Chapter 10
What is tax swapping? What is portfolio shifting? Give an example of each.
A tax swap involves exchanging one type of investment security for another when it is advantageous to do so in reducing the bank's current or future tax exposure. For example, the bank may sell 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 on its investment portfolio or to replace taxable securities with tax-exempt securities. Portfolio shifting which involves selling certain securities out of a bank's portfolio, often at a loss, and replacing them with other securities, is usually carried out to gain additional current income, add to future income, or to minimize a bank's current or future tax liability. For example, the bank may shift its holdings of investment securities by selling off selected lower-yielding securities at a loss, and substituting higher-yielding securities in order to offset large amounts of loan income, thereby reducing their tax liability.
Suppose a corporate bond an investments officer would like to purchase for her bank has a before-tax yield of 8.98 percent and the bank is in the 35 percent federal income tax bracket. What is the bond's after-tax gross yield? What after-tax rate of return must a prospective loan generate to be competitive with the corporate bond? Does a loan have some advantages for a lending institution that a corporate bond would not have?
After-tax gross yield on corporate bond = 8.98 percent × (1 − 0.35) = 5.84 percent. A prospective loan must generate a comparable yield to that of the bond to be competitive. However, granting a loan to a corporation may have the added advantage of bringing in additional service business for the bank that merely purchasing a corporate bond would not do. Also, the management may desire to keep good loan customers, or there can be changes in the state and local government credit quality. In such cases, the bank would probably be willing to accept a lower yield on the loan compared to the bond in anticipation of getting more total revenue from the loan relationship due to the sale of other bank services.
Bacone National Bank has structured its investment portfolio, which extends out to four-year maturities, so that it holds about $11 million each in one-year, two-year, three-year, and four-year securities. In contrast, Dunham National Bank and Trust holds $36 million in one- and two-year securities and about $30 million in 8- to 10-year maturities. What maturity strategy is each bank following? Why do you believe that each of these banks has adopted the particular strategy it has as reflected in the maturity structure of its portfolio?
Bacone National Bank has structured its investment portfolio to include $11 million equally in each of four one-year maturity intervals. This is clearly a spaced-maturity or ladder policy. In contrast, Dunham National Bank holds $36 million in one and two-year securities and about $30 million in 8- and 10-year maturities, which is clearly a barbell strategy. Dunham National Bank pursues its strategy to provide both liquidity (from the short maturities) and high income (from the long maturities), while Bacone National is a small bank that needs less income fluctuations and a simple-to-execute strategy.
What are the principal money market and capital market instruments available to institutions today? What are their most important characteristics?
Banks purchase a wide range of investment securities. The principal money market instruments available to banks today are Treasury bills, short-term Treasury notes and bonds, federal agency securities, certificates of deposits issued by other depository institutions, international Eurocurrency deposits, bankers' acceptances, commercial paper, and short-term municipal obligations. The common characteristics of most these instruments are their safety and high marketability. Capital market instruments available to banks include U.S. Treasury notes and bonds, municipal notes and bonds, and corporate notes and bonds. The characteristics of these securities are their higher expected rate of return and capital gains potential..
What types of investment securities do banks seem to prefer the most? Can you explain why?
Commercial banks clearly prefer these major types of investment securities: U. S government obligations, federal agency securities, and state and local government obligations, and asset-backed securities. They also hold small amounts of equities and other domestic and foreign debt securities (mainly corporate notes and bonds). They pick these types because they are best suited to meet the objectives of a bank's investment portfolio, such as a comparatively high yield, tax sheltering, reducing overall risk exposure, a source of liquidity, and generating income as well as diversifying their assets.
How is the expected yield on most bonds determined?
For most bonds, determining the expected yield requires the calculation of the yield to maturity (YTM), if the bond is to be held to maturity or the planned holding period yield (HPY) between point of purchase and point of sale. YTM determines the yield on a bond that equalizes the market price of the bond with its expected stream of cash flows. However, many financial firms frequently do not hold all their investments to maturity. Some must be sold off early 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.
What factors affect a financial-service institution's decision regarding the different maturities of securities it should hold?
In choosing among various maturities of short-term and long-term securities to hold, the financial institution needs to carefully consider the use of two key maturity management tools—the yield curve and duration. These two tools help management understand more fully the consequences and potential impact on earnings and risk of any particular maturity mix of securities they choose.
What maturity strategies do financial firms employ in managing their portfolios?
In choosing the maturity distribution of securities to be held in the financial firm's investment portfolio one of the following strategies typically is chosen by most institutions: a. The Ladder, or Spaced-Maturity, Policy b. The Front-End Load Maturity Policy c. The Back-End Load Maturity Policy d. The Barbell Strategy e. The Rate Expectations Approach The ladder or spaced-maturity strategy involves equally spacing out a bank's security holdings over its preferred maturity range to stabilize investment earnings. The front-end load maturity strategy implies that a bank will pile up its security holdings into the shortest maturities to have maximum liquidity and minimize the risk of loss due to rising interest rates. The back-end loaded maturity policy calls for placing all security holdings at the long-term end of the maturity spectrum to maximize potential gains if interest rates fall and to earn the highest average yields. The barbell strategy places a portion of the bank's security holdings at the short-end of the maturity spectrum and the rest at the longest maturities, thus providing both liquidity and maximum income potential. Finally, the rate expectations approach, the most aggressive of all maturity strategies, calls for shifting maturities toward the short end if rates are expected to rise and toward the long-end of the maturity scale if interest rates are expected to fall.
How has the tax exposure of various U.S. bank security investments changed in recent years?
In recent years, the government has treated interest income and capital gains from most bank investments as ordinary income for tax purposes. In the past, only interest was treated as ordinary income and capital gains were taxed at a lower rate. Tax reform in the United States has also had a major impact on the relative attractiveness of state and local government bonds due to declining tax advantages, lower corporate tax rates and fewer qualified tax-exempt securities.
Spiro Savings Bank currently holds a government bond valued on the day of its purchase at $5 million, with a promised interest yield of 6 percent, whose current market value is $3.9 million. Comparable quality bonds are available today for a promised yield of 8 percent. What are the advantages to Spiro Savings from selling the government bond bearing a 6 percent promised yield and buying some 8 percent bonds?
In this instance the bank could sell the 6-percent bonds, buy the 8-percent bonds, and experience an extra 2 percent in yield. The bank would experience a capital loss of $1.1 million from the bond's book value, but the after-tax loss would be only $1.1 million × (1 − 0.35) or $715,000.
What key roles do investments play in the management of a depository institution?
Investment security portfolios perform many different roles that act as a necessary complement to the advantages loans provide. They help stabilize income when loan revenues fall. Investment in high-quality securities can be purchased and held to balance out the risk from loans. Investment in securities allow the bank or thrift institution to diversify into different localities than most of its loans permit, provide additional liquid reserves in case more cash is needed, provide collateral as called for by law and regulation to back government deposits. Security investments aid banks in reducing their exposure to taxes, and also help hedge against losses due to changing interest rates. Investment securities, unlike many loans, can be bought or sold quickly to restructure assets, hence providing flexibility to the banks. Over and above, the bank managers can also dress up the balance sheet and make a financial institution look financially stronger due to the high quality of many marketable securities.
What is the net after-tax return on a qualified municipal security whose nominal gross return is 6 percent, the cost of borrowed funds is 5 percent, and the financial firm holding the bond is in the 35 percent tax bracket? What is the tax-equivalent yield (TEY) on this tax-exempt security?
NET AFTER TAX RETURN ON MUNICIPALS = nominal return on municipals after taxes (in percent) - interest expense incurred in acquiring the municipals (in percent) + tax advantage of a qualified bond tax advantage of qualified bond = (the banks marginal income tax rate * percent of interest expense the is still tax deductible * interest expense of acquiring the municipals) Net after-tax return = (0.06 − 0.05) + (0.35 × 0.80 × 0.05) = 0.024 or 2.4 percent tax - quivilant yield = after tax return on a tax exempt investment / (1 - investing firms marginal tax rate) The security's tax-equivalent yield in gross terms: = 6 percent / (1-.35) = 9.23 %
A bond currently sells for $950 based on a par value of $1,000 and promises $100 in interest for three years before being retired. Yields to maturity on comparable-quality securities are currently at 12 percent. What is the bond's duration? Suppose interest rates in the market fall to 10 percent. What will be the approximate percent change in the bond's price?
PV of Cash Flows × t = $2,597.60 Hence, duration of the bond = $2,597.60 ÷ $950= 2.73 years If interest in the market fall to 10 percent, the approximate percentage change in the bond's price will be: Therefore, the bond's price will approximately reduce by 4.88 percent.
Why do depository institutions face pledging requirements when they accept government deposits?
Pledging requirements are in place to safeguard the deposit of public funds. At least the first $100,000 of public deposits is covered by federal deposit insurance; the rest must be backed up by bank holdings of U.S. Treasury and federal agency securities valued at their par values.
What are securitized assets? Why have they grown so rapidly in recent years?
Securitized assets are loans that are placed in a pool and, as the loans generate interest and principal income, that income is passed on to the holders of securities representing an interest in the loan pool. These loan-backed securities are attractive to many banks because of their higher yields. Also, guarantees are received from government agencies (in the case of most home-mortgage-backed securities) or from private institutions such as banks or insurance companies pledging to back credit card loans. The loan-backed securities are also attractive because of their relatively high liquidity and marketability of securities backed by loans compared to the liquidity and marketability of loans themselves.
What special risks do securitized assets present to institutions investing in them?
Securitized assets often carry substantial prepayment risk, which arises when certain loans in the securitized-asset pool are paid off early by the borrowers (usually because interest rates have fallen and new loans can be substituted for the old loans at cheaper loan rates). Prepayment risk can significantly decrease the values of securities backed by loans and change their effective maturities, thus making the holder of the security receive diminished income. Also, a substantial weakness among these securitized assets is that, there can be a sharp deterioration in the underlying assets' (loans) market values when they experience a significant rise in default rates.
What are structured notes and stripped securities? What unusual features do they contain?
Structured notes usually are packaged investments, such as pools of federal agency securities, assembled by security dealers that offer customers flexible yields in order to protect their customers' investments against losses due to changing interest rates. Interest yield on such notes could be reset periodically based on a reference interest rate, such as a U.S. Treasury bond rate. Stripped securities represent a claim against either the principal or interest payments associated with a debt security. The expected cash flow from a Treasury note, Treasury bond or mortgage-backed security is separated into a stream of principal payments and a stream of interest payments, each of which may be sold as a separate security maturing on the day the payment is due. In particular, stripped securities offer interest-rate hedging possibilities to help protect an investment portfolio against loss from interest-rate changes.
Why do banks and other institutions choose to devote a significant portion of their assets to investment securities?
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. After all, loans support business investment and consumer spending in local communities and provide jobs and income to thousands of community residents. However, many loans are illiquid—they cannot easily be sold or securitized prior to maturity. And loans are among the riskiest assets, generally carrying the highest customer default rates of any form of credit. 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, have devoted a significant portion of their asset portfolios—usually somewhere between a fifth to a third of all assets—to another major category of earning asset: investments in securities that are under the management of investments officers. 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 certain kinds of common and preferred stock permitted by law.
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 $1,000 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 yield be?
The relevant formula for YTM is: Using a financial calculator we determine the YTM to be 13 percent. If the bond is sold after one year, the formula to find investor's holding period yield is: Therefore, the HPY when the bond is sold after one year is 12.63 percent.
What types of securities are used to meet collateralization requirements?
When a bank borrows from the discount window of its district Federal Reserve Bank, it must pledge either federal government securities or other collateral acceptable to the Fed. Typically, banks will use U.S. Treasury and federal securities to meet these collateral requirements. Some municipal bonds (provided they are at least A-rated) can also be used to secure the federal government's deposits in depository institutions. If the bank raises funds through repurchase agreements (RPs), banks must pledge securities, typically U.S. Treasury and federal agency issues, as collateral in order to borrow at the low RP interest rate.
How can the yield curve and duration help an investments officer choose which securities to acquire or sell?
Yield curves possibly provide a forecast of the future course of short-term rates, telling us what the current average expectation is in the market. The yield curve also provides an indication of equilibrium yields at varying maturities and, therefore, gives an indication if there are any significantly underpriced or overpriced securities. Finally, the yield curve's shape gives the bank's investment officer a measure of the yield trade-off—how much yield can be earned replacing shorter-term securities with longer-term issues, or vice versa. Duration tells a bank about the price volatility of its earning assets and liabilities due to changes in interest rates. Higher values of duration imply greater risk to the value of assets and liabilities held by a bank. For example, a loan or security with a duration of 4 years stands to lose twice as much in terms of value for the same change in interest rates as a loan or security with a duration of 2 years.
What forms of risk affect investments?
a.interest rate risk, b.credit or default risk, c.business risk, d.liquidity risk, e.prepayment risk, f.call risk, and g.inflation risk. Interest-rate risk captures the sensitivity of the value of investments to interest-rate movements while credit risk reflects the risk that the security issuer may default on either interest or principal payments. Business risk refers to the impact of credit conditions and the economy, where delinquent loans may rise as borrowers struggle to generate enough cash flow to pay the lender. Liquidity risk focuses on the price stability and marketability of investments. Prepayment risk is specific to certain types of investments and focuses on the fact that some loans, which the securities are based on, can be paid off early. Call risk refers to the early retirement of some government and corporate securities and inflation risk refers to the possible loss of purchasing power of interest income and repaid principal from a security or a loan.
