STRATEGICALLY MANAGING THE INVESTMENT PORTFOLIO FOR LONG-TERM PERFORMANCE Raleigh A. Trovillion Executive Vice President UMB Bank Investment Division St. Louis, MO raleigh.trovillion@umb.com 314-612-8039 August 9 & 10, 2018
Graduate School of Banking Madison, Wisconsin Strategically Managing the Investment Portfolio for Long-Term Performance Raleigh A. Andy Trovillion Executive Vice President UMB Bank, N.A. August 9-10, 2018
Disclosure This communication is provided for informational purposes only. UMB Bank, n.a. and UMB Financial Corporation are not liable for any errors, omissions, or misstatements. This is not an offer or solicitation for the purchase or sale of any financial instrument, nor a solicitation to participate in any trading strategy, nor an official confirmation of any transaction. The information is believed to be reliable, but we do not warrant its completeness or accuracy. Past performance is no indication of future results. The numbers cited are for illustrative purposes only. UMB Financial Corporation, its affiliates, and its employees are not in the business of providing tax or legal advice. Any materials or tax related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor. The opinions expressed herein are those of the author and do not necessarily represent the opinions of UMB or UMB Financial Corporation. Products offered through UMB Bank, n.a. Investment Banking Division are: Not FDIC Insured, May Lose Value, Not Bank Guaranteed. Andy Trovillion UMB Bank, n.a. UMB Bank, n.a. Investment Banking Division Investment Banking Division 2 S. Broadway 1010 Grand Blvd St. Louis, MO 63102 Kansas City, MO 64106 314.612.8039 866.651.9262 2
Topics to be Addressed Introduction Putting Interest Rates into Perspective: A Short History The Relationship between Interest Rates, the Yield Curve and the Economy How does the yield curve behave as interest rates rise and fall? The Impact these changes have on Bank Portfolio Investing The Bond Trap How to Strategically Manage the Bond Portfolio-The Bond Trap A lesson on gains and losses Managing option risk Managing duration risk Good Ideas for Now 3
INTRODUCTION PUTTING INTEREST RATES INTO PERSPECTIVE 4
18 A History of Interest Rates: The 2 Year Treasury Yield (Source: Bloomberg) 16 14 12 10 8 6 4 2 0 6/1/1976 6/1/1977 6/1/1978 6/1/1979 6/1/1980 6/1/1981 6/1/1982 6/1/1983 6/1/1984 6/1/1985 6/1/1986 6/1/1987 6/1/1988 6/1/1989 6/1/1990 6/1/1991 6/1/1992 6/1/1993 6/1/1994 6/1/1995 6/1/1996 6/1/1997 6/1/1998 6/1/1999 6/1/2000 6/1/2001 6/1/2002 6/1/2003 6/1/2004 6/1/2005 6/1/2006 6/1/2007 6/1/2008 6/1/2009 6/1/2010 6/1/2011 6/1/2012 6/1/2013 6/1/2014 6/1/2015 6/1/2016 6/1/2017 PX_LAST 5
17 A History of Interest Rates: The 10 Year Treasury Yield (Source: Bloomberg) 15 13 11 9 7 5 3 1 4/1/1953 10/1/1954 4/1/1956 10/1/1957 4/1/1959 10/1/1960 4/1/1962 10/1/1963 4/1/1965 10/1/1966 4/1/1968 10/1/1969 4/1/1971 10/1/1972 4/1/1974 10/1/1975 4/1/1977 10/1/1978 4/1/1980 10/1/1981 4/1/1983 10/1/1984 4/1/1986 10/1/1987 4/1/1989 10/1/1990 4/1/1992 10/1/1993 4/1/1995 10/1/1996 4/1/1998 10/1/1999 4/1/2001 10/1/2002 4/1/2004 10/1/2005 4/1/2007 10/1/2008 4/1/2010 10/1/2011 4/1/2013 10/1/2014 4/1/2016 10/1/2017 PX_LAST 6
4 The Yield Curve: 2 YR TO 10 YR Spread (Source: Bloomberg) 3 2 1 0-1 6/1/1976 6/1/1977 6/1/1978 6/1/1979 6/1/1980 6/1/1981 6/1/1982 6/1/1983 6/1/1984 6/1/1985 6/1/1986 6/1/1987 6/1/1988 6/1/1989 6/1/1990 6/1/1991 6/1/1992 6/1/1993 6/1/1994 6/1/1995 6/1/1996 6/1/1997 6/1/1998 6/1/1999 6/1/2000 6/1/2001 6/1/2002 6/1/2003 6/1/2004 6/1/2005 6/1/2006 6/1/2007 6/1/2008 6/1/2009 6/1/2010 6/1/2011 6/1/2012 6/1/2013 6/1/2014 6/1/2015 6/1/2016 6/1/2017-2 -3 SPREAD 7
THE REALTIONSHIP BETWEEN INTEREST RATES, THE YIELD CURVE AND THE ECONOMY HOW DOES THE YIELD CURVE BEHAVE AS INTEREST RATES RISE AND FALL 8
A History of Interest Rates: The 2 Yr-10 Yr Relationship (Source: Bloomberg) 18 4 16 3 14 12 10 2 1 8 0 6-1 4 2-2 0 6/1/1976 6/1/1977 6/1/1978 6/1/1979 6/1/1980 6/1/1981 6/1/1982 6/1/1983 6/1/1984 6/1/1985 6/1/1986 6/1/1987 6/1/1988 6/1/1989 6/1/1990 6/1/1991 6/1/1992 6/1/1993 6/1/1994 6/1/1995 6/1/1996 6/1/1997 6/1/1998 6/1/1999 6/1/2000 6/1/2001 6/1/2002 6/1/2003 6/1/2004 6/1/2005 6/1/2006 6/1/2007 6/1/2008 6/1/2009 6/1/2010 6/1/2011 6/1/2012 6/1/2013 6/1/2014 6/1/2015 6/1/2016 6/1/2017-3 SPREAD 2 YEAR 10 YEAR 9
6.00% U.S. Treasury Yield Curve Comparison (Source: Bloomberg) 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 3 6 mo mo 1 yr 2 yr 3 yr 5 yr 10 yr 30 yr 6/1/2003 6/1/2006 6/1/2018 10
Long-Term Look at US Economic Cycles (Source: Bloomberg) 20 18 16 14 12 10 8 6 4 2 0-2 -4-6 -8-10 6/1/1947 2/1/1949 10/1/1950 6/1/1952 2/1/1954 10/1/1955 6/1/1957 2/1/1959 10/1/1960 6/1/1962 2/1/1964 10/1/1965 6/1/1967 2/1/1969 10/1/1970 6/1/1972 2/1/1974 10/1/1975 6/1/1977 2/1/1979 10/1/1980 6/1/1982 2/1/1984 10/1/1985 6/1/1987 2/1/1989 10/1/1990 6/1/1992 2/1/1994 10/1/1995 6/1/1997 2/1/1999 10/1/2000 6/1/2002 2/1/2004 10/1/2005 6/1/2007 2/1/2009 10/1/2010 6/1/2012 2/1/2014 10/1/2015 6/1/2017 GDP 11
The Yield Curve and US Economic Cycles (Source: Bloomberg) 18 4 16 14 3 12 10 2 % GDP 8 6 4 2 0-2 -4-6 -8-10 6/1/1976 7/1/1977 8/1/1978 9/1/1979 10/1/1980 11/1/1981 12/1/1982 1/1/1984 2/1/1985 3/1/1986 4/1/1987 5/1/1988 6/1/1989 7/1/1990 8/1/1991 9/1/1992 10/1/1993 11/1/1994 12/1/1995 1/1/1997 2/1/1998 3/1/1999 4/1/2000 5/1/2001 6/1/2002 7/1/2003 8/1/2004 9/1/2005 10/1/2006 11/1/2007 12/1/2008 1/1/2010 2/1/2011 3/1/2012 4/1/2013 5/1/2014 6/1/2015 7/1/2016 8/1/2017 1 0-1 -2-3 % YIELD SPREAD GDP SPREAD 12
THE IMPACT ON BANK PORTFOLIO INVESTING THE BOND TRAP 13
The Bond Trap As the economy slows: Loan totals and demand for new credit declines The Federal Reserve lowers interest rates The investment portfolio increases as unlendable dollars must be reinvested into securities If optionality is present in the investment portfolio, bonds are called and/or pre-payments increase forcing additional security purchases in low interest rate environments. As a result, banks tend to purchase the majority of their securities in lower interest rate environments.
The Bond Trap As the economy recovers and begins to expand: Loan demand increases as the economy improves. The Federal Reserve begins to raise interest rates in response to the improving economy and rising inflation expectations. Cash flow from the investment portfolio is used to meet new loan demand and/or deposit withdrawals. As interest rates rise, call options extend and pre-payments decrease. The investment portfolio begins to extend. Bonds have losses. Fewer new purchases are made at the higher yield levels. As the cycle matures, yield curve flattens reducing the relative value of longer-term securities.
HOW TO STRATEGICALLY MANAGE THE BOND PORTFOLIO- The Bond Trap A LESSON IN GAINS & LOSSES MANAGING OPTION RISK MANAGING DURATION RISK 16
The Math Behind Gains and Losses 17
The Math Behind Gains and Losses 18
The Math Behind Gains and Losses 19
The Math Behind Gains and Losses 20
Total Return as a Measurement of Performance and Market Risk Total return includes the yield of a security and the market value gain (or loss). Total return is a much better measurement of a portfolio s performance and risk. $1,000,000 * 3.50% yield=$35,000 annual income plus a gain of $10,000 generates a total return of 4.50%. If the total return is greater than the yield there is a market value gain in the security. If the total return is less than the yield there is a market value loss in the security. Market prices are extremely efficient at pricing risk (call risk, credit risk, extension risk ). Since market value is the present value of the future income, total return also provides an indication of how long you will maintain the superior income stream(gain) or below market income stream(loss). 21
Current Investment Portfolio Total Return Analysis (Source: UMB Bank Financial Services Group)
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Extension Risk (Source: UMB, FSG) 24
Extension Risk (Source: UMB, FSG) 25
Good Ideas for Right Now MANAGING RISK WHILE STILL MAKING MONEY 26
Good Ideas for Right Now! Two opposing goals: Maximize yield/interest income today Prepare for the next interest rate cycle, whenever it comes Environment we are investing in: While higher we still have historically low yields Sluggish, but improving economic recovery. For some banks, improving loan volumes; others experiencing flat loan growth-at best! Steep, but flattening yield curve rewards extension to add yield at the same time we need the yield. Solutions: Security Diversification Manage duration/extension risks Prepare for balance sheet changes 27
Security Distribution (Source: UMB, FSG) 28
Security Distribution (Source: UMB, FSG) 29
Security Distribution (Source: UMB, FSG) 30
Managing Duration/Extension Risk Duration is the time-weighted, present value of a bond s cash flows. Stated in terms of years. Will always be shorter than the maturity of a bond due to interest payments and principal payments. Modified duration can be used to measure the approximate price sensitivity of a bond. A duration of 3.50 years indicates the price of the bond will change 3.50% given a 100 basis point change in interest rates. The longer (larger) the duration the more price sensitive of the security. The duration can/will change as the cash flows change. Example would be a callable security or mortgage-backed bond. Term of Bond % Change in Price 6 months 1x 1 year 2x 5 years 7x 10 years 13x 30 years 19x The price on a 30 year bond will change 19x as much as a 6 month bond. 31
Cash Flow Issues (Source: UMB, FSG) 12 Month Cash Flow Comparison -200-100 Base +100 +200 Date Cash Flow Yield Cash Flow Yield Cash Flow Yield Cash Flow Yield Cash Flow Yield Jun-16 $2,037,948 2.29% $2,037,948 2.29% $1,462,948 2.47% $977,948 2.83% $977,948 2.83% Jul-16 $1,582,621 2.72% $1,582,621 2.72% $930,088 2.74% $771,825 2.75% $716,020 2.77% Aug-16 $3,575,030 2.68% $3,575,030 2.68% $978,017 2.75% $592,467 2.77% $536,635 2.78% Sep-16 $3,627,727 2.72% $3,627,727 2.72% $953,623 2.75% $586,941 2.77% $533,180 2.78% Oct-16 $3,682,270 2.75% $3,682,270 2.75% $934,899 2.76% $581,886 2.78% $531,171 2.79% Nov-16 $3,618,211 2.80% $3,618,211 2.80% $948,093 2.81% $571,515 2.78% $524,261 2.79% Dec-16 $3,357,616 2.85% $3,357,616 2.85% $1,027,706 2.91% $574,202 2.83% $525,210 2.84% Jan-17 $2,925,895 2.83% $2,925,895 2.83% $885,540 2.81% $510,753 2.79% $464,980 2.80% Feb-17 $2,638,303 2.84% $2,638,303 2.84% $897,396 2.85% $501,753 2.79% $458,081 2.81% Mar-17 $3,872,592 2.98% $3,872,592 2.98% $1,860,844 3.42% $472,065 2.80% $432,513 2.81% Apr-17 $2,153,103 2.85% $2,153,103 2.85% $853,441 2.84% $470,200 2.80% $431,735 2.81% May-17 $1,986,950 2.85% $1,986,950 2.85% $887,599 2.84% $513,102 2.80% $471,877 2.82% Grand Total $35,058,270 2.78% $35,058,270 2.78% $12,620,194 2.86% $7,124,657 2.79% $6,603,613 2.80% 32
Cash Flow Issues (Source: UMB, FSG) Cash Flow -200-100 Base +100 +200 Cash Flow Date Cash Flow Yield Cash Flow Yield Cash Flow Yield Cash Flow Yield Cash Flow Yield 0-12months $35,058,270 2.78% $27,796,679 2.81% $12,620,194 2.86% $8,551,303 2.92% $7,124,657 2.79% 13-24months $14,188,950 2.93% $15,232,332 2.89% $10,116,076 2.84% $7,716,036 2.78% $6,964,080 2.77% 25-36months $5,824,548 2.99% $7,129,348 2.92% $8,432,815 2.92% $6,599,417 2.93% $5,901,668 2.85% 37-48months $11,764,723 3.78% $12,989,755 3.70% $12,869,318 3.78% $10,762,147 3.82% $6,805,345 3.13% 49-60months $6,193,847 3.32% $6,894,988 3.31% $7,438,800 3.23% $7,138,633 3.27% $6,048,205 2.99% >60months $35,097,341 3.24% $38,084,576 3.12% $56,650,475 2.34% $67,360,142 1.70% $75,283,722 1.40% Grand Total $108,127,678 3.10% $108,127,678 3.08% $108,127,678 2.72% $108,127,678 2.27% $108,127,678 1.86% 33
Market Value Issues (Source: UMB, FSG) 34
Investment Strategies for Bank Investment Portfolios What determines the right investment strategy for your bank? Risk tolerance Interest rate risk. Credit risk. Market volatility risk. Cash flow. Time & Expertise Other responsibilities. Part-time portfolio manager or full-time. Board Direction Risk guidelines from the Board Policy limitations for interest rate risk as well as the investment portfolio. Balance sheet composition Loan-to-deposit ratio Funding make-up Interest rate forecast Rising or falling rates? Premium or discount bonds? Duration? Callable or bullets? Taxable or tax-exempt?
How and Where to Invest Now Securities FDIC Insured Certificates of Deposits High quality municipal bonds-taxable and tax exempt (????) Additional regulatory emphasis on credit review Extraordinary call feature on Build America Bonds Non-callable Agencies Callable Agencies Low risk, short-final maturity mortgage-backed securities and CMOs. High quality corporate bonds Additional regulatory emphasis on credit review make whole call features Adjustable rate securities MBS ARMs SBA Pools Floating rate CMOs 36
Bar Bell Maturity Structure Traditionally, banks have managed the cash flows from the investment portfolio using a laddered maturity approach. Relatively equal amounts of maturities are invested annually, quarterly, monthly to insure sufficient cash flow and provide multiple reinvestment options throughout the course of the year. This is still an excellent method of investing. However, in the current interest rate environment a bar bell approach makes more sense. A bar bell allows a short-term ladder of maturities invested from 1 year to as much as 3 years and then a second portion of maturities out longer (5-7 or 10 years). The benefits, especially given the dynamics of today s environment, are substantial. It permits a short-term liquidity ladder and a longer-term ladder to generate higher yields. The additional market value risk of the long-term portion is offset by the short-term ladder of securities 37
Example of a Modified Bar Bell Bond Purchase Scenario Agency Bullet Ladder 1-4years Bond Purchase Scenario Municipal Ladder 5-10years Maturity 1yr 2yr 3yr 4yr Maturity 5yr 6yr 7yr 8yr 9yr 10yr Book Value $1,500,000 $1,500,000 $1,500,000 $1,500,000 Book Value $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 Yield 0.083 0.212 0.42 0.662 Yield 1.29 1.80 2.03 2.32 2.61 2.77 Modified Duration 1.013 1.929 2.959 3.85 Modified Duration 4.72 5.53 6.41 7.26 8.11 9.25 Yield/Unit of Duration 0.082bps 0.11bps 0.142bps 0.172bps Yield/Unit of Duration 0.273bps 0.326bps 0.317bps 0.319bps 0.321bps 0.3bps Total Book Value: $6,000,000 Total Book Value: $6,000,000 Weighted Average Yield: 0.34 Weighted Average Yield: 2.14 Weighted Average Duration: 2.44 Weighted Average Duration: 6.88 Mkt Value Decline +100bps -$146,265 Mkt Value Decline +100bps -$412,800 Yield/Unit of Duration: 0.14bps Yield/Unit of Duration: 0.31bps *Yields on Municipals reported as Taxable Equivalent Yield assuming 34% Tax Rate and 0% TEFRA Bond Purchase Scenario Agency-Municipal Barbell Maturity 1yr Agency 2yr Agency 3yr Agency 6yr Muni 7yr Muni 8yr Muni 9yr Muni Book Value $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $500,000 $500,000 Yield* 0.083 0.212 0.42 1.80 2.03 2.32 2.61 Modified Duration 1.013 1.929 2.959 5.53 6.41 7.26 8.11 Total Book Value: $6,000,000 Weighted Average Yield: 1.20 Weighted Average Duration: 4.51 Mkt Value Decline +100bps -$270,470 Yield/Unit of Duration: 0.27bps *Yields on Municipals reported as Taxable Equivalent Yield assuming 34% Tax Rate and 0% TEFRA Agencies Munis Combined Ladder Ladder Barbell Total Book Value: $6,000,000 $6,000,000 $6,000,000 Weighted Average Yield: 0.34 2.14 1.20 Weighted Average Duration: 2.44 6.88 4.51 Mkt Value Decline +100bps -$146,265 -$412,800 -$270,470 Yield/Unit of Duration: 0.14bps 0.31bps 0.27bps 38
Benefits and Costs of Taking Losses Now Benefits Allows the opportunity to improve income. Opportunity to improve credit quality by selling low quality bonds. Allows the bank to reposition maturities now with little cost. Provide funding for loan growth. Costs Sometimes hard to realize a loss. If interest rates continue to rise quickly you may have reinvested too early. Tax considerations at new 21% tax bracket. Flattening yield curve makes it hard to recover the loss quickly. 39
Be Careful Watch excessively high premiums on mortgage-backed securities. Be aware of yields if pre-payments increase. Watch for negative yields. Poorly structured CMOs that permit significant extension risk for small decreases in pre-payment speeds. Excessive call risk/extension risk in callable Agencies, MBS/CMOs and municipals. Reaching for yield by lowering credit quality or extending durations. Watch the shape of the yield curve for direction on where to invest. 40
Final Thoughts Today s investment environment is one of the most difficult I have experienced in more than 30 years of working with banks on interest rate risk management and investment portfolio management. Diversification and prudent investment decisions today have never been more important. Resist the temptation to reach for yield: credit quality or maturity/duration. Stay with high quality, well structured issues (municipals, corporate, MBS/CMOs). Cheap in; cheaper out. Perform pre-purchase analysis Perform a regular post-purchase analysis that includes on-going credit review and extension risk analysis. Add not just rate shock analysis, but consider adding rate ramp scenarios(interest rate risk analysis as well) If needed, upgrade municipal credit quality now. If it is painful, it is likely the right thing to do. Where you are rewarded the least, you will benefit the most. 41
Raleigh A. Andy Trovillion Executive Vice President, UMB Andy Trovillion joined UMB s Investment Banking Division in 1987. As executive vice president for our St. Louis Investment Division, Mr. Trovillion is responsible for advising institutional clients about interest rate risk management issues and fixed-income portfolio management issues. His specialties are interest rate risk management and portfolio management for financial institutions. Prior to joining UMB, Mr. Trovillion was employed by Newhard, Cook & Co. While there, Mr. Trovillion was responsible for tax-exempt bond trading. Mr. Trovillion received a Bachelor of Arts in economics with a concentration in history from Hampden-Sydney College in Virginia. In addition to his responsibilities with UMB, Mr. Trovillion is active in the community, teaching investment portfolio management and asset/liability management at the Graduate School of Banking in Madison, Wisconsin, asset/liability management and investment portfolio management at the Missouri Banker s School of Bank Management. Mr. Trovillion serves on the Board of the USS PHELPS Shipmates organization, the FBI Citizen s Academy and the Association of Military Banks of America. Mr. Trovillion volunteers his time as a mentor with the Matthews- Dickey Boys and Girls Club. He also is an active leader with the Greater St. Louis Boy Scout Association and a Scout Leader with his local Scouting Troop. 42
Contact Information Raleigh A. Andy Trovillion Executive Vice President UMB Bank, N.A. 2 South Broadway Saint Louis, Missouri 63102 800-443-5962 (office) 314-517-7384 (Cell) raleigh.trovillion@umb.com 43