Chapter Ten The Investment Function in FinancialServices Management

Chapter Ten The Investment Function in Financial-Services Management Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Key Topics • Nature and Functions of Investments • Investment Securities Available: Advantages and Disadvantages • Measuring Expected Returns • Taxes, Credit, and Interest-Rate Risks • Liquidity, Prepayment, and Other Risks • Investment Maturity Strategies • Maturity Management Tools Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -2

Introduction • Depository institutions devote a significant portion of their asset portfolios to investments in securities ▫ Nonbank financial-service providers such as insurance companies, pension funds, and mutual funds often devote an even bigger portion of their assets to investment securities • Investments perform a number of vital functions in the asset portfolios of financial firms, providing income, liquidity, diversification, and shelter for at least a portion of earnings from taxation • Investments also tend to stabilize earnings, providing supplemental income when other sources of revenue are in decline Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -3

EXHIBIT 10– 1 Investments: The Crossroads Account on a Depository Institution’s Balance Sheet Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -4

Investment Instruments Available to Financial Firms • The number of financial instruments available for financial institutions to add to their portfolios is both large and growing • Each financial instrument has different characteristics with regard to expected yields, risk, sensitivity to inflation, and sensitivity to shifting government policies and economic conditions • It is useful to divide them into two broad groups 1. Money market instruments ▫ Reach maturity within one year and are noted for their low risk and ready marketability 2. Capital market instruments ▫ Have remaining maturities beyond one year and are generally noted for their higher expected rate of return and capital gains potential Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -5

Investment Instruments Available to Financial Firms (continued) • Investment security portfolios help to ▫ ▫ ▫ ▫ ▫ Stabilize the bank’s income Offset credit risk exposure Provide geographic diversification Provide backup source of liquidity Reduce tax exposure Serve as collateral Hedge against interest rate risk Provide flexibility Dress up a bank’s balance sheet • Some authorities refer to investments as the crossroads account Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -6

Investment Instruments Available to Financial Firms (continued) • Federal regulations stress the need for every regulated institution to develop a written investment policy giving specific guidelines on ▫ The quality or degree of default risk exposure the institution is willing to accept ▫ The desired maturity range and degree of marketability sought for all securities purchased ▫ The goals sought for its investment portfolio ▫ The degree of portfolio diversification to reduce risk the institution wishes to achieve Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -7

Popular Money Market Investment Instruments • • Treasury Bills Short-Term Treasury Notes and Bonds Federal Agency Securities Certificates of Deposit Eurocurrency Deposits Banker’s Acceptances Commercial Paper Short-Term Municipal Obligations Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -8

Popular Capital Market Investment Instruments • Treasury Notes and Bonds • Municipal Notes and Bonds • Corporate Notes and Bonds Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -9

Investment Instruments Developed More Recently • Structured Notes ▫ Arose from security dealers who assembled pools of federal agency securities and offered investments officers a packaged investment whose interest yield could be reset periodically based on what happened to a reference interest rate • Securitized Assets ▫ Pass-through securities ▫ CMOs ▫ Mortgage-backed bonds ▫ Guarantees from government agencies; higher average yields; lack of good-quality assets; superior liquidity • Stripped Securities ▫ Principal-Only (PO) and Interest-Only (IO) securities Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -10

Investment Securities Held by Banks • Just a few types of securities dominate bank investment portfolios 1. U. S. government (especially Treasury) securities 2. Obligations of various federal agencies such as the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC), and the Government National Mortgage Association (GNMA), especially in the form of mortgage-backed securities 3. State and local government obligations (municipals) 4. Nonmortgage-related asset-backed securities (such as obligations backed by credit card and automobile loans) 5. Equities (common and preferred stock) Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -11

TABLE 10– 3 Investment Securities Held by FDIC-Insured Commercial Banks, 2010 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -12

Factors Affecting Choice of Investment Securities • The principal factors bearing on which investments are chosen include 1. Expected rate of return 2. Tax exposure 3. Interest rate risk 4. Credit or default risk 5. Business risk 6. Liquidity risk 7. Call risk 8. Prepayment risk 9. Inflation risk 10. Pledging requirements Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -13

Factors Affecting Choice of Investment Securities (continued) • Expected Rate of Return ▫ Yield to Maturity (YTM) versus Holding Period Yield (HPY) ▫ Example ▫ An investments officer is considering purchasing a $1, 000 par-value Treasury note that promises an 8 percent coupon rate and matures in five years with a current of $900 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -14

Factors Affecting Choice of Investment Securities (continued) • Tax Exposure ▫ The tax status of state and local government bonds ▫ Bank qualified bonds ▫ Tax swapping tool ▫ The portfolio shifting tool Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -15

Factors Affecting Choice of Investment Securities (continued) • Tax Exposure ▫ To evaluate the attractiveness of municipals, financial firms calculate the net after-tax returns and/or the tax-equivalent yields to enable comparisons with other investment alternatives ▫ The net after-tax return of bank-qualified municipals is calculated as Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -16

Factors Affecting Choice of Investment Securities (continued) • Tax Exposure ▫ The tax advantage of a qualified bond is determined as Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -17

Factors Affecting Choice of Investment Securities (continued) • Tax Exposure ▫ Suppose a bank purchases a bank-qualified bond from a small city, county, or school district and the bond carries a nominal gross rate of return of 7 percent ▫ The bank had to borrow the funds needed to make this purchase at an interest rate of 6. 5 percent and is in the 35 percent tax bracket ▫ The bond’s net annual after-tax return (after all funding costs and taxes) must be: Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -18

Factors Affecting Choice of Investment Securities (continued) • Tax Exposure ▫ In years when loan revenues are high, it may be beneficial to engage in tax swapping ▫ In a tax swap, the lending institution sells lower-yielding securities at a loss in order to reduce its current taxable income, while simultaneously purchasing new higher-yielding securities in order to boost future returns ▫ Lending institutions also do a great deal of portfolio shifting in their holdings of investment securities, with both taxes and higher returns in mind Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -19

Factors Affecting Choice of Investment Securities (continued) • Interest Rate Risk ▫ Rising interest rates lowers the value of previously issued bonds ▫ Longest –term bonds suffer the greatest Losses ▫ Many interest rate risk tools including futures, options, and swaps exist today Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -20

Factors Affecting Choice of Investment Securities (continued) • Credit or Default Risk ▫ The risk that the security issuer may default on the principal or interest owed ▫ Three major credit ratings agencies 1. Moody’s 2. Standard & Poor’s 3. Fitch’s Rating Service Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -21

TABLE 10– 4 Default Risk Ratings on Marketable Investment Securities (including long-term corporate obligations) Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -22

Factors Affecting Choice of Investment Securities (continued) • Business Risk ▫ Risk that the economy of the market area the financial institution serves may slow down ▫ Security portfolio can offset this risk ▫ Securities can be purchased from outside the market area served • Liquidity Risk ▫ Can a security be converted into cash quickly and easily without significant loss in value? ▫ A key issue – the breadth and depth of a security’s resale market Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -23

Factors Affecting Choice of Investment Securities (continued) • Call Risk ▫ Many corporations and some governments that issue securities reserve the right to call in instruments in advance of maturity and pay them off ▫ Because such calls usually take place when market interest rates have declined (and the borrower can get lower interest costs), the financial firm investing in callable securities runs the risk of an earnings loss because it must reinvest its recovered funds at lower interest rates Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -24

Factors Affecting Choice of Investment Securities (continued) • Prepayment Risk ▫ A form of risk specific to asset-backed securities ▫ This form of risk arises because the realized interest and principal payments from a pool of securitized loans may be quite different from the cash flows expected originally ▫ Variations in cash flow to holders of the securities backed by these loans can arise from 1. Loan refinancings 2. Turnover of the assets behind the loans Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -25

Factors Affecting Choice of Investment Securities (continued) • Prepayment Risk ▫ This means that the market value of a loan-backed security depends not only upon the promised cash flows it will generate, but also on the projected prepayments and loan defaults that occur Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -26

Factors Affecting Choice of Investment Securities (continued) • Inflation Risk ▫ Purchasing power from a security or loan may be eroded by rising prices ▫ Recently developed inflation risk hedge – Treasury Inflation Protected Securities (TIPS) ▫ Both coupon payments and principal adjusted annually for inflation based on Consumer Price Index ▫ TIPS do not protect investors from all the effects of inflation, such as moving into higher tax brackets ▫ Carry market risk like regular bonds ▫ Tend to be less liquid Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -27

Factors Affecting Choice of Investment Securities (continued) • Pledging Requirements ▫ Depository institutions in the United States cannot accept deposits from federal, state, and local governments unless they post collateral acceptable to these governmental units ▫ State and local government deposit pledging requirements differ widely from state to state, though most allow a combination of federal and municipal securities to meet government pledging requirements ▫ If a financial institution uses repurchase agreements (RPs) to raise money, it must pledge some of its securities (usually Treasury and federal agency issues) as collateral in order to receive funds at the lowest RP rate Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -28

Investment Maturity Strategies • • • The Ladder or Spaced-Maturity Policy The Front-End Load Maturity Policy The Back-End Load Maturity Policy The Barbell Strategy The Rate Expectation Approach Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -29

EXHIBIT 10– 2 Alternative Maturity Strategies for Managing Investment Portfolios Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -30

EXHIBIT 10– 2 Alternative Maturity Strategies for Managing Investment Portfolios Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -31

EXHIBIT 10– 2 Alternative Maturity Strategies for Managing Investment Portfolios Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -32

EXHIBIT 10– 3 Additional Maturity Strategies for Managing Investment Portfolios Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -33

EXHIBIT 10– 3 Additional Maturity Strategies for Managing Investment Portfolios Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -34

Maturity Management Tools • The Yield Curve ▫ Picture of how market interest rates differ across various maturities ▫ Constructed most easily with Treasury securities ▫ Provides information about under and over priced securities ▫ Provides information about the risk-return trade-off • Duration ▫ Present value weighted average maturity of the cash flows ▫ Can be used to insulate the securities from interest rate changes Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -35

EXHIBIT 10– 4 The Yield Curve Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -36

Maturity Management Tools (continued) • Immunization ▫ Duration also suggests a way to minimize damage to an investing institution’s earnings that changes in market interest rates may cause ▫ Duration gives the investments officer a tool to reduce his or her institution’s exposure to interest rate risk ▫ Portfolio immunization is protecting securities purchased from loss of return, no matter which way interest rates go Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -37

Quick Quiz • Why do banks and other institutions choose to devote a significant portion of their assets to investment securities? • What are the principal money market and capital market instruments available to institutions today? • What types of investment securities do banks seem to prefer the most? By size of institutions? Explain. • If a government bond is expected to mature in two years and has a current price of $950, what is the bond’s YTM if it has a par value of $1000 and a promised coupon rate of 10 percent? Suppose this bond is sold one year after purchase for a price of $970. What would this investor’s holding period return be? • How can the yield curve and duration help an investment officer choose which securities to acquire or sell? Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 10 -38