Defense Wins Championships
Geetika Bansal
Fixed Income Strategies
07.24.17
West Virginia Banking Landscape
W. Virginia vs. National
National (%)W. Virginia
(%)
Yield on E. Assets 4.08 3.86
COF 0.45 0.43
NIM 3.62 3.43
ROA 1.07 0.95
ROE 9.43 8.06
Efficiency Ratio 64 63
Loans/Assets 67 69
Bonds/Assets 19 18
How do Bonds contribute to Performance?
Bonds/
Assets Assets ROA ROE
Efficiency
Ratio
Top Half 28% 516,186 0.69 6.14 76%
Bottom Half 11% 713,665 0.72 6.40 72%
• Loans are a “costly” investment
• Overhead expenses impact efficiency ratio
• Bonds are efficient
Investment Portfolio Allocation
32.31 52.08
39.45
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
West Virginia Insured Banks National Banks Top 25% of Banks
Treasuries & Agencies *
Municipals
Pass Through MBS
CMBS
CMO & REMIC
ABS
Other
Investment Portfolio Performance
FDIC UBPR Classifications
West Virginia
Insured Banks
National
Banks
Top 25% of
Banks
Yield (TEY) 2.36% 2.39% 2.79% +
Treasuries & Agencies * 39.45% 26.93% 14.62%
Municipals 27.35% 32.31% 52.08%
Pass Through MBS 22.67% 24.31% 18.31%
CMBS .99% 2.15% 1.87%
CMO & REMIC 6.72% 8.91% 6.93%
ABS .00% .46% .48%
Other 2.82% 4.94% 5.73%
Total Securities 100.00% 100.00% 100.00%
W. Virginia Quartile Performance
FDIC UBPR Classifications Bottom 25%
West Virginia
Insured Banks
Top 25% of
Banks
Yield (TEY) 1.49% 2.36% 3.30%
Treasuries & Agencies * 77.01% 39.45% 7.31%
Municipals 11.97% 27.35% 33.54%
Pass Through MBS 4.12% 22.67% 24.90%
CMBS 0.00% 0.99% 5.08%
CMO & REMIC 0.17% 6.27% 24.92%
ABS 0.00% .00% 0.00%
Other 6.35% 2.82% 4.25%
Total Securities 100.00% 100.00% 100.00%
The Market
• Growth is low (GDP = 1.4%)
• Inflation is low (PCE = 1.4%, Wages 2.5%)
• Unemployment is low (4.3% ~ a 16 year low)
• But so is participation….(62%)
• Fed wants to remove accommodation
• But the market seems to disagree…..
Market Backdrop
Fed is Fueling Uncertainty
3 Year Fed Dots
1.91
1.15
3.00
-
0.50
1.00
1.50
2.00
2.50
3.00
3.50
Jul-
17
Se
p-1
7
No
v-1
7
Jan
-18
Ma
r-1
8
Ma
y-1
8
Jul-
18
Se
p-1
8
No
v-1
8
Jan
-19
Ma
r-1
9
Ma
y-1
9
Jul-
19
Se
p-1
9
No
v-1
9
Jan
-20
Ma
r-2
0
FF Futures vs Fed Dot Plot Forecast
Market = FF Futures
• CNBC July 11th, 2017: Bottom State for Business
• 2016: GDP shrank by 0.9%
Meanwhile in West Virginia
• Decline in coal production
• Mining employment down 40% in the past 5 years
Meanwhile in West Virginia
Why Should Rates Rise?
The Trump Effect is Diminishing….
0.65
1.78
2.58
1.21
2.36
0.50
1.00
1.50
2.00
2.50
1 2 3 4 5 6 7 8 9 10Years
UST
Current
Jan 17
Banking Concerns? Deposit Pricing
Deposit / COF Pressure
Asset Yields
Deposit Sensitivity (2004-2006)
• WV Banks = 94% Corr. Coef. & 31.5bps per 100 FF
• National Banks = 96% Corr. Coef. & 43. bps per 100 FF
If Fed funds rise from 1.16% to 1.76% by March 2020 WV banks will
go from .43 to .62 COF based off past sensitivity
1.00
5.25
1.73
3.08
-
1.00
2.00
3.00
4.00
5.00
6.00
De
c-0
3
Feb
-04
Ap
r-0
4
Jun
-04
Au
g-0
4
Oct
-04
De
c-0
4
Feb
-05
Ap
r-0
5
Jun
-05
Au
g-0
5
Oct
-05
De
c-0
5
Feb
-06
Ap
r-0
6
Jun
-06
Au
g-0
6
Oct
-06
De
c-0
6
Feb
-07
Ap
r-0
7
Jun
-07
Au
g-0
7
Oct
-07
De
c-0
7
Fed Funds
West Virginia Banks
Defense Wins Championships
Know the Plays
�Understand the Curve
� Know the purpose of the portfolio
�Determine average life/duration
�Diversify within sectors
�Develop structure
� Layer in credit exposure
� Yield Matters: Spread Matters too
�Manage with a Reward-to-Risk mindset
The Shape of the Yield Curve Matters
• A steep curve creates opportunities– SCORE
� Rewards Extension
� Allows for potential gains with “roll down”
Steep Curve Opportunities Raise Earnings
• Rewards Extension
(3.00)
(2.00)
(1.00)
-
1.00
2.00
3.00
4.00
2-10 Spread
Buy here
Stay Short
Steep Curve Opportunities Raise Earnings
� Allows for potential gains with “roll down”
1.21
1.41
1.59
1.78
1.94
2.08 2.20
2.27 2.32 2.36
0.50
0.70
0.90
1.10
1.30
1.50
1.70
1.90
2.10
2.30
2.50
1 2 3 4 5 6 7 8 9 10
Years
UST
6yr UST 10yr UST
Par $ 1,000,000 $ 1,000,000
Yield 2.08% 2.36%
2yr Forward Price $ 101.15 $ 100.62
2yr Forward Income 41,600 47,200
2yr Forward Gain $ 11,500 $ 6,200
Total Return 53,100 53,400
Price Vol +300 $ (148,900) $ (279,000)
The Credit Hierarchy
Credit Risk
• Treasuries (0%)
• FDIC guaranteed debt (0%)
• TVA/GNMA/SBA (0%)
• US agency bonds (20%)
• US agency MBS/CMO (20%)
• Municipal bond (20-50%)
• Corporates (100%)
High performing portfolios have credit risk
Credit Risk Pays
Steeper, Wider, Higher
10y7y
1y
3y
5y
UST
AA Corp
IG Corp
Credit Spreads are Wide
But Vol is Low……
Vol is falling; Corp Spreads are
wide; low payup for the risk
Historical Outperformance
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
12/31/201612/31/201312/31/201012/31/200712/31/200412/31/200112/31/199812/29/199512/31/1992
Barclays Aggregate Index Barclays Corp Index Barclays MBS Index
• Agg. = 6.14%
• MBS = 6.15%
• Corp. = 7.12%
AAA MMD to Treasury Ratio Change
60
70
80
90
100
110
120
130
1 year 5 year 10 Year 15 Year 20 Year 30 Year
AA
A M
MD
% o
f Tr
ea
sury
Maturity
AAA Muni/
Treasury Ratio
Dec. 2016
AAA Muni/
Treasury Ratio
June 2017
Long Term
Average
*Source: Bloomberg, and Reuters
Expectations for 2017
• The “Other” Trump Effect
Expectations for 2017
• Muni Outperformance during rate hike cycles
Yield Matters: Spread Matters too
Sell when spreads tighten
Buy wider spreads
• Extend out the curve
• Sell short, low coupon MBS and reinvest in higher coupon
MBS/CMOs
• Sell short Munis (<5yr) and reinvest out the curve
• Sell short bullet agencies and reinvest out the curve
• Sells short CDs(<2) and reinvest out the curve (5)
Spread Opportunities
Spread Opportunities
1.51
1.77
2.27
3.40
4.49
4.72
1.22 1.40
1.95
2.39
2.61
2.93
-
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
5.00
1yr 2yr 5yr 10yr 20yr 30yr
Muni AAA (TEY) Treasury
3.25% TEY – 2yrs remaining
$102.88
Spread Opportunities
Par Yield (TEY)
Years
Remaining Book Price Mkt Price
Earnings for
2 yrs
Current: $1,000,000 3.25% 2 $ 100.00 $ 102.88 $65,000
unrealized gain: $28,800
Sell & Reinvest: $1,028,800 3.40% 2 $ 100.00 $ 100.00 $69,958
Current Earnings: $65,000
Sell & Reinvest Earnings: $69,958 + $28,800 = $98,758
Net Income Increase: $33,758
% Income Increase: 52%
Portfolio Mgmt Concepts & Strategies
Waiting is Expensive
-
100,000
200,000
300,000
400,000
500,000
600,000
700,000
800,000
900,000
3 6 9 12 15 18 21 24 27 30 33 36
Short Cash/MMKT position
20yr 3.50% MBS
Cumulative Interest Income Comparison
$10mm invested in intermediate MBS yielding 2.54% or Short funds replicating FF
projected path
$201k over 36 Months
+33.4% increase
Basic Components of Earnings Enhancement Strategies
• Reward
� Book Yield
� Earnings/Income
� Function of absolute yield (where interest rates are) and spread (incremental
yield)
• Risk
� Extension Risk
� Price Risk
� Interest Rate Risk is captured by Effective Duration
What is the Reward/Risk Ratio?
Yield
Effective
Duration Rew/Risk
1.25 2.75 45
1.50 2.75 55
2.25 2.75 82
• Reading the Index
� Ratio under 50: More risk (Extension, price) for the reward
� Ratio between 50 and 75: Average reward for the risk
� Ratio higher than 75: Greater reward (yield/income) for the
risk
How to Evaluate and Apply Earnings Enhancement
Strategies?• Applying the Reward/Risk Ratio
� Puts comparable sector investments on a level playing field
• Shape of the Yield Curve Matters
� Extending out the Curve within Sectors
� Structured Product “Rolls Down”
• Value shifts between sectors over time
� MBS vs. CMOs
� DUS vs. Bullets
� CDs vs Bullets
• Tracking Gains/Losses
� “Roll Down”
� Underperforming the market / Too Tight
� Extension Risk (Callables, Amortizing Product)
Agency Bullets - Reward for Risk Analysis
• Hypothetical Portfolio: Agency Bullet Allocation
� Book Yield: 1.66%
� Effective Duration: 2.96
� Reward/Risk: 56%
• Assume we are comfortable with 2.96 Effective Duration
Sector Yield Rew/Risk
Bullets 1.65 56
CDs 1.90 64
10yr 3.0% MBS 2.01 68
Brokered CDs- Reward for Risk Analysis
• Hypothetical Portfolio: Brokered CD Allocation
� Book Yield: 1.63%
� Effective Duration: 2.30
� Reward/Risk: 71%
• Assume we are comfortable with 2.30 Effective Duration
Sector Yield Rew/Risk
Seas 10yr 2.5% MBS 1.92 83
CDs 1.65 72
2yr CMO Seq 1.97 86
Shape of the Yield Curve Matters: Steep Curve Strategies
• A Steep Curve Rewards Extension
� Absolute yields are higher in the belly of the curve from one month ago
2yr
7yr
Curve is Steep between 2-7 yrs
Steep Curve – Capture the “Roll Down”
• Capture the “Roll Down” – Sell lower coupon seasoned CDs under a 2.0
yrs avg life
� Absolute yields are higher; Fed Funds earns approximately 1.20%
� Get Rewarded for Extension (steep yield curve)
� Position yourself to take advantage of opportunities without having
to grow the balance sheet
Cusip Par Value Description Coupon Maturity Bk Price
Mkt
Price Gain/Loss TEY Mkt Yld Avg Life Eff Dur R/R
46176PDJ1 250,000 INVESTORS BK SHORT HILLS NJ 1.65 9/26/18 100.00 100.08 188 1.64 1.57 1.42 1.40 117
20451PEV4 250,000 COMPASS BK BIRMINGHAM ALA 2.00 10/2/18 100.00 100.30 738 2.00 1.76 1.44 1.42 141
080515AT6 250,000 BELMONT SVGS BK MASS 1.55 11/13/18 100.00 100.00 0 1.55 1.55 1.56 1.52 102
984308BE5 250,000 YADKIN VY BK & TR CO ELKIN N 1.75 1/30/19 100.00 100.00 0 1.75 1.75 1.77 1.73 102
1,000,000 1.74 100.00 100.09 925 1.74 1.66 1.55 1.52 114
The Takeaway: Steep Curve Rewards Extension
• Capture the “Roll Down” – Extend into the same product
� The steep yield curve rewards a “roll down” strategy
Sell Buy
1.74 2.40
1.55 5.02
1.52 4.74
0.02 0.13
114 51
6,600
1,800
Yield:
Avg Life:
Eff Duration:
Convexity:
Annual Income Change:
Gain/Loss:
Reward To Risk:
3.22
0.11
0.66
3.47
Change 1. Improve income
(Yield) and take a
gain
2. Rew/Risk
improves as CDs
“roll down” and
provide gains
Sector 1 Cusip Orig Face Par Value Description Coupon Maturity Eff Dur Conv Mkt Price Mkt Value
Market
Yield Avg Life
MM 1404203A6 250,000 250,000 Capital One Bank Usa Na 2.400 05/24/2022 4.74 0.13 100.000 250,000 2.394 5.02
MM 14042RFW6 250,000 250,000 Capital One Na 2.400 05/24/2022 4.74 0.13 100.000 250,000 2.394 5.02
MM 02587DS66 250,000 250,000 American Expr Centurion 2.400 05/24/2022 4.74 0.13 100.000 250,000 2.394 5.02
MM 02587CFG0 250,000 250,000 AMERICAN EXPRESS BANK FSB 2.400 05/24/2022 4.74 0.13 100.000 250,000 2.400 5.00
1,000,000 1,000,000 2.400 4.74 0.13 100.000 1,000,000 2.396 5.02
Steep Curve: Structured Product “Rolls Down”
• Shape of the Yield Curve Matters
� No extension risk; Yield maintenance provision for call protection
Steep Curve and Structured Product : Reduce
Extension Risk
• Structured Product “rolls down” - DUS compares favorably to bullets
for yield and cash flow
� Rates Unchanged: Better total return and Reward/Risk
� Rates Up 75 bps: Higher yield profile, similar rew/risk, slightly lower
total return but added monthly cash flow
1yr Forward (Unch)
Yield Avg Life Eff Dur Rew/Risk Yield Avg Life Eff Dur Rew/Risk
Tot
Return
5.5yr DUS 2.25 5.50 5.05 45 2.12 4.55 4.2 50 2.79
5yr bullet 2.00 5.00 4.77 42 1.82 4.00 3.8 48 2.71
1yr Forward (Up 75 bps)
Yield Avg Life Eff Dur Rew/Risk Yield Avg Life Eff Dur Rew/Risk
Tot
Return
5.5yr DUS 2.25 5.50 5.05 45 2.88 4.53 4.2 69 -0.28
5yr bullet 2.00 5.00 4.77 42 2.60 4.01 3.8 68 -0.13
Relative Value: No Extension, More Cash Flow
• Value Shifts Between Sectors Over Time
� Agency Bullets are Tight
� DUS provides more cash flow and no extension
� Improve income with reallocation within the portfolio
Par Value Description Coupon Maturity Bk Price
Mkt
Price Gain/Loss TEY Mkt Yld Avg Life Eff Dur Conv R/R
1,000,000 FNMA 1.25 05/06/2021 1.25 5/6/21 98.36 98.00 -3,600 1.67 1.77 4.00 3.91 0.09 43
1,000,000 FHLB 2.25 03/11/2022 2.25 3/11/22 100.46 101.00 5,400 2.15 2.03 4.92 4.63 0.12 46
2,000,000 1.75 99.92 99.11 1,800 1.91 1.90 4.46 4.28 0.11 45
The Takeaway: Eliminate Extension, Increase Yield
• Value Shifts Between Sectors Over Time
� DUS improves yield and cash flow for no extension
1. No new money
needed
2. Eliminate
extension
3. Add cash flow
Swap Buy Candidates
Sector 1 Cusip Orig Face Par Value Description Coupon Maturity
Eff
Dur Conv Mkt Price Mkt Value
Market
Yield Avg Life
DUS 3138L7CV6 2,025,000 1,935,646 FN AM6383 2.800 04/01/2023 5.05 0.15 103.313 1,999,774 2.248 5.46
Relative Value – MBS vs. CMOs
• Value Shifts Between Sectors Over time
� Value shifts between sectors over time
� MBS vs CMOs: what sectors provide value right now?
� Improve income with reallocation within the portfolio
The Takeaway: Spreads reflect value for a given level of
risk/avg life
• Value shifts between sectors over time
� Sell seasoned lower yield, lower coupon MBS
� Reduce credit risk concentration (Goldman Corp and MS Munis)
� Take gains in longer duration Municipals ahead of Fed Meeting
1. No new money
needed
2. Buy Defensive
Coupons
3. Add monthly
Principal and
interest
4. Protect “value”
into rising rates
Sell Buy
2.37 2.48
5.45 4.04
3.21 1.66
-0.06 -1.51
(1.55)
(1.45)
0.11
(1.40)
Change
Yield:
Avg Life:
Eff Duration:
Convexity:
Annual Income Change:
Gross Income Change: 35,260
8,853
(551)
0.75
Gain/Loss:
Time to make up loss:
Sector 1 Cusip Par Value Description Coupon Maturity
Eff
Dur Bk Price Bk Value
Tax Bk
Yld
Avg
Life Mkt Price Mkt Value
Market
Yield Gain/Loss
OGVT 60535QLZ1 337,247 MISSISSIPPI HOME CORP SINGL 3.050 12/01/2034 10.13 100.000 337,247 3.068 17.42 99.500 335,561 3.107 -1,686.24
FIN 38141EB81 2,500,000 GOLDMAN SACHS GRP INC MTN BE 2.800 11/29/2023 0.21 101.940 2,548,500 2.580 6.42 103.050 2,576,250 2.393 27,750.02
PASS 31417DCC5 661,320 FNMA POOL - AB6366 2.500 10/01/2027 3.42 102.380 677,059 1.796 3.75 100.875 667,106 2.214 -9,952.85
PASS 31294UAT0 1,006,640 FHLMC GOLD POOL - E09018 2.500 01/01/2028 3.41 103.350 1,040,362 1.544 3.75 100.875 1,015,448 2.232 -24,914.32
PASS 3138AVRH0 938,540 FNMA POOL - AJ4087 3.000 10/01/2026 2.97 103.780 974,017 1.771 3.33 102.625 963,177 2.118 -10,840.13
PASS 3128PYAC8 853,023 FHLMC GOLD POOL - J18103 2.500 02/01/2027 3.13 101.800 868,377 1.932 3.42 100.938 861,020 2.192 -7,357.35
PASS 3138AVRH0 602,346 FNMA POOL - AJ4087 3.000 10/01/2026 2.97 104.080 626,922 1.681 3.33 102.625 618,158 2.118 -8,764.15
PASS 3138WVW31 1,099,787 FNMA POOL - AT7865 3.000 06/01/2028 3.28 103.500 1,138,280 1.997 3.83 102.625 1,128,657 2.227 -9,623.14
MUNI 223129BW6 365,000 COVINGTON CNTY MISS GO REF 3.000 07/01/2025 7.10 100.710 367,591 4.393 8.00 104.406 381,083 2.392 13,491.51
MUNI 888253AH4 330,000 TISHOMINGO CNTY MISS GO REF 2.625 12/01/2025 7.62 99.430 328,119 4.093 8.42 101.000 333,300 2.492 5,181.00
MUNI 241559TX1 625,000 DE SOTO CNTY MISS SCH DIST 3.000 04/01/2025 6.98 103.070 644,187 3.877 7.75 107.256 670,352 1.985 26,164.39
9,318,903 2.800 3.21 102.500 9,550,661 2.368 5.45 102.509 9,550,112 2.280 -551.26
Credit Risk: Where is the reward?
• Value Shifts within a sector over time
� Municipal yield curve is steep: Short Munis vs Long Munis
� Sell Underperforming, higher premium taxables
� Reduce exposure to certain “troubled” states
Swap Sale Candidates
Cusip Orig Face Description Coupon Call Date Maturity Eff Dur Bk Price Bk Value
Tax Bk
Yld
Avg
Life Mkt Price
Market
Yield Gain/Loss
341271AC8 1,000,000 FLORIDA ST BRD ADMIN FIN CO 2.638 07/01/2021 3.78 101.244 1,012,440 2.309 4.00 100.700 2.452 -5,440.06
349545K44 500,000 FORT ZUMWALT MO SCH DIST GO 4.450 03/01/2020 03/01/2022 2.62 105.244 526,220 2.395 2.67 105.220 2.404 -120.01
084509QQ4 385,000 BERKS CNTY PA GO BDS 2010B 5.085 11/15/2020 11/15/2022 3.13 107.950 415,607 2.595 3.33 108.850 2.327 3,465.01
1,885,000 3.618 3.33 103.747 1,954,267 2.393 3.50 103.668 2.412 -2,095.06
Swap Buy Candidates
Sector 1 Cusip Par Value Description Coupon Call Date Maturity Eff Dur Mkt Price Mkt Value
Market
Yield Avg Life
MUNI 150213FC5 500,000 CEDAR FALLS IOWA CMNTY SCH 3.375 06/01/2026 06/01/2034 12.66 101.400 507,000 4.836 8.92
MUNI 082761VP9 750,000 BENTON ARK SCH DIST NO 008 3.125 08/01/2022 02/01/2031 9.26 100.578 754,335 4.492 5.08
MUNI 181059XF8 1,000,000 CLARK CNTY NEV SCH DIST FOR 4.000 06/15/2027 06/15/2035 12.66 105.800 1,058,000 5.015 9.92
2,250,000 3.569 11.55 103.140 2,319,335 4.806 8.13
Credit Risk: Where is the reward?
• Value Shifts within a sector over time
� Extending out the Municipal yield curve picks up 241 bps
� Add tax free income
� Reduce exposure to certain “troubled” states
� Sell taxable (credit risk) investments that are underperforming the
market
Reward/Risk - Total Return Performance
• Total Return Performance
� Reward/Risk is simply a tool
� Buy where it is “cheap” (value)
� Extend when the curve provides rewards (incremental yield pick up)
� Capture the “roll down” (gains on seasoned positions)
� Amortizing Cash flow provides more re-investable liquidity into rising rates
which also increases/improves total return
Purchases Unch +75 bps
Tot Return - 3.00 0.03
Yield 2.88 2.68 3.64
Avg Life 4.97 4.18 5.82
Prc Change - 0.11 -3.00
Eff Dur 3.87 3.21 4.31
Rew/Risk 74 83 84
1yr forward
Sales Unch +75 bps
Tot Return - 2.31 0.27
Yield 2.26 2.21 2.88
Avg Life 4.76 4.00 4.05
Prc Change - 0.00 -1.85
Eff Dur 3.22 2.69 2.73
Rew/Risk 70 82 105
1yr forward
1. Seasoning
creates this
effect of
attractive
returns as
bonds near
maturity
2. Don’t pay up for
seasoning, pay
up for structure
and value