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Chapter Ten
The Investment Function in Banking
and Financial Services Management
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Functions of a Banks Security Portfolio
Stabilize the Banks Income Over a Business
Cycle
Offset Credit Risk Exposure
Provide Geographic Diversification
Provide Backup Source of Liquidity
Reduce Tax Exposure
Serve as Collateral for Govt. Deposits
Hedge Against Interest Rate Risk


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Money Market Instruments Used by a
Bank (Mostly for Liquidity)
Treasury Bills
Short-Term Treasury Notes and Bonds
Federal Agency Securities
Certificates of Deposit
Eurocurrency Deposits
Bankers Acceptances
Commercial Paper
Short-Term Municipal Obligations
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Capital Market Instruments Used by a
Bank (Mostly for Income)
Treasury Notes and Bonds Over One Year
to Maturity
Municipal Notes and Bonds
Corporate Notes and Bonds
Asset Backed Securities
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Other More Recent Investment
Instruments
Structured Notes packaged investments
assembled by security dealers that offer
customers flexible yields.
Securitized Assets loans placed in a pool and
securities issued against that pool
Stripped Securities principal and interest
separated and each sold as a separate zero
coupon security

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Dominant Investments Held By Banks
preferred securities
Obligations of the U.S. Government and
Government Agencies
State and Local Government Obligations

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Factors Affecting the Choice of
Securities
Expected Rate of
Return
Tax Exposure
Interest Rate Risk
Credit Risk
Business Risk
Liquidity Risk
Call Risk
Prepayment Risk
Inflation Risk
Pledging
Requirements
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Expected Rate of Return
Yield to Maturity



Holding Period Return

security the of value face the is FV where
and security on the payments coupon annual the are CP where
YTM) (1
FV
YTM) (1
CP
PV
n
n
1
t
t
Bond

n
t
held is security the years of number the is HP where
and for sold be can security the price the is P where
HPR) (1
P
HPR) (1
CP
PV
HP
1 t
HP
t

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YTM Problem
A govt. bond is expected to mature in two
years and has a current price of $950. What is
the bonds YTM if the par value is 1000 and
the coupon rate is 10%.
YTM = 12.99%=
If the bond is sold after 1 year for $970 what is
the holding period yield.
YTM = 12.63

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Tax Exposure
The Tax Status of State and Local Government
Bonds
Bank Qualified Bonds
The Portfolio Shifting Tool
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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

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Default Risk
Investment Grade

Moodys S&P
Aaa AAA
Aa AA
A A
Baa BBB
Speculative Grade

Moodys S&P
Ba BB
B B
Caa CCC
Ca CC
C C
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Business Risk
Risk that the Economy of the Market Area
they Serve May Turn Down
Security Portfolio Can Offset This Risk
Securities Can be Purchased From Outside
Market Area Served
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Liquidity Risk
Breadth and Depth of Secondary Market
Number of Trades on an Given Day
Volume of Trades on Any Given Day
Treasury Securities are Generally the Most
Liquid
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Call Risk
Corporations and Some Governments Reserve
the Right to Retire the Securities in Advance of
Their Maturity
Generally Called When Interest Rates Have
Fallen
Investor Must Find New Security Often with
a Lower Return
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Prepayment Risk
Specific to Asset-Backed Securities
Most Consumer Mortgages and Loans Can Be
Paid Off Early
Caused by Loan Refinancing Which Accelerate
When Interest Rates Fall
Caused by Asset Turnover When Borrowers
Move or are Not Able to Meet Loan Payments
and Asset is Sold
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Inflation Risk
Purchasing Power from a Security or Loan May
be Eroded by Rising Prices
Recently Developed Inflation Risk Hedge
Treasury Inflation Protected Securities
Both Coupon Payments and Principal Adjusted
Annually for Inflation Based on Consumer
Price Index
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Pledging Requirements
Depository Institutions Cannot Accept Federal,
State and Local Government Deposits Unless
Acceptable Collateral is Pledged
Generally Treasury Securities, Government
Agency Securities and Selected Municipal
Securities Can Be Used as Collateral
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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
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Maturity Management Tools
The Yield Curve
Picture of How Market Interest Rates Differ Across
Differing Maturities
Constructed Most Easily with Treasury 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
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Maturity strategy problem
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 investment
maturity strategy is each bank following? Why do
you believe that each of these banks has adopted the
particular strategy it has reflected in the maturity
structure of its portfolio?
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Maturity strategy answer
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 a simple-to-execute strategy.

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After tax yield on a qualified municipal
security
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 bank is in the 35
percent tax bracket?
Net After-Tax Return = (.06 - .05) + (0.35 x 0.80
x .05) = 0.024 or 2.4%

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After tax gross yield
Suppose a corporate bond investment officer would
like to purchase a bond that 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 %( 1 - 0.35) = 5.84%.

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Loan advantage
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. In this case the bank would
accept a somewhat 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
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Bond sale calculations
Spiro Savings Bank currently holds a government
bond valued on the day of its purchase at $5 million,
with a promised interest yield (Coupon) 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?
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Answer
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 $0.715 million.

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What is Tax Swapping
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 investment securities at a
loss to offset high taxable income on loans or
to replace taxable securities with tax-exempt
securities.
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Tax Swap Continued
Portfolio switching 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.

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Securities for Collateral 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 securities to meet these collateral
requirements. 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.
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Why Banks Face Pledging
Requirements
Pledging requirements are in place to
safeguard the deposit of public funds. 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.
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What Factors Affect Decisions on Holding
Different Maturities
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.
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How can yield curve and duration help in
the decision to sell or buy
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 under priced or over priced securities.
Finally, the yield curve's shape gives the bank's
investment officer a measure of the yield trade-off - that
is, how much yield will change, on average, if a security
portfolio is shortened or lengthened in maturity.
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--- continued from previous slide
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.

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Calculate bond duration and percent
change in bond price
A bond currently selling 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 12 percent. What is the bonds
duration? Suppose interest rates in the
market fall to 10 percent. What will be the
approximate percent change in the bonds
price?
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---continued

CF PV@12% WT of each CF
1 $100 $89.30 (89.30* 1)= 89.30
2 $100 79.70 (79.70* 2)=159.40
3 $1100 783.20 (783.20* 3)=2349.6
total = 2598.3

Duration = 2598.3/950 = 2.7351
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continued
The bond's duration is 2.7351 years. If
interest in the market falls to 10 percent, the
approximate percentage change in the bond's
price will be:

Percentage Change in Price = {-D x Change in I
/(1+I)} x 100
{-2.7351 x -.02/1+.12} x100 = 4.884 percent

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Net after tax yield on bank qualified bonds
Tiger National Bank regularly purchases municipal bonds
issued by small rural school districts in its region of the state.
At the moment, the bank is considering purchasing an $8
million general obligation issue from the Youngstown school
district, the only bond issue that district plans this year. The
bonds, which mature in 15 years, carry a nominal annual rate
of return of 7.75%. Tiger, which is in the top corporate tax
bracket of 35 percent, must pay an average interest rate of
7.38% to borrow the funds needed to purchase the
municipals. Would you recommend purchasing these bonds?
a) Calculate the net after tax return on this bank qualified
municipal security. What is the tax advantage for being a
qualified bond?
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Answer to Net ATR problem
Because these bonds were issued by a small governmental
unit issuing less than $10 million in securities annually, the
interest cost the bank has to pay to acquire the funds needed
to buy these bonds is tax deductible. Therefore, their net
after-tax return is:
Net A.T.R = (7.75% - 7.38%) + (0.80 x 0.35 x 7.38%)
= 7.75% -7.38% + 2.066%
= 2.436%
This net yield figure should be compared with other
investments of comparable risk on an after-tax basis.
However, the tax-exempt status of the income coupled with
the tax-deductibility of the interest expense make these
bonds a very attractive alternative.
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TEY solution
b) What is the tax equivalent yield for this
bank qualified municipal security?
TEY =7.75 +2.066/1-.35 = 15.10%