Pub. 8 2017 Issue 4

www.wvbankers.org 8 West Virginia Banker C ommunity banks are wise to use the bond portfolio in the traditional manner: as an earning asset, a store of liquidity and safety, and a vehicle with which to manage interest rate risk. This is the essence of the “systems approach” or the “Baker Method” of investment portfolio management. The portfolio is not a place in which to “time” the market, hold illiquid assets (or those not easily modeled), or take on undue credit risk. The bonds held in the portfolio should have some sort of government sponsorship or backing (e.g. high-grade municipals, agencies, MBS), and should be highly salable in the secondary market—that is, easily converted to cash. Importantly, purchase decisions should be made based on the posture of the total balance sheet, liquidity needs, and other macro metrics of the total bank, not on a directional “bet” on interest rates or the Fed. Begin with a Bird’s Eye View Assuming we’ve made the commitment to stick with high quality bonds, how should we manage the investment portfolio in terms of risk and reward? The first order of business is to look at the big picture. We must determine how the bank’s balance sheet is sit- uated with respect to re-pricing and maturing volumes of assets versus liabilities. What are the rate differentials between what is rolling off and the new balances being added? How does our forward liquidity look and how stable is that liquidity? Do we have an exposure to rising rates or to falling rates in terms of projected changes in net interest margin and capital at risk? We simply cannot make good bond purchase decisions without first delving into the asset/liability position of the overall institution. Yield, Cash Flow, and Market Value - Managing the Moving Targets Once we clearly understand the balance sheet profile, we can drill down to the investment portfolio to assess our strategic op- tions there. In this phase, we focus on the management of three variables: yield, cash flow, and market value (or price sensitivity). The essential problem is that all of these variables are moving targets. The portfolio yield will drift up and down depending on cash flow fluctuations, reinvestment rates, and the premi- um versus discount prices of the bonds that are owned. Cash flows fluctuate because of the options risk attached to or em- bedded within bond structures themselves. The market value of individual bonds (and entire portfolios for that matter) will rise and fall in tandem with the variation in cash flows and the degree of yield drift. It is critical that banks have an investment portfolio reporting sys- tem that contains good analytics for measuring cash flow, price sensitivity, and options risk. Ideally, this type of system will inte- grate with a sound asset/liability management model to produce investment analysis that helps us make decisions that are optimal for the entire balance sheet and overall financial performance. Relative Value Analysis – Making Purchase Decisions After reviewing the balance sheet and portfolio analytics, we can then move to the security selection phase where we decide what bonds or bond-sectors we should consider. In many cases there are clear-cut reasons for choosing one sector over another. For example, a bank’s tax position may dictate that it can use more tax-exempt income, so it should take a good look at municipals. Another bank might need to smooth out its cash flow profile over a period of years, so a clean structure mortgage-backed security might be the best vehicle for accomplishing that. There are times, however, when there is no obvious sector for a bank that has funds to invest. At these times, we look at the relative yield spreads between and among different types of bonds to see what is rich or cheap at a point in time. Use the portfolio as a means of achieving high performance for the bank overall. Define, measure, and manage the interest rate risk of the total bank, then structure the investment portfolio in a manner that will enhance earnings and build long-term shareholder value for the institution.  Avoiding the Pitfalls: Sound Investment Management for Community Banks Jeffrey F. Caughron is a Managing Director with The Baker Group,whereheservesasPresidentandChiefExecutiveOfficer. Caughron has worked in financial markets and the securities industry since 1985, always with an emphasis on banking, investments, and interest rate risk management. Contact: 800- 937-2257, jcaughron@GoBaker.com . By Jeffrey F. Caughron, The Baker Group