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Tried and True

By: Larry Russell

We are now into the last month of our year. If we are going to make changes to our bond portfolios with the gains or losses registered against calendar year 2013 income, now is the time. Accordingly, this is an appropriate time to review the basics of a bond swap and the rationale in employing such a strategy. A bond swap is a valuable tool used for decades and commonly used by management to fine tune the portfolio to best suit characteristics that exist within the bank. Some of the common drivers of bond swaps are targeted revisions in tax liability, asset mix, credit quality and duration. With respect to reinvestment of sale proceeds, variations in maturity, quality, structure and other factors, all influence the results of the swap and the true benefit to the portfolio overall. While the portfolio manager always keeps track of profits and yield, in these times particularly, other metrics, such as duration, weighting and quality, deserve the focus.

Oftentimes, a tax swap for losses is used to take some income from a good year and in effect, reposition the additional income from improved reinvestment yields into succeeding years that are less certain from a profit perspective. As generating satisfactory net interest rate margin becomes more challenging, the prospect of “putting something back” for additional future profitability makes good sense. Practically speaking, once taxes are paid to Uncle Sam, the money is gone. Instead, hedging to some degree, by the execution of a tax loss swap, earns a blue ribbon.

As opposed to losses, depending on your interest rate bias, taking profits on some issues may be completely appropriate. Rationale may be to fund needed additions to capital, dividend or bank stock loan payments or strengthening loan loss reserves. Consider taking profits on MBS as opposed to being paid down every month at par (with no profit). As we witnessed beginning May 1, profits can evaporate quickly and a bird in the hand may be worth two in the bush.

Importantly, keep in mind that there is the “wash sale rule” where the IRS will not allow a loss generated from the sale and reinvestment of essentially the same security within a 30-day period. Your buyback should not be substantially identical to the bond being sold. Use different issuers, maturity dates and coupons to the greatest degree possible.

Just remember, executing a bond swap may or may not be a winning strategy for your bank. Consider carefully with your management team and trusted investment adviser whether the duration, quality, structure and predictability of the reinvestment package enhances the position and value of your bank going forward.

On a different topic, turning to the bond market and investment alternatives that community bank investment portfolio managers might currently consider, a straightforward, time-tested strategy is alive and well, and appropriate in most cases. This strategy involves investment in a combination of agency bullets or Treasuries as one component, and current coupon 10 and 15-year mortgage pools, as the other component.

The concept is simple. The bullets can be laddered in the four-to-eight year area of the yield curve with the attributes of yield and continuous reduction in duration as the bonds roll down the curve. As the durations shorten, with the constant yield, the risk to principal is reduced over time simply because of the shorter maturities.

In concert with the bullet ladder, the 10 or 15-year current coupon mortgage pools contribute. These structures contain mortgages made to the strongest and thus least interest rate sensitive borrowers, are issued monthly by FNMA and FHLMC, and can be laddered by month just like bullets. Because the coupons are currently in the 2 percent to 2.5 percent area, the dollar prices, and thus the premiums, are lower, which greatly reduces risk to yield if rates move back to the downside. The moderate final maturities limit the extension in duration, and help lessen interest rate risk if higher rates develop. In the meantime, consensus estimates and current experience show that monthly cash flow is significant and principal should pay down by approximately one-third, with two-thirds of the principal remaining after three years. The cash flow can be reinvested into loans or securities at higher rates, assuming rates have increased. Again, simple.

With the current uncertainty about rate direction and timing, the certainty of bullets and their yields is a plus. Those, taken together with the yields, cash flow and predictability of the 10- and 15-year current coupon mortgage pools, can provide valuable attributes to the character of your community bank investment portfolio.

Larry Russell is senior vice president in the Capital Markets Group at Country Club Bank, Kansas City.

Copyright (c) December 2013 by BankNews Media