The Investment

Function in Banking
and Financial Services
Management
 Introduction

 The primary function of most banks is to make loans to

businesses and individuals.
 Yet buying and selling bonds has its place because not
all of a financial firm’s funds can be allocated to loans.
 For one thing, some loans are illiquid—they cannot
easily be sold or securitized prior to maturity if a
lending institution needs cash in a hurry. Another
problem is that loans are among the riskiest assets
generally carrying the highest customer default rates of
any form of credit.
 Depository institutions have learned to devote a
significant portion of their asset portfolios—usually
somewhere between a fifth to a third of all assets—to
investments in securities that are under the management
of investments officers.
 These instruments typically include government bonds
and notes; corporate bonds, notes, and commercial
paper; asset-backed securities arising from lending
activity; domestic and Eurocurrency deposits; and
certain kinds of common and preferred stock where
permitted by law.
 Investment Instruments Available
to Financial Firms
 To examine the different investment vehicles
available, it is useful to divide them into two broad
groups:
(1) money market instruments, which reach maturity
within one year and are noted for their low risk and
ready marketability, and
(2) capital market instruments, which have remaining
maturities beyond one year and are generally noted
for their higher expected rate of return and capital
gains potential.
 Role of Investment security portfolios

 Stabilize income
 Offset credit risk exposure in the loan portfolio
 Provide geographic diversification
 Provide a backup source of liquidity
 Reduce tax exposure
 Serve as collateral (pledged assets)
 Help hedge against losses
 Provide flexibility in a bank’s asset portfolio
 Dress up the balance sheet
 Written Investment Policy

 Every regulated institution to develop a written

investment policy giving specific guidelines on:
a.The quality or degree of default risk exposure the
institution is willing to accept.
b.The desired maturity range and degree of marketability
sought for all securities purchased.
c. The goals sought for its investment portfolio.
d.The degree of portfolio diversification to reduce risk the
institution wishes to achieve with its investment
portfolio.
 Popular Money Market Investment
Instruments

A. Treasury Bills
 A debt obligation of the government that, by law, must
mature within one year from date of issue. T-bills are
issued in weekly and monthly auctions and are
particularly attractive to financial firms because of their
high degree of safety.
 T-bills can serve as collateral for attracting loans from
other institutions. Bills are issued and traded at a
discount from their par (face) value. Thus, the investor’s
return consists purely of price appreciation
B. Short-Term Treasury Notes and Bonds
 When these securities come within one year of maturity,
they are considered money market instruments.
 T-notes and bonds are coupon instruments, which means
they promise investors a fixed rate of return, though the
expected return may fall below or climb above the
promised coupon rate due to fluctuations in their market
price.
C. Federal Agency Securities
 Marketable notes and bonds sold by agencies owned by
or sponsored by the federal government are known as
federal agency securities.
 Familiar examples include securities issued by the
Federal National Mortgage Association, the Farm Credit
System, the Federal Home Loan Mortgage Corporation
etc.
 Interest income on agency-issued notes is federally
taxable and, in most cases, subject to state and local
taxation as well
D. Certificates of Deposit
 It is simply an interest-bearing receipt for the deposit of
funds in a depository institution. Thus, the primary role
of CDs is to provide depository institutions with an
additional source of funds.
 Banks often buy the CDs issued by other depository
institutions, regarding them as an attractive, lower-risk
investment. CDs carry a fixed term and there is a
federally imposed penalty for early withdrawal.
 CDs have negotiated interest rates that, while normally
fixed, may be allowed to fluctuate with market
conditions
E. International Eurocurrency Deposits
 Eurocurrency deposits are time deposits of fixed
maturity issued by the world’s largest banks
headquartered in financial centers around the globe,
though the heart of the Eurocurrency market is in
London.
 Denominated in a currency other than the home
currency of the country in which they are deposited
 Most of these international deposits are of short
maturity—30, 60, or 90 days—to correspond with the
funding requirements of international trade.
F. Bankers’ Acceptances
 They represent a bank’s promise to pay the holder a
designated amount of money on a designated future
date.
 Most acceptances arise from a financial firm’s decision
to guarantee the credit of one of its customers who is
exporting, importing, or storing goods or purchasing
currency.
 The acceptance is a discount instrument and, is always
sold at a price below par before it reaches maturity.
acceptances have a resale market, they may be traded
from one investor to another before reaching maturity.
G. Commercial Paper
• It is short-term, unsecured IOUs offered by major
corporations
 the bulk of it matures in 90 days or less—and generally
is issued by borrowers with the highest credit ratings.
 Most commercial paper is issued at a discount from par,
though some paper bearing a promised rate of return
(coupon) is also issued.
H. Short-Term Municipal Obligations
 State and local governments issue a wide variety of
short-term debt instruments to cover temporary cash
shortages.
 Two of the most common are tax-anticipation notes
(TANs), issued in lieu of expected future tax revenues,
and revenue-anticipation notes (RANs), issued to cover
expenses from special projects, such as the construction
of a toll bridge or a highway in lieu of expected
revenues from those projects
 All interest earned on municipal notes is exempted from
tax
 Popular Capital Market Investment
Instruments

A. Treasury Notes and Bonds

 T-notes are available in a wide variety of maturities
(from 1 year to 10 years) and in large volume.
 T-bonds (maturities of more than 10 years) are traded in
a more limited market with wider price fluctuations than
is usually the case with T-notes.
 They are issued normally in denominations of $1,000,
$5,000, $10,000, $100,000, and $1 million.
B. Municipal Notes and Bonds
• Long-term debt obligations issued by states, cities, and
other local governmental units
 Interest on the majority of these bonds is exempt from
income tax Capital gains on municipals are fully taxable
 The majority fall into one of two categories: (1) general
obligation (GO) bonds, backed by the full faith and
credit of the issuing government, and (2) revenue bonds,
which can be used to fund long-term revenue-raising
projects and are payable only from certain stipulated
sources of funds.
C. Corporate Notes and Bonds
 Long-term debt securities issued by corporations are
usually called corporate notes when they mature within
5 years or corporate bonds when they carry longer
maturities.
 There are many different varieties, depending on the
types of security pledged, purpose of issue, and terms of
issue.
D. Structured Notes
 Most of these notes arose from security dealers who
assembled pools of federal agency securities and offered
investments officers a packaged investment whose
interest yield could be reset periodically based on
Treasury bond rate.
 A guaranteed floor rate and cap rate may be added in
which the investment return could not drop below a
stated (floor) level or rise above maximum (cap) level.
E. Securitized Assets
 These are backed by selected loans of uniform type and
quality
 There are at least 3 main types of mortgage-backed
securitized assets:
 (1) Pass-through securities arise when a lender pools a
group of similar home mortgages appearing on its
balance sheet, and issues securities using the mortgage
loans as collateral. As the mortgage loan pool generates
principal and interest payments, these payments are
“passed through” to investors holding the securities.
 (2) Collateralized Mortgage Obligation (CMO) is a
pass-through security divided into multiple classes
(tranches), each with a different promised (coupon) rate
and level of risk exposure.
 (3) Mortgage Backed Bonds (MBBs) and the mortgage
loans backing them stay on the issuer’s balance sheet.
The financial institution issuing these bonds will
separate the mortgage loans held on its balance sheet
from its other assets and pledge those loans as collateral
to support the MBBs.
 Reasons for popularity of asset-backed investments

1. Guarantees from government agencies (in the case of

home-mortgage-related securities) or from private
institutions
2. The higher average yields available on securitized
assets than on most government securities.
3. The lack of good-quality assets of other kinds in some
markets around the globe.
4. The superior liquidity and marketability of securities
backed by loans compared to the liquidity and
marketability of loans themselves.
F. Stripped Securities
 In stripped security investors have a claim against either
the principal or interest payments associated with a debt
security, such as a Treasury bond.
 Dealers create stripped securities by separating the
principal and interest payments from an underlying debt
security and selling separate claims to these two
promised income streams.
 Claims against only the principal payments are called
PO (principal-only) securities, while claims against
only the stream of promised interest payments are
referred to as IO (interest-only) securities.
Factors Affecting Choice of Investment
Securities

1. Expected rate of return

 For most investments, investments manager calculate
the yield to maturity (YTM) if a security is to be held to
maturity or the planned holding period yield (HPY)
between point of purchase and point of sale.
 The calculated YTM or HPY should be compared with
the expected yields on other loans and investments to
determine where the best possible return lies.
2. Tax Exposure
 Because of their relatively high tax exposure, banks are
more interested in the after-tax rate of return on loans
and securities than in their before-tax return.
 Before-tax gross yield × (1- Firm's marginal income tax
rate) = After-tax gross yield
 Bank Qualified Bonds
 Issued by smaller local governments and are allowed to
deduct 80% of any interest paid to fund these bond
purchases.
 The net after-tax return of bank-qualified municipals is
calculated as follows:
 The tax advantage of a qualified bond is determined like:
 Suppose a bank purchases a bank-qualified bond from a
small city and it carries a nominal gross rate of return
of 7%. Assume also that the bank had to borrow the
funds needed to make this purchase at an interest rate of
6.5% and is in the 35% income tax bracket. The bond’s
net annual after-tax return to the bank (after all funding
costs and taxes) must be:
The Tax Swapping Tool
 In a tax swap, the lending institution sells lower-
yielding securities at a loss in order to reduce its current
taxable income, while simultaneously purchasing new
high yielding securities in order to boost future returns
on its investment portfolio.
 Tax considerations in choosing securities to buy or sell
tend to be more important for larger lending institutions
than for smaller ones.
The Portfolio Shifting Tool
 It means changing the holdings of investment securities,
with both taxes and higher returns in mind.
 Managers may shift their portfolios simply to substitute
new, higher-yielding securities for old security holdings
whose yields are well below current market levels.
 The result may be to take substantial short-run losses in
return for the prospect of higher long-run profits.
3. Interest Rate Risk
 Rising interest rates lower the market value of
previously issued bonds and notes, with the longest term
issues generally suffering the greatest losses.
 Periods of rising interest rates are often marked by
surging loan demand. Many investments must be sold
off to generate cash for lending at the very time their
prices are headed downward.
 Banks purchase investment securities when interest
rates and loan demand are declining and, therefore, the
prices the investments officer must pay for desired
investments are headed upward.
4. Credit or Default Risk
 The risk that the security issuer may default on the
principal or interest owed has led to regulatory controls
that prohibit the acquisition of speculative securities—
those rated below Baa by Moody’s or BBB on Standard
& Poor’s bond-rating schedule.
 Credit options and swaps can be used to protect the
expected yield on investment securities. If the bond
issuer defaults, the option holder receives a payoff from
the credit option that at least partially offsets the loss.
5. Business Risk
 FIs of all sizes face significant risk that the economy of
the market area they serve may turn down, with falling
sales and rising unemployment.
 These adverse developments, often called business risk,
can be reflected quickly in the loan portfolio, where
delinquent loans may rise as borrowers struggle to
generate enough cash to pay the lender.
 Out-of-market security are purchased to balance risk
exposure in the loan portfolio.
6. Liquidity Risk
 The possibility that FIs will be required to sell
investment securities in advance of their maturity due to
liquidity needs and be subjected to liquidity risk.
 Thus, a key issue that a portfolio manager must face in
selecting a security for investment purposes is the
breadth and depth of its resale market.
 Management faces a trade-off between profitability and
liquidity
7. Call Risk
 Many corporations and some governments that issue
securities reserve the right to call in those instruments in
advance of maturity and pay them off.
 Because such calls usually take place when market
interest rates have declined (and the borrower can issue
new securities bearing lower interest costs), the
financial firm investing in callable securities runs the
risk of an earnings loss because it must reinvest its
recovered funds at lower interest rates.
8. Prepayment Risk
 This risk is specific to asset-backed securities. It arises
because the realized interest and principal payments
(cash flow) from a pool of securitized loans may be
quite different from the cash flows expected originally.
 Variations in cash flow to holders of the securities
backed by these loans can arise from A. Loan
refinancings (replacing loans with new lower-rate loans)
and B. Turnover of the assets behind the loans
(borrowers may sell out & move away or default)
 In either or both of the cases some loans will be
terminated or paid off ahead of schedule, generating
smaller long-term cash flows than expected that can
lower the expected rate of return from loan-backed
securities
 The pace at which loans that underlie asset-backed
securities are terminated or paid off depends heavily
upon the interest rate spread between current interest
rates on similar type loans and the interest rates attached
to loans in the securitized pool.
n = no. of years required for the last of the loans in the
pool to be paid off or retired,
m = no. of times during the year interest and principal
must be paid to holders of the loan-backed securities,
y = YTM
 Loan prepayment behavior influenced by expected
market interest rates, future changes in the shape of the
yield curve, the impact of seasonal factors, the condition
of the economy, and how old the loans in the pool are
 Asset-backed securities will fall in value when interest
rates decline if the expected loss of interest income from
prepaid loans and reduced reinvestment earnings
exceeds the expected benefits that arise from recovering
cash more quickly from prepaid loans.
9. Inflation Risk
 It refers to the possibility that the purchasing power of
interest income and repaid principal from a security or
loan will be eroded by rising prices for goods and
services.
 Some protection against inflation risk is provided by
short-term securities and those with variable interest
rates
 In TIPS(Treasury Inflation-Protected Securities), both
coupon rate and principal value are adjusted annually to
match changes in the consumer price index (CPI).
 Investment Maturity Strategies
1. The Ladder, or Spaced-Maturity, Policy
 FIs choose some maximum acceptable maturity and
then invest in an equal proportion of securities in each
of several maturity intervals until the maximum
acceptable maturity is reached.
 This strategy certainly does not maximize investment
income, but it has the advantage of reducing income
fluctuations and it tends to build investment flexibility.
 Because some securities are always rolling over into
cash, the firm can take advantage of any promising
opportunities that may appear.
2. The Front-End Load Maturity Policy
 This strategy is to purchase only short-term securities
and place all investments within a brief interval of time.
 For example, FIs may decide to invest 100% of
institution’s funds not needed for loans or cash reserves
in securities 3 years or less from maturity.
 This approach stresses using the investment portfolio
primarily as a source of liquidity rather than a source of
income
 FIs can avoid large capital losses if market interest rates
rise.
3. The Back-End Load Maturity Policy
 An opposite approach would stress the investment
portfolio as a source of income.
 An investing institution following this approach might
decide to invest only in bonds in the 5- to 10-year
maturity range.
 Institutions would probably rely heavily on borrowing
in the money market to help meet its liquidity
requirements.
 Maximizes income potential from security investments
if market interest rates fall.
4. The Barbell Strategy
 A combination of the front-end and back-end load
approaches in which a FI places most of its funds in a
short-term portfolio of highly liquid securities at one
extreme and in a long-term portfolio of bonds at the
other extreme, with minimal investment holdings in
intermediate maturities.
 The short-term portfolio provides liquidity, while the
long-term portfolio is designed to generate income.
5. The Rate Expectations Approach
 The most aggressive strategy is one that continually
shifts maturities of securities in line with current
forecasts of interest rates and the economy.
 This approach calls for shifting investments toward the
short end of the maturity spectrum when interest rates
are expected to rise and toward the long end when
falling interest rates are expected.
 It offers the potential for large capital gains, but also
raises the specter of substantial losses.
 Maturity Management Tools

A. The Yield Curve

 The yield curve contains an implicit forecast of future
interest rate changes. Positively sloped yield curves
reflect the average expectation in the market that future
short-term interest rates will be higher than today and
would result in shifting investment holdings away from
longer-term securities
 Yield curves also provide a clue about overpriced and
underpriced securities. A security whose yield lies
above the curve represents a tempting buy situation
 Yield curves send signals about what stage of the
business cycle the economy presently occupies. They
generally rise in economic expansions and fall in
recessions.
 It also tells about the current trade-offs between
greater returns and greater risks. The yield curve’s
shape determines how much additional yield the
investments officer can earn by replacing shorter-
term securities with longer-term issues, or vice versa.
 Yield curves provide a measure of how much might be
earned at the moment by pursuing the carry trade
(borrow funds at the shortest end of the curve and then
invest the borrowed funds in income-generating assets
farther out along the curve).
 If the yield curve has a strong positive slope, FIs may
also be able to score significant gains from riding the
yield curve [sell securities which are soon to approach
maturity (prices have risen while YTM have fallen) and
reinvest the proceeds of that sale in longer-term
securities carrying higher rates].
B. Duration
 Duration measures the average amount of time it takes
for all of the cash flows from a security to reach the
investor who holds it.
 It also measures the % change in the price of a security
for change of interest rate.
 It gives a tool to reduce FIs exposure to interest rate risk.
 Duration of an individual security or a security portfolio
= Length of the investor's planned holding period for a
security or a security portfolio
 Duration works to immunize a security or portfolio of
securities against interest rate changes because two key
forms of risk—interest rate risk and reinvestment risk—
offset each other when duration is set equal to the
investing institution’s planned holding period.
 If interest rates rise after the securities are purchased,
their market price will decline, but the investments
officer can reinvest the cash flow those securities are
generating at higher market rates.