Pub. 4 2015 Issue 2

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 26 B ANK INVESTMENT STRATEGIES MUST BE developed within a framework that considers multiple dimensions of risk and reward. We begin with a “big picture” view of the bank and its balance sheet. The asset/liability posture, liquidity position, tax considerations, and expectations for loan demand and deposit growth must all be taken into account. Along with these factors, management must also consider the shape of the yield curve and the cash flow profile of the investment portfolio. This is important since there are distinct strategies that make sense for a steepening yield curve, and different strategies that are optimal for one that is flattening. Textbook portfolio management tells us that when the slope of the yield curve flattens, a duration-weighted combination of short and long maturities will generally perform better than continuous cash flows across the time horizon. On the other hand, if the curve steepens a laddered cash flow of maturities is preferred. As a simple example, we can examine the effects of a change in yield curve slope on positions in three Treasury Notes: a two-year maturity, a ten-year maturity, and a 3.5-year maturity, which has a duration that is roughly the average of the two- and ten-year combination. We can focus on the relative price changes for the three different bonds. What we want to study is the change in price or market value for a combination of 2-year and 10-year bonds versus the 3.5-year bond. When we look at the actual behavior of Treasury yields from year-end 2013 through the second quarter of 2014, we can see that the curve flattened noticeably. For the three bonds in our example, the 2-year yield rose by 5 bps, while the 10-year fell by 50 bps. Meanwhile, the 3.5-year maturity was virtually unchanged. So when we do the math, we can see that the duration-weighted barbell combination of 2s and 10s outperformed the single 3.5- year maturity. This is because the price appreciation of the 10- year more than offset the depreciation of the 2-year, so the net effect was an unrealized gain on the combination. All the while, the middling 3.5-year maturity sat quietly and ended the period at precisely the same yield with no change in price. Even if the duration weighting requires a four-to-one ratio of 2 years vs 10 years, the combined position wins. It confirms what portfolio managers have always known: a barbell structure (all else being equal) will outperform sequentially laddered cash flows when the yield curve flattens. There is much more to the “modified barbell” structure that we generally recommend for bank portfolios. The short end of the barbell provides a source of re-investable liquidity that allows us to maintain a smooth moving average of yield as we add newly purchased securities. The longer end of the barbell should be populated with high-grade bank-qualified municipal bonds (assuming the bank is fully taxable) where the portfolio can achieve high tax-equivalent yield to meld with the liquidity ladder. In combination, this “modified barbell” provides the optimal mix of liquidity and yield. The structure of cash flows has always been a key considera- tion for portfolio managers. As conditions change, the precise distribution of cash flows can be stretched out or pulled in depending on specific needs. This, among other reasons discussed, is what gives the “modified barbell” its power and makes it a high-performance strategy. Jeffrey F. Caughron, Chief Operating Officer/Managing Director of The Baker Group LP, has worked banking, investments, and interest-rate risk manage- ment since 1985 and currently serves as a market analyst and portfolio strate- gist. Contact: 800-937-2257, jcaughron@GoBaker.com . YIELD CURVE CHANGES AND MANAGEMENT OF THE INVESTMENT PORTFOLIO IN PRAISE OF THE “MODIFIED” BARBELL By Jeffrey F. Caughron, Associate Partner, The Baker Group LP