Lecture Materials ASSET/LIABILITY MANAGEMENT YEAR 1 Todd Patrick Senior Vice President - Capital Markets CenterState Bank Atlanta, Georgia tpatrick@centerstatebank.com 770-850-3403 August 7, 2017
Intro to Investment Portfolio Management Todd Patrick, CFA SVP Capital Markets CenterState Bank Agenda Why banks own bonds Psst, what s a bond? Understanding the various types Price/yield relationship It s down to what? (price volatility) Picking the right one (Yawn) accounting issues 1
Why Banks Own Bonds Investment Portfolio Objectives Liquidity Pledging Income Capital preservation Credit diversification IRR management 2
Asset/Liability Made Simple Loans Cash Bonds CD s and Interest Bearing NMD s NMD s Psst, What is a Bond? 3
What is a Bond? A bond is a government or corporate debt security. It represents debt because the bond buyer (investor) actually lends the face amount to the bond issuer (borrower) earning a stated amount of interest in return. Also known as fixed income securities What is a Bond? 4
Commonly Used Terms Par Value The face value or the principal amount of the asset that the investor gets back at maturity Book Value The value an asset is held on the investor s balance sheet Market Value The estimated amount an asset could be exchanged between a willing buyer and seller Maturity Date Length of time until the principal is repaid at a stated price (typically at par) Call Date Investor sells the issuer an underlying option that allows the issuer to redeem bonds prior to maturity at a predetermined price and time Commonly Used Terms Settlement Date When the investor takes possession of the bond Coupon Rate Stated rate of interest that the issuer pays the bond holder (can be fixed or variable) Yield The income return on an investment. It is the sum of annual interest earned +/ accretion or amortization expense divided by the current par. Accretion An accounting adjustment that increases the underlying book value of an asset held at a discount to redemption price Amortization An accounting adjustment that decreases the underlying book value of an asset held at a premium to redemption price 5
Understanding the Various Types 0% Risk Weighted Issuers US Treasury Full faith and credit of US Government Highest quality and most liquid of all securities Benchmark for other securities in determining spread/price Government National Mortgage Association GNMA (Ginnie Mae) Full faith and credit of US Government Supplies sources of capital for government insured mortgages 6
The GSE s Government Sponsored Entities Federal Home Loan Bank FHLB Moral obligation of the US Government State tax exempt in some states Supplies funding and services for financial institutions Federal Farm Credit Bank System FFCB Moral obligation of the US Government State exempt in some states Supplies financing for agriculturally related loans The GSE s Government Sponsored Entities Federal Home Loan Mortgage Corporation FHLMC (Freddie Mac) Moral obligation of the US Government Supplies sources of capital to secondary mortgage markets Typically conventional mortgage loans Federal National Mortgage Association FNMA (Fannie Mae) Moral obligation of the US Government Supplies sources of capital to secondary mortgage markets Typically conventional mortgage loans 7
The GSE s Government Sponsored Entities New Issue Agency Market 8
Agency Step Ups Bonds Step up bonds are callable bonds usually issued by FNMA, FHLMC or FHLB that have the added feature of possible future increases to the coupon over the life of the security (i.e., the coupon steps up, hence the name). Issues can have any number of steps to the coupon and the time between steps can and will vary as well. The bonds typically carry a call option that is similar to a straight callable with the time to first call usually between 3 months, 6 months or 1 year. The calls are usually quarterly in nature but can vary on occasion. Step ups are considered structure notes under the policy guidelines applied by the FDIC and must be reported as such in the call report. Corporate Debt Corporate Securities Bullet and callable issues Fixed and floating coupons No government credit support Assigned credit ratings from companies like Fitch, Moody s, and S&P State bank regulation typically limits exposure on any single issuer to 15% of statutory capital 9
Municipalities Municipals Tax exempt income Rarely has federal government credit support, but many issues have secondary credit sources through insurance or State backing Two main categories: General Obligation Revenue Typically required to be bank qualified for tax free benefit Mortgage Backed Offerings An asset backed pool where mortgages with similar characteristics (term, rate, structure, etc) are pooled together and securitized. The underlying mortgages can be either residential or commercial based. The issuers include GNMA, the GSE s (like FNMA or FHLMC) or can be private label. There are two main types of mbs (mortgage backed security) pools: 1. Passthrough s 2. CMO s (Collateralized Mortgage Obligation) 10
MBS Passthroughs Home Loan Home Loan Home Loan Mortgage Backed Security Investors Investors Home Loan Investors Home Loan Constructing CMO s Mortgage Backed Security Tranche 1 Insurance Co Collateralized Mortgage Obligation Tranche 2 Banks Mortgage Backed Security Tranche 3 Endowments Mortgage Backed Security Tranche 4 Hedge Funds 11
Price/Yield Relationship Price/Yield Relationship In fixed income products, price and yield are inversely related Yield is determined by price, coupon rate, anticipated date of principal return, and accounting standards Bonds are priced as a percentage basis of par (100) to the nearest 1/32 quoted either as a factor or already in decimal form. Agency and mortgage back (mbs s) bonds are quoted as either a factor or decimal Municipals are always quoted as decimals A tick represents 1/32 12
Price/Yield Relationship A bond's price consists of a handle" and "32 nd s". Written as a factor, you would see a bond quoted as 99 20. The 20 represents 20/32 s. 20/32 s is the same as 5/8 s which calculates in decimal form as.625 A 99 20 price is equivalent to seeing the bond priced at 99.625 Price/Yield Relationship For example: The 5yr agency is being offered at 97 12. The handle is 97 and the 32 nd s are 12. We must convert those values into a percentage to determine the dollar amount we will pay for the bond. To do so, we first divide the 12 by 32. This equates to.375 (3/8 s). This amount is added to the handle (97) which equates to 97.375. Therefore, 97 12 purchase price represents 97.375% of the par value of a bond. A $1mm investment in this 5yr agency would result in a book value of $973,750 at purchase. 13
Price/Yield Relationship Another example: The 7yr agency is being offered at 102 22. The handle is 102 and the 32 nd s are 22. We must convert those values into a percentage to determine the dollar amount we will pay for the bond. To do so, we first divide the 22 by 32. This equals.6875. This amount is added to the handle (102) which equates to 102.6875. Therefore, 102 22 purchase price represents 102.6875% of the par value of a bond. A $1mm investment in this 7yr agency would result in a book value of $1,026,875 at purchase. Price/Yield Relationship The impact of accretion income $1,000,000 of a 5yr agency offered at 0.98 = $980,000 The coupon rate is 3% The bond matures at par so the investor adjust his book value to $1mm at maturity The $20,000 discount is considered accretion income and must be factored in to the yield calculation Straight line accounting produces $4000 a year in income 30,000 + 4,000 = 3.40% yield 1,000,000 14
Price/Yield Relationship Book Value adjustments: As the investor recognizes the accretion income, the book value is increased on a pro rata basis. For example, the ending annual book value of a $1mm 5yr bond purchased at a $20,000 discount would be: Year 0 $980,000 Year 1 $984,000 Year 2 $988,000 Year 3 $992,000 Year 4 $996,000 Year 5 $1,000,000 *monthly accretion of $333.33 Price/Yield Relationship The impact of amortization expense $1,000,000 of a 5yr agency offered at 102 16 = $1,025,000 The coupon rate is 3% The bond matures at par so the investor adjust his book value to $1mm at maturity The $25,000 premium is considered amortization expense and must be factored in to the yield calculation Straight line accounting results in $5000 a year in expense 30,000 5,000 = 2.50% yield 1,000,000 15
Price/Yield Relationship Book Value adjustments: As the investor recognizes the amortization expense, the book value is decreased on a pro rata basis. For example, the ending annual book value of a $1mm 5yr bond purchased at a $25,000 premium would be: Year 0 $1,025,000 Year 1 $1,020,000 Year 2 $1,015,000 Year 3 $1,010,000 Year 4 $1,005,000 Year 5 $1,000,000 *monthly amortization of $416.67 Price/Yield Relationship The impact of call options on accretion $1,000,000 of a 5yr/2yr Agency offered at 0.98 = $980,000 The coupon rate is 3% The bond is called at par so the investor needs to recognize the discount at time of call The $20,000 discount is considered accretion income and must be factored in to the yield calculation Straight line accounting produces $10,000 a year in income 30,000 + 10,000 = 4.00% YTC (yield was 3.50%) 1,000,000 (Year1 @ 3.50%) (Year2 @ 4.50%) 16
Price/Yield Relationship Book Value adjustments: As the investor recognizes the accretion income, the book value is increased on a pro rata basis. Bonds purchased at discounts are accreted to maturity. If called, any remaining discount must be accreted to par on the call date. For example, the book value of a $1mm 5yr/2yr bond purchased at 98 would look like following if called: Year 0 $980,000 Year 1 $984,000 Year 2 $1,000,000 Price/Yield Relationship The impact of call options on amortization $1,000,000 of a 5yr/2yr agency offered at 102 16 = $1,025,000 The coupon rate is 3% FASB suggest premiums are amortized to the first call date The $25,000 premium is considered amortization expense and must be factored in to the yield calculation Straight line accounting results in $12,500 a year in expense 30,000 12,500 = 1.75% YTC (Yield was 2.50%) 1,000,000 17
Price/Yield Relationship Book Value adjustments: Callable bonds purchased at premiums are always amortized to the first call date. For example, the book value of a $1mm 5yr/2yr bond purchased at 102 16 would look like following if the call was exercised or not: Year 0 $1,025,000 Year 1 $1,012,500 Year 2 $1,000,000 Price/Yield Relationship Bonds Purchased at Par Price Coupon YTM YTC 18
Price/Yield Relationship Bonds Purchased at a Discount Price Coupon YTM YTC Price/Yield Relationship Bonds Purchased at a Premium YTM YTC 19
It s Down to What? The US Treasury Department The Treasury Department is responsible for a wide range of activities such as advising the President on economic and financial issues, encouraging sustainable economic growth, and fostering improved governance in financial institutions. The Department of the Treasury operates and maintains systems that are critical to the nation's financial infrastructure, such as the production of coin and currency, the disbursement of payments to the American public, revenue collection, and the borrowing of funds necessary to run the federal government. The Treasury Department s primary goal in debt management is to finance government borrowing needs at the lowest cost over time. 20
Benchmarks Used The Treasury Market Treasury rates change throughout the day based on the number of buyers vs sellers trading in the market. When there are more buyers than sellers present, the price of the Treasury being traded goes up (yield goes down). The market refers to this as a rally. When more sellers are present than buyers, prices fall (yields rise) and is called trading off. What is motivating market participants to trade their positions? 21
Treasury Curve So how does this effect my portfolio? Investors buy and sell Treasuries every day trying to anticipate domestic economic data, global economic data, monetary policy, fiscal policy, business cycles, geo political risk, wars, treaties, election results, currency valuations, etc.. The US Treasury market is still considered the safest investment in the world. In times of distress, investors flood into the Treasury market in a flight to quality due to this perceived safety and liquidity. This ever evolving influx of data results a constantly changing market value for your bonds. Price and rate have an inverse relationship in fixed income products. 22
Disturbing Trend? Market Value Shifts Example: You purchase $1,000,000 of FHLB 5yr bullet with a 1.875% coupon at 100 23
Market Value Shifts Market Value Shifts Your timing was perfect as the FOMC surprised the market on the next day with a 100bps rate cut! The Treasury market responds with a parallel shift across the curve. The 5yr bullet holding will now result in a market value gain as your holding yield is above the market rate. As rates fall, bonds prices rise. 24
Market Value Shifts +4.93% Market Value Shifts Yellen hit the wrong button and actually meant to raise rates 100bps. She corrects her mistake the following day. The market responds again with a parallel rate shift +200bps The 5yr bullet holding will now result in a market value loss as your holding yield is below the market rate. As rates rise, bonds prices fall. 25
Market Value Shifts -4.67% Market Value Shifts Duration 26
Market Value Shifts So what other factors determine my price volatility? Structure type Maturity Coupon Optionality Product spread Vol Liquidity Cashflow Credit perception Methods of Bond Measurement Yield Total Return Average Life Duration Convexity Option Adjusted Spread 27
Picking the Right One US Treasuries ARM s Agency Step ups Agency Bullets Corporate Debentures Tax-Free Municipals The Trick? Identifying the good ones! 28
Not the Goal! Accounting Issues 29
Accounting Designations FASB 115 Available for Sale provides the investor the option to sell prior to redemption but requires the institution to report the security at fair value and record any unrealized gain/loss in other comprehensive income Held to Maturity investor claims an intent and ability to hold until redemption (outside unique circumstances) removing any unrealized gain/loss from being recorded Held for Trading purchased with the intent of selling quickly resulting in all unrealized gain/loss being reflected in the institution s income statement Thank you! Questions? Todd Patrick, CFA SVP Capital Markets CenterState Bank 770 850 3403 work 404 358 7730 cell tpatrick@centerstatebank.com 30