BQ bonds. Consider Example 3 below which compares two Kentucky School District Bonds of similar credit quality. Assuming the 0.42% average COFs for West Virginia Banks as of June 30t, 2016, the non-BQ Henderson County KY School District bond has a 51 bps advantage in terms of TEY in the base case rate scenario versus the Lewis County KY School District bond. Even in rising rates, assuming a 41% deposit sensitivity lag (based on COFs regression analysis from 2004-2006 when Fed Funds rate rose 425 bps), the non-BQ municipal main- tains the advantage over the BQ, except if rates were to rise 300 bps where both investments are neutral. Example 3: Assuming a 0.42% COFs, the non-BQ munic- ipal is more attractive from a TEY perspective in all rate scenarios and is income neutral rates up 300 bps. BQ Muni: Lewis County KY School District, 2.50% Coupon, 9/1/28 Maturity, 9/1/2026 Call Non-BQ Muni: Henderson County KY School District, 3.00% Coupon, 10/1/28 Maturity, 10/1/26 Call Example 3: Assuming a 0.42% COFs, the non-BQ municipal is more attractive from a TEY perspective in all rate scenarios and is income neutral rates up 300 bps. BQ Muni: Lewis County KY School District, 2.50% Coupon, 9/1/28 Maturity, 9/1/2026 Call Non-BQ Muni: Henderson County KY School District, 3.00% Coupon, 10/1/28 Maturity, 10/1/26 Call The current interest rate environment presents a window of opportunity for depositories to take advantage of a low COF – a phenomenon that will likely lag rising interest rates initially. Low borrowing costs coupled with increased municipal supply and consequential spread widening, non-BQ municipals can lead to a significant income boost to the bottom line and also provide an opportunity for future gains as supply normalizes and spreads tighten. Moreover, longer municipals typically exhibit a price volatility of only 65% vs their taxable counterparts into rising rates. These criteria, along with the tax free income, make municipals a key component in achieving top tier portfolio performance versus one’s peers. BQ Non BQ BQ Non BQ BQ Non BQ BQ Non BQ Tefra Disallowance % 20% 100% 20.00% 100.00% 20.00% 100.00% 20.00% 100.00% x Tax Rate 34.0% 34.0% 34.00% 34.00% 34.00% 34.00% 34.00% 34.00% x Cost of Funds 0.42% 0.42% 0.83% 0.83% 1.24% 1.24% 1.65% 1.65% = Tefra Haircut 0.03% 0.14% 0.06% 0.28% 0.08% 0.42% 0.11% 0.56% Before Tax Yield 2.400% 2.850% 2.400% 2.850% 2.400% 2.850% 2.400% 2.850% - Tefra Haircut 0.03% 0.14% 0.06% 0.28% 0.08% 0.42% 0.11% 0.56% = Book Yield 2.37% 2.71% 2.34% 2.57% 2.32% 2.43% 2.29% 2.29% TEY (Yield/(1-tax rate)) 3.593% 4.102% 3.551% 3.891% 3.509% 3.679% 3.466% 3.468% Yield difference (bps) 51 34 17 0 Flat Rates Up 300 Rates Up 100 Rates Up 200 The current interest rate environment presents a window of opportunity for depositories to take advantage of a low COF – a phe omenon that will likely l g rising interest rates ini- tially. Low borrowing costs coupled with increased municipal supply and consequential spread widening, non-BQ munici- pals c n lead to a significant income boost to the bottom line and also provide an opportunity for future gains as supply normalizes and spreads tighten. Moreover, longer municipals typically exhibit a price volatility of only 65% vs their taxable counterparts into rising rates. These criteria, along with the tax free income, make municipals a key component i achiev- ing top tier portfolio performance versus one’s peers.  2016 has been a historic year for municipal issu nc due to robust refinancing of older issues. October m nth-end wi nessed the largest week for municipal issuance year-to-da with over $16Bln coming to market. 10 year AAA unicipal yields ar typically used as the benchmark versus comparable Assuming the 0.42% average COFs for West Virginia Banks as of June 30t, 2016, the non-BQ Henderson County KY School District bond has a 51 bps advantage in terms of TEY in the base case rate scenario versus the Lewis County KY School District bond. Even in rising rates, assuming a 41% deposit sensitivity lag (based on COFs regression analysis from 2004- 2006 when Fed Funds rate rose 425 bps), the non-BQ municipal maintains the advantage over the BQ, except if rates were to rise 300 bps where both i vestments re neutral.