Roll or Flow? Amortizing bonds require some analysis

02E36310It seems a popular parlor game is in session this fall, amongst community bankers. The question at hand, and it’s a big one, is “when do you think the Fed is going to start raising rates?”
Of course, it’s a subject that never really escapes the mind of a prudent manager. What’s changed this year is that the Fed has changed its tenor via press releases, statements and speeches. Anywhere from second quarter 2015 to second quarter 2016 is the market’s current guess.
The asset/liability posture of your community bank has a lot to do with determining the next best move for your community bank’s investment portfolio. I am familiar with a number of risk-averse investment managers who stay away from amortizing securities, because of the long period between now and the final maturity. I also know a roughly equal number of risk-averse investment managers who purchase them specifically for the cash flow.
Regardless, it’s telling that nearly 40 percent of all community bank investments are in fixed-rate mortgage securities. As cash flow and price volatility may well be tested in 2015, perhaps it’s time to recall that the two are inversely related. The sooner the principal is returned, the less the market value will fluctuate. But, as we shall see, this is not a linear correlation.
Traditional bond math
A typical investment with community banks is a callable agency, with an intermediate maturity and some decent call protection. All of these are present in a recent Fannie Mae issue, with a coupon of 2.05, a stated final maturity of five years and a first call date in 12 months. This bond was issued in mid-October, at a price of 100.00.
Two things certain about this bond are that 1.) Today it has a duration of about 4.7 years, and 2.) a year from now, it won’t. It will either be in the money to be called away very soon (and the duration will be near zero), or it will not be expected to be called, and the duration will be about 3.7 years. In the eyes of many community bankers, the salvation for this security is that the maturity date is getting ever closer, just with the passage of time, which puts a limit on the uncertainty of when you get your money back.
Example MBS
Mortgage securities aren’t so cut and dried. In fact, the lapse of time doesn’t change much in terms of average lives and duration. A good illustration is a new 15-year pool with a 3 percent rate, also issued by Fannie Mae. Today, it is estimated to have a duration of about 4.5 years, but that’s predicated on a certain amount of refinance activity. Many financial models expect about 10 percent of the loans to prepay each year, so that’s what we’ll use here.
If that’s what happens, a year from now the duration will still be about 4.3 years. This is due to the mechanics behind the duration calculation. It weights the average remaining time to receive your principal and interest, and the number does not decline lock-step with the passage of time. The feature of a mortgage security that helps make up for this seeming anomaly is that some principal is prepaid each month, starting immediately. In fact, half the principal will be paid off in about four years.
What’s best for your bank?
Do you prefer wet or dry ribs? It all depends, on a lot of variables. Such as, the deposit base of your community bank. If there are large blocks of time deposits in certain months or quarters, you may want to buy non-amortizing bonds whose durations mirror those blocks, and control for the call features. If your interest rate risk position needs some help in becoming more rate sensitive, the certainty of the cash flow from mortgage bonds can help.
 
Regardless, keep in mind that your community bank’s investment portfolio has an effective duration that is changing constantly. A shift in rates of even 20 or 25 basis points can cause certain bonds to be called, or to be extended. Most seasoned portfolio managers own a range of different sectors, so that no one segment can materially alter the performance of the whole. Finally, a piece of advice: Review your bond portfolio’s duration regularly, with some help from your brokers. It will help your bank stay fully invested, in the right mix, to achieve its income and risk-containment goals.

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proudly written by
Jim Reber

Jim Reber

Barret School of Banking
650 East Parkway South Memphis, TN 38104
Phone: (901) 321-4000
Email: barret@barret.ws

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