Introduction

• The primary function of most banks and other depository institutions is not to buy and sell bonds, but rather to make loans to businesses and individuals. Yet buying and selling bonds has its place because not all of a financial firm’s funds can be allocated to loans.
  • For one thing, many loans are illiquid – they cannot easily be sold or securitized prior to maturity if a lending institution needs cash in a hurry.
  • Another problem is that loans are among the riskiest assets, generally carrying the highest customer default rates of any from of credit.
  • Moreover, for small and medium-size depository institutions, at least, the majority of loans tend to come from the local area. Therefore, a significant drop in local economic activity can weaken the quality can weaken the quality of the average lender’s loan portfolio, though the widespread use of securitization, loan sales, and credit derivatives may help to insulate many lenders serving local areas.
  • Also, loan income is usually taxable for banks and selected other financial institutions, necessitating the search for tax shelters in years when earnings from loans are high.

For all these reasons depository institutions devote a significant portion of their asset portfolios (usually between 20 percent to 33 percent of all assets) to investments in securities that are under the management of investments officers. Moreover, several non bank financial-service providers – insurance companies, pension funds, and mutual funds, for example, often devote an even bigger portion of their assets to investment securities. These instruments typically include government bonds and notes; corporate bonds, notes, and commercial paper; asset-backed securities arising from lending activity; domestic and Eurocurrency deposits; and some common and preferred stock where permitted by law.

• 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.

• Some authorities refer to investments as the crossroads account. Investments held by depository institutions literally stand between cash, loans, and deposits.
  • When cash is low, some investments will be sold in order to raise more cash.
  • On the other hand, if cash is too high, some of the excess cash will be placed in investment securities.
  • If loan demand is weak, investments will rise in order to provide more earning assets and maintain profitability.
  • But, if loan demand is strong some investments will be sold to accommodate the heavy loan demand.
  • Finally, when deposits are not growing fast enough, some investment securities will be used as collateral to borrow non-deposit funds.

No other account on the balance sheet occupies such a critical intersection as do investments.

Investment Instruments Available to Financial Firms

• To examine the different investment vehicles available, it is useful to divide them into two broad groups:

1. Money market instruments, which reach maturity within one year and are noted for their low risk and ready marketability, and

2. Capital market instruments, which have remaining maturities beyond one year and are generally noted for their higher expected rate of return and capital gains potential.

Popular Money Market Investment instruments

1. TreasuryBills – These are one of the most popular of all short-term investments.

• They are debt obligations of the United States government that, by law, must mature within one year from date of issue.
• T-bills are issued in weekly and monthly auctions and are particularly attractive to financial firms because of their high degree of safety.
• Bills are supported by the taxing power of the federal government, their market prices are relatively stable, and they are readily marketable.
• Moreover, T-bills can serve as collateral for attracting funds from other institutions.
• Bills are issued and traded at a discount from their par (face) value.
• The rate of return (yield) on T-bills is figured by the bank discount method, which uses each bill’s par value at maturity as the basis for calculating its return.

2. Short-Term Treasury Notes and Bonds – At the time they are issued, Treasury notes and Treasury bonds have relatively long original maturities: 1 to 10 years for notes and over 10 years for bonds. However, when these securities come within one year of maturity, they are considered money market instruments.

• While T-notes and bonds are more sensitive to interest rate risk and less marketable than T-bills, their expected returns are usually higher than for bills with greater potential for capital gains.
• T-notes and bonds are coupon instruments, which means they promise investors a fixed rate of return, though the expected return may fall below or climb above the promised coupon rate due to fluctuations in market price.
• All negotiable Treasury Department securities are issued by electronic book entry. Any interest and principal payments earned are deposited directly into the owners’ checking or savings account. This approach means not only greater convenience but also increased protection against theft.

3. Federal Agency Securities – Marketable notes and bonds sold by agencies owned by or sponsored by the federal government are known as federal agency securities. Familiar examples include securities issued by the Federal National Mortgage Association (Fannie Mae), the Farm Credit System (FCS), the Federal Land Banks (FLBs), and the Federal Home Loan Mortgage Corporation (Freddie Mac).

• Most of these instruments are not formally guaranteed by the federal government, though many believe Congress would rescue an agency in trouble. This implied
• government support keeps agency yields close to those on Treasury securities and contributes to the high liquidity of many agency securities.
• Interest income on agency-issued notes is federally taxable and, in most cases, subject to state and local taxation as well.

4. Certificates of Deposit – A certificate of deposit (CD) is simply an interest-bearing receipt for the deposit of funds in a depository institution.

• The primary role of CDs is to provide depository institutions with an additional source of funds. Banks often buy CDs issued by other depository institutions, believing them to be an attractive, lower-risk investment.
• CDs carry a fixed term and a penalty for early withdrawal.
• Depository institutions issue both small consumer-oriented CDs, from $500 to $100,000, and larger business-oriented or institution-oriented CDs (often called jumbos or negotiable CDs) with denominations over $100,000 (though only the first $250,000 is federally insured).
• CDs have negotiated interest rates that, while normally fixed, may fluctuate with market conditions.

5. International Eurocurrency Deposits – Eurocurrency deposits are time deposits of fixed maturity issued in million-dollar units by the world’s largest banks headquartered in financial centers around the globe, but mainly in London.

• Most of these international deposits are of short maturity – 30, 60, or 90 days.
• They are not insured, and due to their perceived higher credit risk, they often carry slightly higher market yields than domestic time deposits issued by comparable-size U.S. banks.

6. Bankers’ Acceptances – They represent a bank’s promise to pay the holder a designated amount of money on a designated future date. Most arise from a financial firm’s decision to guarantee the credit of one of its customers who is exporting, importing, or storing goods or purchasing currency. In legal language, the financial firm issuing the credit guarantee agrees to be the primary obligor, committed to paying off a customer’s debt in return for a fee. The issuing institution supplies its name and credit standing so its customer will be able to obtain credit elsewhere at lower cost.

• These are considered to be among the safest of all money market instruments.
• Because acceptances have a resale market, they may be traded from one investor to another before reaching maturity If the current holder sells the acceptances, this does not erase the issuer’s obligation to pay off its outstanding acceptances at maturity. However, by selling an acceptance, the holder adds to its reserves and transfers interest rate risk to another investor.
• The acceptance is a discount instrument and, therefore, is sold at a price below par.
• Rates of return on acceptances generally lie close to the yields on Eurocurrency deposits and Treasury bills.
• Another important advantage of acceptances is that they may qualify for discounting (borrowing) at the Federal Reserve Banks, provided they are eligible acceptances, which means they must be denominated in U.S. dollars, normally cannot exceed six months to maturity, and must arise from the export or import of goods or from the storage of marketable commodities.

7. Commercial Paper – The are short-term, unsecured IOUs offered by major corporations – an attractive investment safer than many types of loans.

• Commercial paper sold in the US is of relatively short maturity – mostly maturing in 90 days or less, and generally is issued by borrowers with the highest credit ratings. European paper generally carries longer maturities and higher interest rates than U.S. paper due to its greater perceived credit risk; however, there is a more active resale market for Europaper than for most U.S. paper issues. Most commercial paper is issued at a discount from par, though some bears a promised rate of return (coupon).

8. Short-Term Municipal Obligations – State and local governments issue a variety of short- term debt instruments to cover temporary shortages.

• Two of the most common are tax-anticipation notes (TANs), issued in lieu of future tax revenues, and revenue-anticipation notes (RANs), issued to cover expenses from special projects, such as the construction of a toll bridge or highway until revenues flow in.
• All interest earned on municipal notes is exempt from U.S. federal income taxation, so they may be attractive to investors bearing relatively high income tax rates. But the tax savings associated with municipals has been sharply limited for U.S. banks in recent years, reducing their attractiveness relative to federal and privately issued securities.
• At the same time, some state and local governments have encountered serious financial problems in the wake of the Great Recession of 2007-2009 that weakened the credit quality of their notes, and their volatility has increased.

Popular Capital Market Investment Instruments

1. Treasury Notes and Bonds– They are among the safest assets investing institutions can buy.

• T-notes are available in a wide variety of maturities (ranging from 1 year to 10 years when issued) and in large volume.
• T-bonds (with original maturities of more than 10 years) are traded in a more limited market with wider price fluctuations.
• Treasury bonds and notes carry higher expected returns than T-bills, but present an investing institution with greater price and liquidity risk. They are issued normally in denominations of $1,000, $5,000, $10,000, $100,000, and $1 million.
• The Eurozone government bond market is valued below the U.S. government security market with serious European budget problems.

2. Municipal Notes and Bonds– Long-term debt obligations issued by states, cities, and other local governmental units are known collectively as municipal bonds.

• Interest on the majority of these bonds is exempt from U.S. federal income tax provided they are issued to fund public, not private, projects.
• Capital gains on municipals are fully taxable, however, except for bonds sold at a discounted price.
• Unfortunately, municipals are often not very liquid as few issues trade on any given day.
• The majority of municipal bonds fall into one of two categories:

• general obligation (GO) bonds, backed by the full faith and credit of the issuing government, which means they may be paid from any available source of revenue (including the levying of additional taxes); and
• revenue bonds, which can be used to fund long-term revenue-raising projects and are payable only from certain stipulated sources of funds.

3. Corporate Notes and Bonds – Long-term debt securities issued by corporations are usually called corporate notes when they mature within five years or corporate bonds when they carry longer maturities. There are many different varieties, depending on the types of security pledged (e.g., mortgages on property versus debentures), purpose and terms of issue.

• Corporate notes and bonds generally are more attractive to insurance companies and pension funds than to banks
• They have higher credit risk and returns relative to government securities and a more limited resale market. Their yield spread over government bonds widens when investors become more concerned about credit quality and economic downturns.

Investment Instruments Developed Recently

• The range of investment opportunities for investing institutions has expanded in recent years. Some new securities have been developed; some of these are variations on traditional notes and bonds, while others represent relatively young investment vehicles. Examples include structured notes, securitized assets, and stripped securities.

1. Structured Notes – In their search to protect themselves against shifting interest rates, many investing institutions added structured notes to their portfolios during the 1990s.

• Most of these notes are assembled pools of federal agency whose interest yield could be reset periodically based on what happened to a reference interest rate, such as a U.S. Treasury bond rate.
• A guaranteed floor rate and cap rate may be added in which the investment return could not drop below a stated (floor) level or rise above some maximum (cap) level.
• Some structured notes carry multiple coupon (promised) rates that periodically are given a boost (“step-up”) to give investors a higher yield; others carry adjustable coupon (promised) rates determined by formula.
• The complexity of these notes has resulted in substantial losses for some investing institutions, especially where interest rate risk is rising.

2. Securitized Assets – These are backed by selected loans of uniform type and quality, home loans and credit card loans. The most common securitized assets that depository institutions have employed as investments are based upon home mortgages.

• There are at least three main types of mortgage-backed securitized assets:

a) Pass-through securities – These arise when a lender pools a group of similar home mortgages appearing on its balance sheet, removes them from that balance sheet into an account controlled by a legal trustee, and issues securities using the mortgage loans as collateral. As the mortgage loan pool generates principal and interest payments, these payments are “passed through” to investors holding the mortgage-backed securities. Repayment of principal and interest on the calendar dates promised may be guaranteed by Ginnie Mae, an agency of the U.S. government, in return for a small fee.

b) Collateralized mortgage obligations (CMOs) – These are pass-through securities divided into multiple classes (tranches), each with a different promised (coupon) rate and level of risk exposure. CMOs arise either from securitizing of mortgage loans themselves or from securitizing pass-through securities. Closely related to CMOs are REMICs, or real estate mortgage investment conduits, that also partition the cash flow from a pool of mortgage loans or mortgage-backed securities into multiple maturity classes in order to help reduce the cash-flow uncertainty of investors.

c) Mortgage-backed bonds – Unlike pass-throughs and CMOs, where mortgage loans are removed from the balance sheet, mortgage backed bonds (MBBs) and the mortgage loans backing them stay on the issuer’s balance sheet. The financial institution issuing these bonds will separate the mortgage loans held on its balance sheet from its other assets and pledge those loans as collateral to support the MBBs. A trustee acting on behalf of the mortgage bondholders keeps track of the dedicated loans and checks periodically to be sure the market value of the loans is greater than what is owed on the bonds.

• The principal risk to an investor buying these securities is prepayment risk.
• Pass-throughs, CMOs, and other securitized assets had been among the largest segments of the financial marketplace when purchases of new homes reached record levels. Several factors accounted for the popularity of these asset-backed investment securities, including:

i) Guarantees from government agencies (in the case of home-mortgage-related securities) or from private institutions (such as banks or insurance companies pledging to back credit card loans).

ii) The higher average yields generally available on securitized assets than on most government securities.

iii) The lack of good-quality assets of other kinds in some markets around the globe.

iv) The superior liquidity and marketability of securities backed by loans compared to the liquidity and marketability of loans themselves.

• However, the credit crisis of 2007-2009 revealed substantial weaknesses among these investments, including sharp deterioration in their market values as the underlying assets (loans) experienced a significant rise in default rates. Trading volume among securitized assets plummeted, with minor recovery later on.

3. Stripped Securities– Dealers create stripped securities by separating the principal and interest payments from an underlying debt security and selling separate claims to these two promised income streams. Claims against only the principal payments are called PO (principal-only) securities, while claims against only the promised interest payments are referred to as IO (interest only) securities.

• Stripped securities often display different behavior from the underlying securities from which they come.
• Stripped securities offer interest-rate hedging possibilities to help protect an investment portfolio against loss from interest rate changes.
• The securities whose interest and principal payments are most likely to be stripped today include U.S. Treasury notes and bonds and mortgage-backed securities.
• Both PO and IO bond strips are really zero coupon bonds with no periodic interest payments; they therefore carry zero reinvestment risk.
• POs tend to be more price sensitive to interest rate changes than regular bonds, whereas IOs tend to be less price sensitive.
• The investments officer of a financial firm must consider several factors in deciding which investment securities to buy, sell, or hold. 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

Factors Affecting Choice of Investments

1. Expected Rate of Return – For most investments, determination of the total rate of return requires the portfolio manager to calculate the yield to maturity (YTM) if a security is to be held to maturity or the planned holding period yield (HPY) between point of purchase and point of sale. It is advisable to use the TVM buttons in the financial calculator and solve for YTM and HPY directly.

• The yield to maturity formula determines the rate of discount (or yield) on a loan or security that equalizes the market price of the loan or security with its expected stream o f cash flows (interest and principal). Suppose the officer is considering purchasing a $1,000 par-value Treasury note that promises an 8 percent coupon rate (or 1000 × 0.08 — $80) and is slated to mature in five years. If the T-note’s current price is $900, then

\[ 900 = \frac{80}{(1 + YTM)^1} + \frac{80}{(1 + YTM)^2} + \dots + \frac{80}{(1 + YTM)^5} + \frac{1,000}{(1 + YTM)^5}\]

• However, some investments must be sold off prior to maturity to accommodate new loan demand or to cover deposit withdrawals. To deal with this situation, the investments officer needs to calculate the holding period yield (HPY). The HPY is simply the rate of return (discount factor) that equates a security’s purchase price with the stream of income expected until it is sold to another investor. For example, suppose the 8 percent T-note described before this slide and currently priced at $900 was sold at the end of two years for $950. Its holding period yield could be found from

\(900 = \frac{80}{(1 + HPY)^1} + \frac{80}{(1 + HPY)^2} + \frac{950}{(1 + HPY)^2}\)

2. Tax Exposure– Because of their relatively high tax exposure, banks are more interested in the after-tax rate of return on loans and securities than in their before-tax return. This situation contrasts with such institutions as credit unions and mutual funds, which are generally tax- exempt. For banks in the upper tax brackets, tax-exempt state and local government (municipal) bonds and notes have been more attractive.

• The straightforward computation of after-tax yield is

𝐵𝑒𝑓𝑜𝑟𝑒_𝑡𝑎𝑥 𝑔𝑟𝑜𝑠𝑠 𝑦𝑖𝑒𝑙𝑑 × (1 — 𝐹𝑖𝑟𝑚’𝑠 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) = 𝐴𝑓𝑡𝑒𝑟_𝑡𝑎𝑥 𝑔𝑟𝑜𝑠𝑠 𝑦𝑖𝑒𝑙𝑑

• The tax-equivalent yield (TEY) from a municipal bond or other tax-exempt security indicates what before-tax rate of return on a taxable investment provides an investor with the same after-tax return as a tax-exempt investment would. The TEY can be computed as

\( TEY = \frac{\text{After_tax return on a tax_exempt investment}}{1 – \text{Investing firm’s marginal tax rate}} \)

• Tax reform in the United States has led to banks holding lesser proportion of municipal market bonds due to (1) declining tax advantages, (2) lower corporate tax rates, and (3) fewer qualified tax-exempt securities.
• Bank-qualified bonds are those issued by smaller local governments which issue no more than $ 10 million of public securities per year. Today banks buying bank-qualified bonds are allowed to deduct 80 percent of any interest paid to fund these purchases. This tax advantage is not available for nonbank-qualified bonds.
• Tax advantage of qualified bond is calculated as

𝑇ℎ𝑒 𝑏𝑎𝑛𝑘′𝑠 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 (𝑖𝑛 𝑝𝑒𝑟𝑐𝑒𝑛𝑡)

×

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑡ℎ𝑎𝑡 𝑖𝑠 𝑠𝑡𝑖𝑙𝑙 𝑡𝑎𝑥 𝑑𝑒𝑐𝑢𝑐𝑡𝑖𝑏𝑙𝑒 𝑖𝑓 𝑎𝑛𝑦

×

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑜𝑓 𝑎𝑐𝑞𝑢𝑖𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑚𝑢𝑛𝑖𝑐𝑖𝑝𝑎𝑙𝑠 (𝑖𝑛 𝑝𝑒𝑟𝑐𝑒𝑛𝑡)

• Today the top bracket is 35 percent for corporations earning more than $ 10 million in annual taxable income or 34 percent otherwise. Lower tax brackets reduce the tax savings associated with the tax-exemption feature.
• Fewer state and local bonds qualify for tax exemption today. If 10 percent or more of the proceeds of a municipal bond issue is used to benefit a private individual or business, it is considered a private activity issue and fully taxable. In addition, Congress placed ceilings on the amount of industrial development bonds (IDBs) local governments could issue to provide new facilities or tax breaks in order to attract new industry.
• The net after-tax return of bank-qualified municipals is calculated as

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑚𝑢𝑛𝑖𝑐𝑖𝑝𝑎𝑙𝑠 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 𝑖𝑛 𝑝𝑒𝑟𝑐𝑒𝑛𝑡

—

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑜𝑓 𝑎𝑐𝑞𝑢𝑖𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑚𝑢𝑛𝑖𝑐𝑖𝑝𝑎𝑙𝑠 (𝑖𝑛 𝑝𝑒𝑟𝑐𝑒𝑛𝑡)

+

𝑇𝑎𝑥 𝑎𝑑𝑣𝑎𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑞𝑢𝑎𝑙𝑖𝑓𝑖𝑒𝑑 𝑏𝑜𝑛𝑑

• Numericals have been discussed in the video.
• The Tax Swapping Tool – 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. Tax considerations in choosing securities to buy or sell tend to be more important for larger lending institutions than for smaller ones. Usually larger lending institutions are in the top income tax bracket and have the most to gain from security portfolio trades that minimize tax exposure. The manager tries to estimate the institution’s projected net taxable income under alternative portfolio choices. This involves, among other things, estimating how much tax exempt income the taxed lending institution can use.
• The Portfolio Shifting Tool – A great deal of portfolio shifting is done, with both taxes and higher returns in mind. Financial firms, for example, often sell off selected securities at a loss in order to offset large amounts of loan income, thereby reducing their tax liability. They may also shift their portfolios simply to substitute new, higher-yielding securities for old security holdings whose yields may be below current market levels. The result may be to take substantial short-run losses in return for the prospect of higher long-run profits. For example, the investments officer of First National Bank may be considering this shift in its municipal bond portfolio as given on the right side. Clearly, this bank takes an immediate $500,000 loss before taxes ($10 million— $9.5 million) on selling the 7 percent New York City bonds. But if First National is in the 35 percent tax bracket, its immediate loss after taxes becomes only $500,000 × (1 — 0.35), or $325,000. Moreover, it has swapped this loss for an additional $200, 000 annually in tax-exempt income for 10 years. This portfolio shift is probably worth the immediate loss the bank must absorb from its current earnings. Moreover, if the bank has high taxable income from loans, that near-term loss can be used to lower current taxable income and perhaps increase this year’s after-tax profits.

3. Interest Rate Risk – Changing interest rates create real risk for investments officers and their institutions.

• Periods of rising interest rates are often marked by surging loan demand.
• On the other hand, investments officers often find themselves purchasing investment
  securities when interest rates and loan demand are declining.
• A growing number of tools to hedge (counteract) interest rate risk have appeared in recent years, including financial futures, options, interest-rate swaps, gap management, and duration.

4. Credit or Default Risk– It is the risk that a security issuer entity will not be unable to fulfill its commitment of making scheduled principal or interest payments, or may default on their obligations.

• This risk has led to regulatory controls that prohibit the acquisition of speculative securities

– those rated below Baa by Moody’s or BBB on Standard & Poor’s bond-rating schedule and below BBB on Fitch’s Rating Service.

• U.S. banks generally are allowed to buy only investment-grade securities, rated at least Baa or BBB, in order to protect depositors against excessive risk.
• Moreover, banks through their securities affiliates or through the formation of a financial holding company are permitted to underwrite government and privately issued securities (including corporate bonds, notes, and stock).
• The credit rating process has become far more stressful as investors increasingly question the reliability of the credit reports they are receiving. Financial reform in the wake of the Great Recession of 2007-2009 appears to have exposed credit rating companies to greater risk of legal action when investors lose money. In some cases credit raters have refused to let bond issuers publish the ratings they are assigned.
• Credit options and swaps can be used to protect the expected yield on investment securities. For example, investments officers may be able to find another financial institution willing to swap an uncertain return on securities held for a lower but more certain return based upon a standard reference rate, such as the market yield on Treasury bonds. Credit options are also available in today’s markets that help to hedge the value of a corporate bond, for example. If the bond issuer defaults, the option holder receives a payoff from the credit option that at least partially offsets the loss. Investments officers can also use credit options to protect the market value of a bond in case its credit rating is lowered

5. Business Risk– Financial institutions face significant risk that the economy of the market area they serve may turn down, with falling sales and rising unemployment. These adverse developments, often called business risk, can be reflected quickly in the loan portfolio, where delinquent loans may rise as borrowers struggle to generate enough cash flow to pay the lender.

• Because business risk is always present, many financial institutions rely heavily on their security portfolios to offset the impact of this form of risk on their loan portfolios. This usually means that many investment securities purchased will come from borrowers located outside the principal market for loans.
• Bank examiners often encourage out-of-market security purchases to balance risk exposure in the loan portfolio.

6. Liquidity Risk – Financial institutions must be ever mindful of the possibility they will be required to sell investment securities in advance of their maturity due to liquidity needs and be subjected to liquidity risk.

• A key issue that a portfolio manager must face in selecting a security for investment portfolios is the breadth and depth o f its resale market.
• Liquid securities are, by definition, those investments that have a ready market, relatively stable price over time, and high probability of recovering the original amount invested (i.e., the risk to the principal value is low). Treasury securities are generally the most liquid and have the most active resale markets, followed by federal agency securities, municipals, and mortgage-backed securities.
• Unfortunately, the purchase of a large volume of liquid, readily marketable securities tends to lower the average yield from a financial institution’s earning assets and reduce its profitability. Thus, management faces a trade-off between profitability and liquidity that must be reevaluated daily as market interest rates and exposure to liquidity risk change.

7. Call Risk– Many corporations and some governments that issue securities reserve the right to call in those 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.

• Investments officers generally try to minimize this call risk by purchasing callable instruments bearing longer call deferments (so that a call cannot occur for several years) or simply by avoiding the purchase of callable securities.
• Fortunately for investments officers, call privileges attached to bonds have been declining in recent years due to the availability of other tools to manage interest-rate risk (though call privileges are quite common today in municipal bonds).

8. Prepayment Risk– A form of risk specific to asset-backed securities is prepayment risk. This form of risk arises because the realized interest and principal payments (cash flow) from a pool of securitized loans, CMOs, or securitized packages of auto or credit card 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

a) Loan refinancings, which tend to accelerate when market interest rates fall – Borrowers may realize they will save on loan payments if they replace their existing loans with new lower-rate loans).

b) Turnover of the assets behind the loans – Borrowers may sell out and move away or some borrowers may not be able to meet their required loan payments and default on their loans.

In either or both of these cases some loans will be terminated or paid off ahead of schedule, generating smaller long-term cash flows than expected, which can lower the expected rate of return from loan-backed securities.

• The pace at which loans that underlie asset-backed securities are terminated or paid off depends heavily upon the interest rate spread between current interest rates on similar type loans and the interest rates attached to loans in the securitized pool. When market interest rates drop below the rates attached to loans in the pool far enough to cover refinancing costs, more borrowers will call in their loans and pay them off early. In making estimates of loan prepayment behavior, some of the factors that should be considered are –

a) Expected market interest rates,

b) Future changes in the shape of the yield curve,

c) Impact of seasonal factors (e.g., most homes are bought and sold in the spring of each year),

d) The condition of the economy,

e) The age of the loans in the pool (because new loans are less likely to be repaid).

• One commonly employed way of making loan prepayment estimates is to use the prepayment model developed by the Public Securities Association (PSA), which calculates an average loan prepayment rate based upon past experience. The 100 percent PSA model typically assumes, for example, that insured home mortgages will prepay at an annual rate of 0.2 percent the first month and the prepayment rate will grow by 0.2 percent each month for the first 30 months. Loan prepayments are then assumed to level off at a 6 percent annual rate for the remainder of the loan pool’s life. However, the investments officer may decide to alter the PSA model to 75 percent PSA or some other percentage multiplier based upon his or her knowledge of the nature of loans in the pool, such as their geographic location, distribution of maturities, or the average age of borrowers.
• While prepayment of securitized loans tends to accelerate in periods of falling interest rates, this is not always a disadvantage for investors in asset-backed securities. For example, as prepayments accelerate, an investing institution recovers its invested cash at a faster rate, which can be a favorable development if it has other profitable uses for those funds. Moreover, lower interest rates increase the present value of all projected cash flows from a loan-backed security so that its market value could rise.
• In general, asset-backed securities will fall in value when interest rates decline if the expected loss of interest income from prepaid loans and reduced reinvestment earnings exceeds the expected benefits that arise from recovering cash more quickly from prepaid loans.

9. Inflation Risk – It is the risk of purchasing power of interest income and repaid principal from a security or loan being eroded by rising prices for goods and services. Inflation can also erode the value of the stockholders’ investment in a financial firm – its net worth.

• Some protection against inflation risk is provided by short-term securities and those with variable interest rates, which usually grant the investments officer greater flexibility in responding to any flare-up in inflationary pressures.
• One recently developed inflation risk hedge that may aid some financial firms is the United States Treasury Department’s TIPS – Treasury Inflation-Protected Securities. Both the coupon rate and the principal (face) value of a TIPS are adjusted annually to match changes in the consumer price index (CPI). Thus, the spread between the market yield on non inflation-adjusted Treasury notes or bonds and the yield on TIPS of the same maturity provides an index of expected inflation as viewed by the average investor in the marketplace. If expected inflation rises, TIPS tend to become more valuable to investors.
• TIPS have lost some of their popularity, because of low inflation and the eveolution of other securities for inflation protection.

10. 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 in order to safeguard public funds.

• At least the first $100,000 of public deposits is covered by federal deposit insurance; the rest must be backed up by holdings of Treasury and federal agency securities valued at par.
• Some municipal bonds (provided they are at least A-rated) can also be used to secure the federal government’s deposits in depository institutions, but these securities must be valued at a discount from par (often 80 to 90 percent of their face value).
• 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.
• Sometimes the government owning the deposit requires that the pledged securities be placed with a trustee not affiliated with the institution receiving the deposit.

Investment Maturity Strategies

• Once the investments officer chooses the type of securities to be held by the financial firm, the distribution of those security holdings over time becomes important.

1. The Ladder, or Spaced-Maturity, Policy – One popular approach to the maturity problem, particularly among smaller institutions, is to choose some maximum acceptable maturity and then invest in an equal proportion of securities in each of several maturity intervals until the maximum acceptable maturity is reached. For example, of maximum acceptable maturity is five years, management can decide to invest 20 percent of the firm’s investment portfolio in securities one year or less from maturity, another 20 percent in securities maturing within two years but no less than one year, and so forth, until the five-year point is reached.

Advantages –

a) Reduces investment income fluctuations

b) Requires little management expertise

c) Builds investment flexibility as some securities are always rolling over into cash

Disadvantages –

a) Does not maximize income

2. The Front-End Load Maturity Policy – Another popular strategy is to purchase only short- term securities and place all investments within a brief interval of time. For example, the investments officer may decide to invest 100 percent of his or her institution’s funds not needed for loans or cash reserves in securities three years or less from maturity. This approach stresses using the investment portfolio primarily as a source of liquidity rather than as a source of income.

Advantages –

a) Strengthens the financial firm’s liquidity position

b) Avoids large capital losses if market interest rates rise

Disadvantages –

a) Low Returns

3. The Back-End Load Maturity Policy – An investing institution following the backend load approach might decide to invest only in bonds in the 5- to 10-year maturity range. This approach is opposite to the previous approach. It stresses the investment portfolio as a source of income.

Advantages –

a) Maximizes income potential from security investments if market interest rates fall.

Disadvantages –

a) The institution would probably rely heavily on borrowing in the money market to help meet its liquidity requirements.

4. The Barbell Strategy – A combination of the front-end and back-end load approaches, frequently employed by smaller financial firms, is the barbell strategy, in which an investing institution places most of its funds in a short-term portfolio of highly liquid securities at one extreme and in a long-term portfolio of bonds at the other extreme, with minimal investment holdings in intermediate maturities. The short-term portfolio provides liquidity, while the long- term portfolio is designed to generate income.

Advantages –

• Helps to meet liquidity needs with short term securities and to achieve earnings goals due to higher potential earnings from the long term portion of the portfolio.

5. The Rate Expectations Approach – The most aggressive of all maturity strategies, often used by the largest financial firms, is one that continually shifts maturities of securities in line with current forecasts of interest rates and the economy. This total performance, or rate expectation, approach calls for shifting investments toward the short end of the maturity spectrum when interest rates are expected to rise and toward the long end when falling interest rates are expected.

Advantages –

a) Offers the potential for large capital gains

Disadvantages

a) It requires in-depth knowledge of market forces

b) Presents greater risk if expectations turn out to be wrong

c) Carries greater transactions costs because it may require frequent security trading and switching.

Maturity Management Tools

• In choosing among various maturities of investments, investments officers need to consider carefully the use of two key maturity management tools – (1) The yield curve, and (2) Duration. These tools help the investments officer understand more fully the consequences and potential impact upon earnings and risk from any particular maturity mix of securities.

1. The Yield Curve– The yield curve is simply a picture of how market interest rates differ across loans and securities of varying term (time) to maturity. Each yield curve assumes that all interest rates (or yields) included along the curve are measured at the same time and that all other rate-determining forces are held fixed. Yields curve may slope upward or slope downward or be horizontal.

a) Forecasting Interest Rates and the Economy – The yield curve contains an implicit forecast of future interest rate changes. Positively sloped yield curves reflect the average expectation in the market that future short-term interest rates will be higher than investments officer must make. In this case, investors expect to see an upward interest-rate movement, and they often translate this expectation into action by shifting their investment holdings away from longer-term securities (which will incur greater capital losses when market interest rates do rise). Conversely, a downward-sloping yield curve points to investor expectations of declining short-term interest rates in the period ahead. The investments officer will consider lengthening portfolio maturity because falling interest rates offer the prospect of substantial capital gains income from longer-term investments.

Yield curves also provide the investments officer with a clue about overpriced and underpriced securities. A security whose yield lies above the curve represents a tempting buy situation; its yield is temporarily too high (and, therefore, its price is too low). On the other hand, a security whose yield lies below the curve represents a possible sell or “don’t buy” situation because its yield is too low for its maturity (and, thus, its price is too high).

In the long run, yield curves send signals about what stage of the business cycle the economy presently occupies, They generally rise in economic expansions and fall in recessions.

b) Risk-Return Trade-Offs – The yield curve conveys the current trade-offs between greater returns and greater risks. The yield curve’s shape determines how much additional yield the investments officer can earn by replacing shorter-term securities with longer-term issues, or vice versa. For example, a steeply sloped positive yield curve that rises 100 basis points between 2 -year and 10 -year maturity bonds indicates that the investments officer can pick up a full percentage point in extra yield (less broker or dealer commissions and any tax liability incurred) by switching from 2 -year to 10 -year bonds. However, 10-year bonds are generally more volatile in price than 2 -year bonds, so the investments officer must be willing to accept greater risk of a capital loss on the 10 -year bonds if interest rates rise.

Longer-term bonds often have a thinner market in case cash must be raised quickly. The investments officer can measure along the curve what gain in yield will result from maturity extension and compare that gain against the likelihood a financial firm will face a liquidity crisis (“cash out”) or suffer capital losses if interest rates go in an unexpected direction.

c) Pursuing the Carry Trade – Yield curves provide the investments officer with a measure of how much might be earned at the moment by pursuing the carry trade. The officer can borrow funds at the shortest end of the curve (such as borrowing short-term money using the safest and most liquid investment securities in the financial firm’s portfolio as collateral) and then invest the borrowed funds in income-generating assets farther out along the curve. For example, the officer may borrow funds for 30 days at 4 percent and use that money to invest in five-year government bonds yielding 6 percent. The difference between these two rates of return is called carry income and tends to be greatest when the yield curve has a steep upward slope.

d) Riding the Yield Curve – If the yield curve does have a sufficiently strong positive slope, an investing institution may also be able to score significant gains with a maneuver known as riding the yield curve. The investments officer looks for a situation in which some securities are soon to approach maturity and their prices have risen significantly while their yields to maturity have fallen. If the yield curve’s slope is steep enough to more than cover transactions costs, the investing institution can sell those securities, scoring a capital gain due to the recent rise in their prices, and reinvest the proceeds of that sale in longer- term securities carrying higher rates of return.

Issues With Yield Curve-

While the yield curve presents the investments officer with valuable information and occasionally the opportunity for substantial gains, it has several limitations –

• There is uncertainty over exactly how and why the curve appears the way it does at any particular moment and the possibility of a change in the curve’s shape at any time.
• Moreover, the yield curve counts only clock time, not the timing of cash flows expected from a security. The most critical information for the investments officer is usually not how long any particular security will be around but, rather, when it will generate cash and how much cash will be generated each month, quarter, or year the security is held.

These issues gave rise to the concept of duration.

2. Duration –Duration measures the average amount of time needed for all of the cash flows from a security to reach the investor who holds it.

• There is a critical relationship between duration, market interest rates, and investment security prices. The percentage change in the price of an investment security is equal to the negative of its duration times the change in interest rates divided by one plus the initial interest rate or yield, i.e.

\(\text{Percentage change in price} = -\text{Duration} \times \left[\frac{\text{Change in interest rate}}{1 + \frac{1}{m} \times \text{initial rate}}\right]\)

Using this relationship the sensitivity of an investment security’s market price to changes in market interest rates can be understood and decision can be made whether the security we are interested in is too price sensitive, or perhaps not price sensitive enough, to meet our financial firm’s investment needs. For example, suppose a Treasury note has a duration of 4.26 years and market interest rates rise from 10.73 percent to 12 percent, or 1.27 percent. According to the duration relationship, if interest rates rise just over one percentage point, the security in question will experience almost a 5 percent decline in price. The investments officer must decide how much chance there is that market interest rates will rise, whether this degree of price sensitivity is acceptable, and whether other investments would better suit the institution’s current investment needs.

• Immunization – Duration also suggests a way to minimize damage to an investing institution’s earnings that changes in market interest rates may cause. That is, duration gives the investments officer a tool to reduce his or her institution’s exposure to interest rate risk. It suggests a formula for minimizing interest rate risk:

Duration of an individual security or a security portfolio =

Length of the investor’s planned holding period for a security or a security portfolio

For example, suppose a bank is interested in buying Treasury notes because loan demand currently is weak. However, the investments officer is concerned that he or she may be required to sell those securities at this time next year in order to make profitable loans. Faced with this prospect and determined to minimize interest rate risk, the officer could choose those notes with a duration of one year. The effect of this step is to engage in portfolio immunization, i.e., protecting securities purchased from loss of return, no matter which way interest rates go.

Duration works to immunize a security or portfolio of securities against interest rate changes because two key forms of risk – interest rate risk and reinvestment risk, offset each other when duration is set equal to the investing institution’s planned holding period. If interest rates rise after the securities are purchased, their market price will decline, but the investments officer can reinvest the cash flow those securities are generating at higher market rates. Similarly, if interest rates fall, the institution will be forced to reinvest at lower interest rates but, correspondingly, the prices of those securities will have risen. The net result is to approximately freeze the total return from investment security holdings. Capital gains or losses are counterbalanced by falling or rising reinvestment yields when duration matches the investing institution’s planned holding period.