lecture materials asset/liability management – year 1€¦ · 30,000 –12,500 = 1.75% ytc (yield...

Lecture Materials

ASSET/LIABILITY MANAGEMENT – YEAR 1

Todd Patrick Senior Vice President - Capital Markets

CenterState Bank Atlanta, Georgia

[email protected] 770-850-3403

August 7, 2017

1

Intro to Investment Portfolio Management

Todd Patrick, CFASVP – Capital MarketsCenterState 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

2

Why Banks Own Bonds

Investment Portfolio Objectives

• Liquidity

• Pledging

• Income

• Capital preservation

• Credit diversification

• IRR management

3

Asset/Liability Made Simple

LoansCash

CD’s and Interest Bearing NMD’s

NMD’s

Bonds

Psst, What is a Bond?

4

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?

5

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

6

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

7

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


– State exempt in some states

– Supplies financing for agriculturally related loans


• Federal Home Loan Mortgage Corporation– FHLMC (Freddie Mac)


– Supplies sources of capital to secondary mortgage markets

– Typically conventional mortgage loans

• Federal National Mortgage Association– FNMA (Fannie Mae)


– Supplies sources of capital to secondary mortgage markets

– Typically conventional mortgage loans

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New Issue Agency Market

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Agency Step‐Ups Bonds

• Step‐up bonds are callable bonds usually issued by FNMA, FHLMC or FHLBthat have the added feature of possible future increases to the coupon overthe 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 betweensteps can and will vary as well.

• The bonds typically carry a call option that is similar to a straight callablewith the time to first call usually between 3‐months, 6‐months or 1‐year. Thecalls are usually quarterly in nature but can vary on occasion.

• Step‐ups are considered structure notes under the policy guidelines appliedby the FDIC and must be reported as such in the call report.

• 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

Corporate Debt

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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 similarcharacteristics (term, rate, structure, etc) are pooled togetherand securitized. The underlying mortgages can be eitherresidential or commercial based. The issuers include GNMA, theGSE’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)

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MBS Passthroughs

Home Loan

Home Loan

Home Loan

Home Loan

Home Loan

Mortgage Backed Security

Investors

Investors

Investors

Constructing CMO’s




Tranche 1

Tranche 2

Tranche 3

Tranche 4

Collateralized Mortgage Obligation

Insurance Co

Banks

Endowments

Hedge Funds

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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

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• A bond's price consists of a “handle" and "32nds".

• 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


For example:

• The 5yr agency is being offered at 97‐12. The handle is 97 andthe 32nd’s are 12. We must convert those values into apercentage to determine the dollar amount we will pay forthe bond. To do so, we first divide the 12 by 32. This equatesto .375 (3/8’s). This amount is added to the handle (97) whichequates to 97.375. Therefore, 97‐12 purchase pricerepresents 97.375% of the par value of a bond. A $1mminvestment in this 5yr agency would result in a book value of$973,750 at purchase.

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Another example:

• The 7yr agency is being offered at 102‐22. The handle is 102and the 32nds are 22. We must convert those values into apercentage to determine the dollar amount we will pay forthe bond. To do so, we first divide the 22 by 32. This equals.6875. This amount is added to the handle (102) whichequates to 102.6875. Therefore, 102‐22 purchase pricerepresents 102.6875% of the par value of a bond. A $1mminvestment 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

15


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 RelationshipThe impact of amortization expense

• $1,000,000 of a 5yr agency offered at 102‐16 = $1,025,000


• 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

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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 RelationshipThe 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%)

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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 RelationshipThe impact of call options on amortization

• $1,000,000 of a 5yr/2yr agency offered at 102‐16 = $1,025,000


• 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

18



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


Bonds Purchased at Par

Coupon YTCYTMPrice

19


Coupon

YTCYTM

Price

Bonds Purchased at a Discount


YTCYTM

Bonds Purchased at a Premium

20

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.

21

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?

22

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.

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Disturbing Trend?

Market Value Shifts

Example:

You purchase $1,000,000 of FHLB 5yr bullet with a 1.875% coupon at 100

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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.

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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.

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Market Value Shifts

-4.67%

Market Value Shifts ‐ Duration

27

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

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Picking the Right One

US Treasuries

Tax-Free Municipals

ARM’s

CorporateDebentures

Agency Step‐ups Agency

Bullets

The Trick?

Identifying the good ones!

29

Not the Goal!

Accounting Issues

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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

[email protected]

lecture materials asset/liability management – year 1€¦ · 30,000 –12,500 = 1.75% ytc (yield...

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