Bank InvestmentsSlide 2SecuritiesMuni TaxesSecurities RiskInterest Rate riskSecurity Specific riskInvestment strategiesPassive Investment StrategiesSlide 10Aggressive Investment StrategiesBank InvestmentsBank InvestmentsG & K Chp. 7Review Economic Environment (Loans)Types of investment securitiesEvaluating investment riskInvestment strategiesSecuritiesU.S. government and agency securities–(Agencies: FNMA, FHLMC, GNMA, FCA, SBA)Mortgage-backed securities (MBSs) and collateralized mortgage obligations (CMOs) are dominant in this investment category (prepayment risk).Municipal bonds–General obligation bonds (GOs) and revenue bonds–TaxesCorporate bondsMuni TaxesTax formula for munis:YTMm/(1-T) - (1.0 x Average cost of funds x T)/(1-T) = YTMTEwhere T = bank tax rate, the factor 1.0 is for 100% of interest expenses are not deductible from taxes (i.e., 0.20 for bank qualified munis), and average cost of funds is based on IRS rules, and YTMTE = a tax equivalent yield for comparison to taxable bonds.Example: given T = 0.34, 1.0 is used, average cost of fund = 7%, and YTMm= 8%, we have0.08/(1 - 0.34) - [(1.0 x 0.07 x 0.34)/(1 - 0.34)] = 0.0852 or 8.52%Securities RiskInterest Rate riskSecurity Specific riskInterest Rate riskDuration–Coupon Rate, YTM inverse to Duration–Maturity directly related to Duration–Assumes Parallel Shifts in YTMs !!!Convexity (Second Derivative of Price)–Notice that price change prediction gets worse–Positive and Negative Convexity•D= (CF DF (t)(CF DF(PV (t)(PVtt=1Nttt=1Nttt=1Ntt=1N)( ))( )))Security Specific riskBond Ratings–Investment grade bonds (top 4 credit ratings)AAA (Aaa)  BBB (Baa)–Junk bonds (lower rated bonds)BB (Ba)  C; Default: DDD, DD, D–Estimates of the probability of default–Bondholder losses in default not captured by credit ratingsInvestment strategiesPassive investment strategiesAggressive investment strategiesPassive Investment StrategiesSpace-maturity approach (ladder approach)Spread available investment funds evenly across a specified number of periods within the bank’s investment horizon.Simple and low transactions costs, but passive with respect to interest rate conditions and liquidity is sacrificed to some extent.Split-maturity approach (barbell approach)Greater quantities of short-term and long-term securities are held.This strategy balances liquidity and higher income.Passive Investment Strategies$10 $10 $10 $10 $101 yr 2 yrs 3 yrs 4 yrs 5 yrs Maturities of SecuritiesLadder ApproachBarbell Approach$10$20$20Aggressive Investment StrategiesYield curve strategies–Playing the yield curve–Riding the yield curveBond-swapping strategies–Tax swap–Substitution, or price, swap–Yield-pickup, or coupon, swap–Spread, or quality, swap–Portfolio