1. The Investment Function in Financial-Services Management
Chapter Ten
The Investment Function in
Financial-Services Management
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2. Key Topics Nature and Functions of Investments
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Key Topics
Nature and Functions of Investments
Investment Securities Available: Advantages and Disadvantages
Measuring Expected Returns
Taxes, Credit, and Interest-Rate Risks
Liquidity, Prepayment, and Other Risks
Investment Maturity Strategies
Maturity Management Tools
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3. 10-3
Introduction
Depository institutions devote a significant portion of their asset portfolios to investments in securities
Nonbank financial-service providers such as insurance companies, pension funds, and mutual funds often devote an even bigger portion of their assets to investment securities
Investments perform a number of vital functions in the asset portfolios of financial firms, providing income, liquidity, diversification, and shelter for at least a portion of earnings from taxation
Investments also tend to stabilize earnings, providing supplemental income when other sources of revenue are in decline
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4. 10-4
EXHIBIT 10–1 Investments: The Crossroads Account on a Depository Institution’s Balance Sheet
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5. Investment Instruments Available to Financial Firms
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Investment Instruments Available to Financial Firms
The number of financial instruments available for financial institutions to add to their portfolios is both large and growing
Each financial instrument has different characteristics with regard to expected yields, risk, sensitivity to inflation, and sensitivity to shifting government policies and economic conditions
It is useful to divide them into two broad groups
Money market instruments
Reach maturity within one year and are noted for their low risk and ready marketability
Capital market instruments
Have remaining maturities beyond one year and are generally noted for their higher expected rate of return and capital gains potential
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6. Investment Instruments Available to Financial Firms (continued)
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Investment Instruments Available to Financial Firms (continued)
Investment security portfolios help to
Stabilize the bank’s income
Offset credit risk exposure
Provide geographic diversification
Provide backup source of liquidity
Reduce tax exposure
Serve as collateral
Hedge against interest rate risk
Provide flexibility
Dress up a bank’s balance sheet
Some authorities refer to investments as the crossroads account
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7. Investment Instruments Available to Financial Firms (continued)
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Investment Instruments Available to Financial Firms (continued)
Federal regulations stress the need for every regulated institution to develop a written investment policy giving specific guidelines on
The quality or degree of default risk exposure the institution is willing to accept
The desired maturity range and degree of marketability sought for all securities purchased
The goals sought for its investment portfolio
The degree of portfolio diversification to reduce risk the institution wishes to achieve
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8. Popular Money Market Investment Instruments
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Popular Money Market Investment Instruments
Treasury Bills
Short-Term Treasury Notes and Bonds
Federal Agency Securities
Certificates of Deposit
Eurocurrency Deposits
Banker’s Acceptances
Commercial Paper
Short-Term Municipal Obligations
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9. Popular Capital Market Investment Instruments
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Popular Capital Market Investment Instruments
Treasury Notes and Bonds
Municipal Notes and Bonds
Corporate Notes and Bonds
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10. Investment Instruments Developed More Recently
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Investment Instruments Developed More Recently
Structured 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 what happened to a reference interest rate
Securitized Assets
Pass-through securities
CMOs
Mortgage-backed bonds
Guarantees from government agencies; higher average yields; lack of good-quality assets; superior liquidity
Stripped Securities
Principal-Only (PO) and Interest-Only (IO) securities
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11. Investment Securities Held by Banks
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Investment Securities Held by Banks
Just a few types of securities dominate bank investment portfolios
U.S. government (especially Treasury) securities
Obligations of various federal agencies such as the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC), and the Government National Mortgage Association (GNMA), especially in the form of mortgage-backed securities
State and local government obligations (municipals)
Nonmortgage-related asset-backed securities (such as obligations backed by credit card and automobile loans)
Equities (common and preferred stock)
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12. 10-12
TABLE 10–3 Investment Securities Held by FDIC-Insured Commercial Banks, 2010
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13. Factors Affecting Choice of Investment Securities
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Factors Affecting Choice of Investment Securities
The principal factors bearing on which investments are chosen include
Expected rate of return
Tax exposure
Interest rate risk
Credit or default risk
Business risk
Liquidity risk
Call risk
Prepayment risk
Inflation risk
Pledging requirements
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14. Factors Affecting Choice of Investment Securities (continued)
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Factors Affecting Choice of Investment Securities (continued)
Expected Rate of Return
Yield to Maturity (YTM) versus Holding Period Yield (HPY)
Example
An investments officer is considering purchasing a $1,000 par-value Treasury note that promises an 8 percent coupon rate and matures in five years with a current of $900
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15. Factors Affecting Choice of Investment Securities (continued)
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Factors Affecting Choice of Investment Securities (continued)
Tax Exposure
The tax status of state and local government bonds
Bank qualified bonds
Tax swapping tool
The portfolio shifting tool
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16. Factors Affecting Choice of Investment Securities (continued)
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Factors Affecting Choice of Investment Securities (continued)
Tax Exposure
To evaluate the attractiveness of municipals, financial firms calculate the net after-tax returns and/or the tax-equivalent yields to enable comparisons with other investment alternatives
The net after-tax return of bank-qualified municipals is calculated as
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17. Factors Affecting Choice of Investment Securities (continued)
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Factors Affecting Choice of Investment Securities (continued)
Tax Exposure
The tax advantage of a qualified bond is determined as
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18. Factors Affecting Choice of Investment Securities (continued)
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Factors Affecting Choice of Investment Securities (continued)
Tax Exposure
Suppose a bank purchases a bank-qualified bond from a small city, county, or school district and the bond carries a nominal gross rate of return of 7 percent
The bank had to borrow the funds needed to make this purchase at an interest rate of 6.5 percent and is in the 35 percent tax bracket
The bond’s net annual after-tax return (after all funding costs and taxes) must be:
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19. Factors Affecting Choice of Investment Securities (continued)
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Factors Affecting Choice of Investment Securities (continued)
Tax Exposure
In years when loan revenues are high, it may be beneficial to engage in tax swapping
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 higher-yielding securities in order to boost future returns
Lending institutions also do a great deal of portfolio shifting in their holdings of investment securities, with both taxes and higher returns in mind
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