STRATEGICALLY MANAGING THE INVESTMENT PORTFOLIO FOR … · Products offered through Investment Banking are: NOT FDIC INSURED I MAY LOSE VALUE I NOT BANK GUARANTEED INVESTMENT BANKING

STRATEGICALLY MANAGING THE INVESTMENT PORTFOLIO FOR LONG-TERM PERFORMANCE

Raleigh A. Trovillion Executive Vice President

UMB Bank Investment Division

St. Louis, MO [email protected]

314-612-8039

August 9 & 10, 2018

Products offered through Investment Banking are:NOT FDIC INSURED I MAY LOSE VALUE I NOT BANK GUARANTEED

INVESTMENT BANKING DIVISIONINVESTMENT BANKING DIVISION

Strategically Managing the Investment Portfolio for Long-Term Performance

Raleigh A. “Andy” TrovillionExecutive Vice President

UMB Bank, N.A.August 9-10, 2018

Graduate School of Banking

Madison, Wisconsin


INVESTMENT BANKING DIVISION

Disclosure

This communication is provided for informational purposes only. UMB Bank, n.a. and UMB FinancialCorporation are not liable for any errors, omissions, or misstatements. This is not an offer or solicitation for the purchase or sale of any financial instrument, nor a solicitation to participate in any trading strategy, nor an official confirmation of any transaction.

The information is believed to be reliable, but we do not warrant its completeness or accuracy. Past performance is no indicationof future results. The numbers cited are for illustrative purposes only.

UMB Financial Corporation, its affiliates, and its employees are not in the business of providing tax or legal advice. Any materialsor tax‐related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer's particular circumstances from anindependent tax advisor. The opinions expressed herein are those of the author and do not necessarily represent the opinions ofUMB or UMB Financial Corporation. Products offered through UMB Bank, n.a. Investment Banking Division are: Not FDIC Insured, May Lose Value, Not Bank Guaranteed.

Andy TrovillionUMB Bank, n.a. UMB Bank, n.a.Investment Banking Division Investment Banking Division2 S. Broadway 1010 Grand BlvdSt. Louis, MO 63102 Kansas City, MO 64106314.612.8039 866.651.9262

2



Topics to be Addressed

• Introduction– Putting Interest Rates into Perspective: A Short History

• The Relationship between Interest Rates, the Yield Curve and the Economy

– How does the yield curve behave as interest rates rise and fall?

• The Impact these changes have on Bank Portfolio Investing– “The Bond Trap”

• How to Strategically Manage the Bond Portfolio-The Bond Trap– A lesson on gains and losses– Managing option risk– Managing duration risk

• Good Ideas for Now

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PUTTING INTEREST RATES INTO PERSPECTIVE

INTRODUCTION

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A History of Interest Rates: The 2 Year Treasury Yield(Source: Bloomberg)

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A History of Interest Rates: The 10 Year Treasury Yield(Source: Bloomberg)

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The Yield Curve: 2 YR TO 10 YR Spread(Source: Bloomberg)

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SPREAD



HOW DOES THE YIELD CURVE BEHAVE AS INTEREST RATES

RISE AND FALL

THE REALTIONSHIP BETWEEN INTEREST RATES, THE YIELD CURVE AND THE ECONOMY

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A History of Interest Rates: The 2 Yr-10 Yr Relationship(Source: Bloomberg)

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SPREAD 2 YEAR 10 YEAR



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U.S. Treasury Yield Curve Comparison (Source: Bloomberg)

6/1/2003 6/1/2006 6/1/2018



Long-Term Look at US Economic Cycles (Source: Bloomberg)

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The Yield Curve and US Economic Cycles (Source: Bloomberg)

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% Y

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GDP SPREAD



“THE BOND TRAP”

THE IMPACT ON BANK PORTFOLIO INVESTING

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The Bond Trap

• As the economy slows:– Loan totals and demand for new credit declines– The Federal Reserve lowers interest rates– The investment portfolio increases as “unlendable” dollars must

be reinvested into securities– If optionality is present in the investment portfolio, bonds are

called and/or pre-payments increase forcing additional security purchases in low interest rate environments.

• As a result, banks tend to purchase the majority of their securities in lower interest rate environments.



The Bond Trap

• As the economy recovers and begins to expand:– Loan demand increases as the economy improves.– The Federal Reserve begins to raise interest rates in response

to the improving economy and rising inflation expectations.– Cash flow from the investment portfolio is used to meet new loan

demand and/or deposit withdrawals.– As interest rates rise, call options extend and pre-payments

decrease.• The investment portfolio begins to extend.

– Bonds have losses.– Fewer new purchases are made at the higher yield levels.

• As the cycle matures, yield curve flattens reducing the relative value of longer-term securities.



A LESSON IN GAINS & LOSSESMANAGING OPTION RISK

MANAGING DURATION RISK

HOW TO STRATEGICALLY MANAGE THE BOND PORTFOLIO-

The Bond Trap

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The Math Behind Gains and Losses

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Total Return as a Measurement of Performance and Market Risk

• Total return includes the yield of a security and the market value gain (or loss).

• Total return is a much better measurement of a portfolio’s performance and risk.

• $1,000,000 * 3.50% yield=$35,000 annual income plus a gain of $10,000 generates a total return of 4.50%.

– If the total return is greater than the yield there is a market value gain in the security.

– If the total return is less than the yield there is a market value loss in the security.

• Market prices are extremely efficient at pricing risk (call risk, credit risk, extension risk…).

• Since market value is the present value of the future income, total return also provides an indication of how long you will maintain the superior income stream(gain) or below market income stream(loss).

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Current Investment Portfolio Total Return Analysis (Source: UMB Bank Financial Services Group)



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Extension Risk (Source: UMB, FSG)

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Extension Risk (Source: UMB, FSG)

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MANAGING RISK WHILE STILL MAKING MONEY

Good Ideas for Right Now

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Good Ideas for Right Now!

• Two opposing goals:– Maximize yield/interest income today– Prepare for the next interest rate cycle, whenever it comes

• Environment we are investing in:– While higher we still have historically low yields– Sluggish, but improving economic recovery.– For some banks, improving loan volumes; others experiencing flat loan growth-at

best!– Steep, but flattening yield curve rewards extension to add yield at the same time

we need the yield.• Solutions:

– Security Diversification– Manage duration/extension risks– Prepare for balance sheet changes

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Security Distribution (Source: UMB, FSG)

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Managing Duration/Extension Risk

• Duration is the time-weighted, present value of a bond’s cash flows.• Stated in terms of years. Will always be shorter than the maturity of a bond due

to interest payments and principal payments.• Modified duration can be used to measure the approximate price sensitivity of a

bond. A duration of 3.50 years indicates the price of the bond will change 3.50% given a 100 basis point change in interest rates.

– The longer (larger) the duration the more price sensitive of the security.– The duration can/will change as the cash flows change. Example would be a callable

security or mortgage-backed bond.Term of Bond % Change in Price6 months 1x1 year 2x5 years 7x10 years 13x30 years 19xThe price on a 30 year bond will change 19x as much as a 6 month bond.

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Cash Flow Issues (Source: UMB, FSG)

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12 Month Cash Flow Comparison-200 -100 Base +100 +200

Date Cash Flow Yield Cash Flow Yield Cash Flow Yield Cash Flow Yield Cash Flow Yield

Jun‐16 $2,037,948 2.29% $2,037,948 2.29% $1,462,948 2.47% $977,948 2.83% $977,948 2.83%

Jul‐16 $1,582,621 2.72% $1,582,621 2.72% $930,088 2.74% $771,825 2.75% $716,020 2.77%

Aug‐16 $3,575,030 2.68% $3,575,030 2.68% $978,017 2.75% $592,467 2.77% $536,635 2.78%

Sep‐16 $3,627,727 2.72% $3,627,727 2.72% $953,623 2.75% $586,941 2.77% $533,180 2.78%

Oct‐16 $3,682,270 2.75% $3,682,270 2.75% $934,899 2.76% $581,886 2.78% $531,171 2.79%

Nov‐16 $3,618,211 2.80% $3,618,211 2.80% $948,093 2.81% $571,515 2.78% $524,261 2.79%

Dec‐16 $3,357,616 2.85% $3,357,616 2.85% $1,027,706 2.91% $574,202 2.83% $525,210 2.84%

Jan‐17 $2,925,895 2.83% $2,925,895 2.83% $885,540 2.81% $510,753 2.79% $464,980 2.80%

Feb‐17 $2,638,303 2.84% $2,638,303 2.84% $897,396 2.85% $501,753 2.79% $458,081 2.81%

Mar‐17 $3,872,592 2.98% $3,872,592 2.98% $1,860,844 3.42% $472,065 2.80% $432,513 2.81%

Apr‐17 $2,153,103 2.85% $2,153,103 2.85% $853,441 2.84% $470,200 2.80% $431,735 2.81%

May‐17 $1,986,950 2.85% $1,986,950 2.85% $887,599 2.84% $513,102 2.80% $471,877 2.82%

Grand Total $35,058,270 2.78% $35,058,270 2.78% $12,620,194 2.86% $7,124,657 2.79% $6,603,613 2.80%



Cash Flow Issues (Source: UMB, FSG)

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Cash Flow -200 -100 Base +100 +200

Cash Flow Date

Cash Flow Yield Cash Flow Yield Cash Flow Yield Cash Flow Yield Cash Flow Yield

0-12months $35,058,270 2.78% $27,796,679 2.81% $12,620,194 2.86% $8,551,303 2.92% $7,124,657 2.79%

13-24months $14,188,950 2.93% $15,232,332 2.89% $10,116,076 2.84% $7,716,036 2.78% $6,964,080 2.77%

25-36months $5,824,548 2.99% $7,129,348 2.92% $8,432,815 2.92% $6,599,417 2.93% $5,901,668 2.85%

37-48months $11,764,723 3.78% $12,989,755 3.70% $12,869,318 3.78% $10,762,147 3.82% $6,805,345 3.13%

49-60months $6,193,847 3.32% $6,894,988 3.31% $7,438,800 3.23% $7,138,633 3.27% $6,048,205 2.99%

>60months $35,097,341 3.24% $38,084,576 3.12% $56,650,475 2.34% $67,360,142 1.70% $75,283,722 1.40%

Grand Total $108,127,678 3.10% $108,127,678 3.08% $108,127,678 2.72% $108,127,678 2.27% $108,127,678 1.86%



Market Value Issues (Source: UMB, FSG)

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Investment Strategies for Bank Investment Portfolios

• What determines the right investment strategy for your bank?– Risk tolerance

• Interest rate risk.• Credit risk.• Market volatility risk.• Cash flow.

– Time & Expertise• Other responsibilities.• Part-time portfolio manager or full-time.

– Board Direction• Risk guidelines from the Board• Policy limitations for interest rate risk as well as the investment portfolio.

– Balance sheet composition• Loan-to-deposit ratio• Funding make-up

– Interest rate forecast• Rising or falling rates?• Premium or discount bonds?• Duration?• Callable or bullets?• Taxable or tax-exempt?



How and Where to Invest Now

• Securities– FDIC Insured Certificates of Deposits– High quality municipal bonds-taxable and tax exempt (????)

• Additional regulatory emphasis on credit review• Extraordinary call feature on Build America Bonds

– Non-callable Agencies– Callable Agencies– Low risk, short-final maturity mortgage-backed securities and CMOs.– High quality corporate bonds

• Additional regulatory emphasis on credit review• “make whole” call features

– Adjustable rate securities• MBS ARMs• SBA Pools• Floating rate CMOs

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“Bar Bell” Maturity Structure

• Traditionally, banks have managed the cash flows from the investment portfolio using a laddered maturity approach.

– Relatively equal amounts of maturities are invested annually, quarterly, monthly to insure sufficient cash flow and provide multiple reinvestment options throughout the course of the year.

– This is still an excellent method of investing.• However, in the current interest rate environment a “bar bell” approach

makes more sense.– A bar bell allows a short-term ladder of maturities invested from 1 year to as

much as 3 years and then a second portion of maturities out longer (5-7 or 10 years).

– The benefits, especially given the dynamics of today’s environment, are substantial.

• It permits a short-term liquidity ladder and a longer-term ladder to generate higher yields.

• The additional market value risk of the long-term portion is offset by the short-term ladder of securities

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Example of a Modified Bar Bell

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Bond Purchase Scenario Agency Bullet Ladder 1-4years Bond Purchase Scenario Municipal Ladder 5-10yearsMaturity 1yr 2yr 3yr 4yr Maturity 5yr 6yr 7yr 8yr 9yr 10yr

Book Value $1,500,000 $1,500,000 $1,500,000 $1,500,000 Book Value $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000Yield 0.083 0.212 0.42 0.662 Yield 1.29 1.80 2.03 2.32 2.61 2.77

Modified Duration 1.013 1.929 2.959 3.85 Modified Duration 4.72 5.53 6.41 7.26 8.11 9.25

Yield/Unit of Duration 0.082bps 0.11bps 0.142bps 0.172bps Yield/Unit of Duration 0.273bps 0.326bps 0.317bps 0.319bps 0.321bps 0.3bpsTotal Book Value: $6,000,000 Total Book Value: $6,000,000

Weighted Average Yield: 0.34 Weighted Average Yield: 2.14Weighted Average Duration: 2.44 Weighted Average Duration: 6.88

Mkt Value Decline +100bps -$146,265 Mkt Value Decline +100bps -$412,800

Yield/Unit of Duration: 0.14bps Yield/Unit of Duration: 0.31bps

*Yields on Municipals reported as Taxable Equivalent Yield assuming 34% Tax Rate and 0% TEFRA

Bond Purchase Scenario Agency-Municipal BarbellMaturity 1yr Agency 2yr Agency 3yr Agency 6yr Muni 7yr Muni 8yr Muni 9yr Muni

Book Value $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $500,000 $500,000Yield* 0.083 0.212 0.42 1.80 2.03 2.32 2.61

Modified Duration 1.013 1.929 2.959 5.53 6.41 7.26 8.11Total Book Value: $6,000,000

Weighted Average Yield: 1.20Weighted Average Duration: 4.51

Mkt Value Decline +100bps -$270,470

Yield/Unit of Duration: 0.27bps

*Yields on Municipals reported as Taxable Equivalent Yield assuming 34% Tax Rate and 0% TEFRA

Agencies Munis Combined

Ladder Ladder BarbellTotal Book Value: $6,000,000 $6,000,000 $6,000,000Weighted Average Yield: 0.34 2.14 1.20

Weighted Average Duration: 2.44 6.88 4.51

Mkt Value Decline +100bps -$146,265 -$412,800 -$270,470

Yield/Unit of Duration: 0.14bps 0.31bps 0.27bps



Benefits and Costs of Taking Losses Now

• Benefits• Allows the opportunity to improve

income.• Opportunity to improve credit

quality by selling low quality bonds.

• Allows the bank to reposition maturities now with little cost.

• Provide funding for loan growth.

• Costs• Sometimes hard to realize a loss.• If interest rates continue to rise

quickly you may have reinvested too early.

• Tax considerations at new 21% tax bracket.

• Flattening yield curve makes it hard to recover the loss quickly.

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Be Careful

• Watch excessively high premiums on mortgage-backed securities. Be aware of yields if pre-payments increase. Watch for negative yields.

• Poorly structured CMOs that permit significant extension risk for small decreases in pre-payment speeds.

• Excessive call risk/extension risk in callable Agencies, MBS/CMOs and municipals.

• “Reaching” for yield by lowering credit quality or extending durations.• Watch the shape of the yield curve for direction on where to invest.

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Final Thoughts

• Today’s investment environment is one of the most difficult I have experienced in more than 30 years of working with banks on interest rate risk management and investment portfolio management.

• Diversification and prudent investment decisions today have never been more important.

• Resist the temptation to reach for yield: credit quality or maturity/duration.• Stay with high quality, well structured issues (municipals, corporate,

MBS/CMOs). “Cheap in; cheaper out.”• Perform pre-purchase analysis• Perform a regular post-purchase analysis that includes on-going credit

review and extension risk analysis. Add not just rate shock analysis, but consider adding rate ramp scenarios(interest rate risk analysis as well)

• If needed, upgrade municipal credit quality now.• If it is painful, it is likely the right thing to do. “Where you are rewarded the

least, you will benefit the most.”

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Raleigh A. “Andy” TrovillionExecutive Vice President, UMB

Andy Trovillion joined UMB’s Investment Banking Division in 1987. Asexecutive vice president for our St. Louis Investment Division, Mr. Trovillion isresponsible for advising institutional clients about interest rate risk managementissues and fixed-income portfolio management issues. His specialties are interestrate risk management and portfolio management for financial institutions.

Prior to joining UMB, Mr. Trovillion was employed by Newhard, Cook & Co.While there, Mr. Trovillion was responsible for tax-exempt bond trading.

Mr. Trovillion received a Bachelor of Arts in economics with a concentration inhistory from Hampden-Sydney College in Virginia.

In addition to his responsibilities with UMB, Mr. Trovillion is active in thecommunity, teaching investment portfolio management and asset/liabilitymanagement at the Graduate School of Banking in Madison, Wisconsin, asset/liabilitymanagement and investment portfolio management at the Missouri Banker’s Schoolof Bank Management. Mr. Trovillion serves on the Board of the USS PHELPSShipmates organization, the FBI Citizen’s Academy and the Association of MilitaryBanks of America. Mr. Trovillion volunteers his time as a mentor with the Matthews-Dickey Boys and Girls Club. He also is an active leader with the Greater St. LouisBoy Scout Association and a Scout Leader with his local Scouting Troop.

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Contact Information

Raleigh A. “Andy” TrovillionExecutive Vice PresidentUMB Bank, N.A.2 South BroadwaySaint Louis, Missouri 63102800-443-5962 (office)314-517-7384 (Cell)[email protected]

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Documents

STRATEGICALLY MANAGING THE INVESTMENT PORTFOLIO FOR … · Products offered through Investment Banking are: NOT FDIC INSURED I MAY LOSE VALUE I NOT BANK GUARANTEED INVESTMENT BANKING