Chapter 16
Managing the Investment Portfolio
Chapter Objectives
1. Describe the bank’s role as a securities dealer and in managing a trading account.
2. Explain the objectives of the investment portfolio.
3. Describe the composition of the average bank’s investment portfolio.
4. Examine the characteristics of securities comprising the investment portfolio.
5. Explain the nature and impact of prepayment risk in mortgage-backed securities.
6. Describe the nature of the market for asset-backed securities and provide an example of an
asset-backed security.
7. Summarize basic investment policy guidelines.
8. Compare the laddered maturity strategy with the barbell (long and short) strategy when
determining the appropriate maturity for new security purchases.
9. Discuss the advantages and disadvantages of active versus passive investment strategies.
10. Describe maturity strategies to ride the yield curve using total return analysis.
11. Examine the relationship between interest rates and the business cycle. Indicate why
contra-cyclical investment strategies often provide the highest returns.
12. Describe how prices of securities with embedded options are affected by changing interest
rates. Explain how effective duration and convexity can be used to assess price volatility.
13. Introduce option-adjusted spread (OAS) as a measure of incremental return.
14. Explain how the Tax Reform Act of 1986 changed the tax treatment of municipal bonds and
affected the comparison of a1er-tax yields on taxables and municipals.
15. Describe the strategies underlying security swaps and leveraged arbitrage.
Key Concepts
1. Banks perform three functions within trading activities. They offer investment advice,
maintain an inventory of securities to sell and stand willing to buy securities, and they
speculatively trade securities for the banks own account.
2. The fundamental objectives of the investment portfolio are:
a. safety or preservation of capital
b. liquidity
c. yield
d. diversi;cation of credit risk
e. to help manage interest rate risk exposure
f. to meet pledging requirements
3. Banks earn profit from trading activities by charging higher prices for securities sold than
what they pay for the securities, and charging fees (requiring compensating balances) for
investment advice, and guessing correctly when speculating on interest rates. Banks earn a
return on investment securities in the form of coupon interest and capital gains (losses).
4. Banks must classify securities that they buy at the time of purchase into one of three
categories based on the objective underlying the purchase. Trading account securities are
those held brie<y with the intent to sell. Held to maturity securities are those the bank
expects to own until they mature. Available for sale securities are those the bank may
choose to sell prior to maturity. Each category has a different accounting treatment
regarding what is reported on the balance sheet (cost or market) and income statement.
5. Over time, banks have decreased their holdings of U.S. Treasury and municipal securities
substituting agency and corporate/foreign securities. The most popular agency securities are
different forms of mortgage-backed securities. The larger the bank, the smaller is the size of
the investment portfolio relative to total assets. The largest banks, in turn, own more agency
and corporate securities and other securities. Small banks own proportionately more U.S.
Treasury and municipal securities.
6. Many banks buy taxable agency and mortgage-backed securities with embedded options.
The most common agency security with options is a callable bond. The call feature allows
the issuer the call the bond (pay the principal) prior to maturity at its discretion. This is risky
to an investor because the bond’s price will not rise much above the call price when rates fall
and the issuer will prepay the bond when rates fall to refinance at lower rates. Thus, the
investor loses the above market coupon interest that might have been earned on a bond
without the call feature. Mortgage-backed securities are subject to prepayment risk. As
market rates on mortgages fall, these securities prepay at higher rates. Investors thus see a
return of principal faster than originally expected (if the prepayments are not anticipated)
such that they invest their cash <ows earlier at lower rates. They again lose when
prepayments rise sharply.
7. One of the dominant trends in banking is the securitization of loans. Firms originate loans,
package them into pools, and issue securities collateralized by the loans. Banks act as buyers
of some of these securities for their investment portfolios. The most common of these loans
are called asset-backed securities and include securities collateralized by credit card loans,
automobile receivables, home equity loans, and student loans.
8. Municipal bonds are aBractive because they pay rates that are tax-sheltered. Municipals
include both short-term money market instruments and long-term general obligation and
revenue bonds. Some municipal do not effectively pay interest that is tax-exempt, so banks
must be careful as to which securities they buy.
9. A bank’s ALCO is responsible for establishing investment policy guidelines. The guidelines
specify return objectives and constraints regarding the composition of securities, target
maturities, etc.
10. Laddered maturity strategies are passive because they require liBle analysis or expertise.
They produce yields that represent average interest rates over the investment horizon. The
barbell strategy requires that investors concentrate their security holdings either short-term
for liquidity purposes or longer-term for yield. In most cases, the barbell strategy produces
higher average yields than the laddered strategy.
11. Active portfolio management involves taking risks to improve returns. specific strategies
involve altering the maturity/duration of investments in anticipation of rate moves,
swapping securities for yield, tax, or default risk reasons, and occasionally liquidating
discount bonds to reinvest at higher rates. Generally, banks that follow active strategies
classify most securities as available for sale because they may want to sell the instruments
prior to maturity.
12. Interest rates and the level of economic activity vary coincidentally over time. Interest rates
rise when aggregate spending rises and borrowers compete for financing. Interest rates fall
when spending and borrowing pressures decline. Movements in short-term rates typically
exceed movements in long-term rates.
13. Contra-cyclical investing requires that banks increase the size of their investment portfolio
and lengthen maturities when loan demand is high. This generally coincides with peaks in
the level of interest rates. The cost is that some loan customers are rationed out of the
market and the bank may lose them as permanent customers. When loan demand is low,
banks should keep investments short-term because rates are generally low and will likely
increase. Such investment timing should enable banks to lengthen security maturities when
interest rates are relatively high and thus earn above-average coupon interest.
14. Riding the yield curve involves buying securities with a maturity longer than the bank’s
(investor’s) holding period. With an upsloping yield curve, long-term rates exceed short-term
rates. If the level of rates falls, stays constant, or rises only modestly, the purchase of a
long-term security will increase total return. Total return is greater than buying a
shorter-term security due to the higher coupon interest, higher reinvestment income, and
capital gain if rates move as anticipated.
15. Many banks buy callable agency securities and mortgage-backed securities that contain
embedded options. Callable bonds can be called (prepaid) prior to maturity at the issuer’s
discretion. Mortgage-backed securities (MBSs) can be prepaid at speeds different than that
expected when borrowers refinance. These options are diGcult to value. In general, the
bank as investor sells the option to the security issuer (mortgage borrower). In turn, the
bank receives a higher promised yield. If interest rates fall, the security will not increase in
price beyond some base level because the security will be called or prepaid.
16. The concepts of effective duration and effective convexity describe the price sensitivity of
securities with embedded options. These measures provide an estimate of the price
sensitivity of the underlying security, on average, in rising versus falling rate environments.
17. Many analysts and investors use option-adjusted spread (OAS) to assess whether a specific
security with embedded options is priced reasonably. OAS represents the incremental yield
earned by an investor over the Treasury spot curve a1er accounting for the value of the
embedded option. It is estimated by simulating interest rates and when options will be
exercised, then determining the yield spread over the spot curve that discounts expected
cash <ows to the prevailing security price, on average.
18. The Tax Reform Act of 1986 reduced the tax advantage to most municipal bonds. Only bank
qualified municipals are tax-sheltered to banks, which can deduct 80% of the carrying cost to
finance their purchase. Banks can deduct none of the carrying costs associated with
non-bank qualified municipals. The impact is that the yield on nonqualified municipals is
always below that for other comparable risk and maturity securities. Banks that pay taxes at
the full corporate income tax rate still ;nd that qualified municipals yield more than
comparable maturity and risk taxable securities.
19. Banks use security swaps to change the risk and return profile of the securities portfolio.
Banks must report gains for securities sold at prices above cost and losses for securities sold
at prices below cost. Gains can be o2set by losses. Generally, selling discount securities
allows the bank to share losses with the government because the losses reduce tax
liabilities. Selling securities at a gain increases reported net income and ROA, but reduces
cash <ow long-term as future coupon interest is reduced unless the bank buys a riskier
security.
Teaching Suggestions
The material in Chapter 16 provides an overview of the types of securities that banks buy as part
of their investment portfolios, why they buy securities, and the basic risk and return features of
the most popular taxable and tax-sheltered securities. It represents an extension of information
that students have generally been introduced to in other finance and economics classes. Have
students examine the annual report of a large super-regional bank and a community bank to
compare the size of the investment portfolio and the types of securities owned.
In recent years, banks have been forced to classify their securities holdings as held to maturity,
available for sale, and trading account securities. Select different bank balance sheets,
particularly from 1996 forward to compare the reporting. These balance sheets should reveal
different magnitudes of securities in trading accounts and classified as held to maturity or
available for sale. This should serve as a good discussion point in comparing the impact of
accounting treatment on financial decisions.
A hot trend in bank investments has been the increasing emphasis on buying securities with
embedded options. Discuss the types of securities with the most common options in bank
portfolios, callable agency, callable municipals, and mortgage-backed securities. differentiate
between as many types of mortgage-backed securities as possible. If your institution has access
to a Bloomberg terminal, show students the type of information that is available and the
complexity of the marketplace for ;xed-income securities. Describe the nature of the options
embedded in some bonds, the fact that the bank as buyer of securities is actually selling the
option to the issuer, how the bank is compensated for selling the option (presumably in a higher
yield), and when the option will likely be exercised. Have students discuss whether they would
like callable bonds to be called and mortgage-backed securities to be prepaid if they represent
the investor. If you have access to Bloomberg, demonstrate option-adjusted spread analysis via
different Bloomberg examples.
Have students read carefully the investment policy section. Discuss why banks buy bonds, what
the role of bonds is in the bank’s portfolio, how bonds are priced relative to loans (banks are
price takers), and the corresponding implications for asset and liability management.
The chapter discusses strategies related to 1) the maturity choice, 2) the timing of when to buy
short-term versus long-term securities relative to the business cycle, 3) buying securities with
embedded options, 4) buying tax-sheltered municipals, and 5) security swaps. Discuss each in
turn.
Key points include:
1. The barbell strategy has historically outperformed the laddered-maturity strategy.
2. A contra-cyclical investment strategy, buying longer-term securities when the yield curve
inverts, allows banks to earn above-average returns on the securities portfolio.
3. Banks that buy callable agency and mortgage-backed securities are selling options to the
issuers. The question is whether they are being compensated adequately for the risk.
4. Bank qualified municipals still provide higher a1er-tax yields than comparable taxable
securities for banks that pay the full corporate income tax.
5. Security swaps are aBractive when changing the risk and return profile of the bank. A bank
can minimize its tax liabilities if it can simultaneously sell securities at gains and losses.
Make an effort to have students distinguish between total return (Exhibit 13.14) as a income
measure, yield to maturity, and current yield. Banks manage their investment portfolios
focusing on each of these. Also, ask students to assess how and when they should adjust the
size of the investment portfolio relative to loans and other assets. Refer to Exhibit 13.11 and
discuss the contra-cyclical investment strategy. In this instance, a bank should buy more
securities and longer-term securities when interest rates are at their cyclical peaks. This timing
occurs as the economy heats up and the yield curve inverts. Of course, this is the time when
loan demand is high and banks typically believe that they have few funds to invest. Banks are
loan driven in their own cultures. Thus, when they should be buying more securities and making
fewer loans because the economy is headed into a recession, banks are making more loans and
shrinking the size of their investments. Similarly, banks should be buying long-term securities,
but they buy short-term ones because they offer what is perceived to be more aBractive yields.