Pub. 3 2014 Issue 2

March 2014 29 l e a d i n g a d v o c a t e f o r t h e b a n k i n g i n d u s t r y i n k a n s a s STRATEGIC BOND SWAPS: OPTIMIZING RISK AND REWARD IN INVESTMENTS By Jeffrey F. Caughron, Associate Partner The Baker Group LP P RUDENT MANAGEMENT OF A BANK investment portfolio requires active restructuring as conditions change. On an ongoing basis, portfolio managers should evaluate the risk/ reward posture of the 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 early in the year when the bank can do tax loss swaps and 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 uncertainty and risk. In a sense, waiting for maturity is a bet that rates will be the same or higher than today. Regardless of the rate outlook, there are a number of reasons to restructure the portfolio. Here are some specific types of bond swaps: DurationAdjustment 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. 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 exposure. Duration adjustment is a textbook asset/liability management strategy for banks that are too asset (or liability) sensitive 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 municipals, callables versus MBS… all of these relationships should be monitored as markets move. Savvy portfolio managers will take advantage of the changing relationships and do swaps that sell what is rich and buy what is cheap compared to historical averages. Muni Tax-Loss Swap Banks should always be looking at their tax position and working with their accountants to optimize their after- tax performance. Each bank has its own unique set of circumstances, but generally the Tax Code allows for a loss on the sale of securities to be deducted for tax purposes. Moreover, for a taxable bank, the interest income from reinvestment is allowed to be earned tax free if the proceeds are used to purchase municipals. The bottom line is that the bank can recoup a tax-deductible loss with tax-free income. This strategy in particular is best executed at the turn of the year in order to have an entire twelve months to recover any loss. Cash Flow/Liquidity Management Swap To a large extent, investment portfolio management is simply the management of cash flows. Just as we look at rate sensitivity for the overall balance sheet, we must also take a macro view of the portfolio and pay close attention to the positioning of cash flows for reinvestment. This involves creating and maintaining a schedule of maturities, prepayments, and other sources of principal return that will optimize the risk and reward of reinvestment in future months and years, regardless of the direction of interest rates. T he Baker Group has always maintained that active portfolio management has distinct advantages if it is done properly. We work with clients to develop a sound decision-making process and well-defined goals as well as reporting systems that allow for pre-trade analysis or scenario simulations. The tools and processes for making better decisions and achieving optimal perfor- mance are available, and now is the time to take advantage of them. Since 1979, The Baker Group LP has helped clients improve decision-making, man- age interest rate risk, and maximize investment portfolio performance. For more information, contact Jeff Caughron at The Baker Group: 800-937-2257, www.GoBaker.com, or email: jcaughron@GoBaker.com .