What s Working CREATING LIQUIDITY THROUGH MUNICIPAL SWAP OPPORTUNITY

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1 FEBRUARY 19, 2019 What s Working CREATING LIQUIDITY THROUGH MUNICIPAL SWAP OPPORTUNITY Steady loan demand paired with slowing deposit growth has created a lack of liquidity for bond purchases causing a roadblock to improve portfolio margins. Several trends in the municipal market have created a strong bid-side for short-term tax-free municipals making them an attractive sale candidate for C-Corp investors. Swapping out of short maturity municipals can create liquidity as a way to add higher yields in the investment portfolio. For best sale candidates, focus on high credit quality 1-4 yr maturities, with TEY book yields below 3.0%, and market value losses of less than 2.0%. As we move into March, one of the biggest hurdles for investors hasn t been the desire to invest but their ability to raise funds to invest. With steady loan demand, slowing deposit growth, and unrealized losses in the investment portfolio, many banks find themselves with a lack of liquidity to use for bond purchases. This issue presents concern as portfolio managers may miss out on the attractive yield levels available in today s market and the ability to re-price the portfolio yield higher. With the a flat yield curve, many swaps are difficult to execute, but with the recent rally in interest rates and strong demand for short municipals from retail investors, there have been attractive municipal sale candidates in many portfolios. What s driving this opportunity? The chart below highlights two trends in the municipal market that are advantageous for C-Corp sellers. First, the 5-year muni ratio (nominal yield as percent of treasuries) has tightened significantly since the beginning of the year coming in from ~80% to 67% currently. Second, since the market s expectations for Fed policy have shifted over the last two months, the 5-year UST has rallied over 50bps from the highs last October. These two trends have created an attractive environment for sellers, many of whom lost much of their TEY advantage after 2017 s tax reform. PORTFOLIO STRATEGIES GROUP Gray Bowles gray.bowles@ftnfinancial.com Derick Garner derick.garner@ftnfinancial.com Lauren Burford lauren.gilbert@ftnfinancial.com David Howard, CFA david.howard@ftnfinancial.com Ruben Rodriguez ruben.rodriguez@ftnfinancial.com Steve Twersky, CPA steve.twersky@ftnfinancial.com Tyler Williamson tyler.williamson@ftnfinancial.com Jake Woodman jake.woodman@ftnfinancial.com Kenneth Young kenneth.young@ftnfinancial.com FTNFINANCIAL.COM Disclosures are contained on the last page of this report.

2 Municipal curve relative value points out this opportunity as well. On a TEY basis, using a 21% corporate tax rate, we have produced a TEY spread to USTs across various maturities. This paints a clear picture, as the short final maturity municipal bonds have zero to negative spreads relative to USTs. There are several market dynamics at play here. We have bulleted several below. The majority of the municipal market (~65%) is made up of retail investors with higher tax brackets than C-Corp investors, therefore keeping spreads contained. The consensus market outlook, until recently, has been for higher rates due to tightening Fed policy, which drove demand for short duration investments. Many short duration municipal funds focused on 1-3 year maturities due to flatness of the yield curve between 2- and 5-year USTs. 2

3 What are the economics of a swap strategy? Below we highlight a recent transaction that illustrates the benefits and potential challenges for implementing this type of strategy. For best sale candidates, we focus on high credit quality 1-4 yr maturities, with TEY book yields below 3.0% and market value losses of less than 2.0%. Bonds Sold: $11 million par value of tax-free BQ municipal bonds Current weighted average life of 3.7 years Tax-equivalent book yield of 2.60% Tax-equivalent market (take-out) yield of 2.76% Loss on transaction of ~$50 thousand Reinvestment: Blend of 20-year 4.0% MBS and FHLMC SEQ CMO with 3.0% Coupon Blended purchase yield of 3.27% Projected average life of 5.0 years 3

4 Results: Pick up ~70bps in book yield, or ~$75 thousand annually Pick up ~50bps over the selling yield Recoup loss in ~6 months, within this calendar year Improve income by ~$200 thousand through December 2022 (average life of sales) This strategy takes advantage of strong pricing in short-term municipals to create liquidity to add higher yields to the portfolio. While it does require a realized loss, most can be recouped within the 2019 calendar year and become immediately accretive to earnings. Are there other reinvestment options? Yes. Investment options are many and cross a wide range of sectors that fit several curve and interest rate outlooks. In our 2019 outlook, we highlighted several sectors that offer a balanced approach to several economic and interest rate scenarios. In amortizing products, we focus on improving portfolio yield with SEQ CMOs and 20-yr MBS. These securities provide attractive spread and total return profiles vs. 15-yr MBS, but with increased optionality. If you favor better structure and are willing to give up some yield and total return, we can improve the convexity profiles by targeting structure, collateral, and coupons within the CMO sector using VADMs and Discount GNMAs. Tactically, we highlighted several sectors that can prepare the portfolio for a potential turn in the economic/ rate cycle. These include ACMBS such as DUS and K-certificates that provide a traditional way to add better convexity profiles. And as seen in the chart above, long final maturity, tax-free municipals offer a compelling value proposition for investors willing to go further out the curve. To offset the additional duration risk, these investments can be paired with floating rate options. With today s flat yield curve and with Fed policy on hold, floating rate yields remain competitive versus their longer duration counterparts. 4

5 Bottom-line: Depository portfolio managers must find ways to increase portfolio yield as funding pressures mount and cost continue to rise. But, many banks find themselves with a lack of liquidity to use for bond purchases. With the a flat yield curve, many swaps are difficult to execute, but as we have highlighted, the recent rally in interest rates and strong demand for short municipals have created attractive sale candidates in many portfolios. Please reach out to us to review your portfolio for these opportunities. Gray Bowles Portfolio Strategies Group gray.bowles@ftnfinancial.com This material was produced by an FTN Financial Strategist and is not considered research and is not a product of any research department. Strategists may provide information to investors as well as to FTN Financial's trading desk. The trading desk may trade as principal in the products discussed in this material. Strategists may have consulted with the trading desk while preparing this material and the trading desk may have accumulated positions in the securities or related derivatives products that are the subject of this material. Strategists receive compensation which may be based in part on the quality of their analysis, FTN Financial revenues, trading revenues, and competitive factors. Although this information has been obtained from sources which we believe to be reliable, we do not guarantee its accuracy, and it may be incomplete or condensed. This is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. All herein listed securities are subject to availability and change in price. Past performance is not indicative of future results, while changes in any assumptions may have a material effect on projected results. Ratings on all securities are subject to change. FTN Financial Group, FTN Financial Capital Markets, FTN Financial Portfolio Advisors and FTN Financial Municipal Advisors are divisions of First Tennessee Bank National Association (FTB). FTN Financial Securities Corp (FTSC), FTN Financial Main Street Advisors, LLC, and FTN Financial Capital Assets Corporation are wholly owned subsidiaries of FTB. FTSC is a member of FINRA and SIPC FTN Financial Municipal Advisors is a registered municipal advisor. FTN Financial Portfolio Advisors is a portfolio manager operating under the trust powers of FTB. FTN Financial Main Street Advisors, LLC is a registered investment advisor. None of the other FTN entities including, FTN Financial Group, FTN Financial Capital Markets, FTN Financial Securities Corp or FTN Financial Capital Assets Corporation are acting as your advisor and none owe a fiduciary duty under the securities laws to you, any municipal entity, or any obligated person with respect to, among other things, the information and material contained in this communication. Instead, these FTN entities are acting for their own interests. You should discuss any information or material contained in this communication with any and all internal or external advisors and experts that you deem appropriate before acting on this information or material. FTN Financial Group, through FTB or its affiliates, offers investment products and services. Investment Products are not FDIC insured, have no bank guarantee and may lose value First Tennessee Bank. All rights reserved. 5