Independent Banker - August 2017 - 110

Nuts & Bolts
PORTFOLIO MANAGEMENT
Shop talk
A community banker asks the questions you've been wondering about.
By Jim Reber
two, it's usually the result of owning a
lot of fl oaters. "
" OK, Jim, that's starting to
make sense. But on the same bond
accounting summary, Vining Sparks
estimates that my effective duration
will increase when rates rise.
Actually, it jumped up quite a bit in
the fourth quarter of 2016. Why did
that happen? "
J
ICBA
VOICE
___
im Reber speaking. "
" Hi Jim, this is Charlie
Brown with Community
Trust Bank. Do you have a
minute? "
" I sure do! How can I help? "
" I've got a question that's been on
my mind, and I can't fi gure this out. I
also don't want to ask this in front of
other bankers. The bank's investment
portfolio has an average life of about
four years, but an effective duration
of about two years, at least according
to your bond accounting summary.
What causes this difference? "
" Charlie, what you're telling me is
that you own some fl oaters. "
" Yes, I do. How did you know this? "
" Average life is an estimate of
Jim Reber (jreber@icbasecurities.
com) is president and CEO of ICBA
Securities, ICBA's institutional,
fi xed-income broker-dealer for
community banks.
______________
the time for all of your principal to
be paid back to you. This includes
the face amount of your agencies,
corporates and munis, and an average
period for your amortizing bonds like
mortgage-backed securities [MBS],
collateralized mortgage obligations
[CMOs], and SBA [Small Business
Administration] pools. Effective duration,
on the other
hand, is an estimate
of how long it will
be until your portfolio
reprices, either
due to a maturity
or an adjustment
to the rate. When a
portfolio has a big
difference in the
110 ICBA IndependentBanker August 2017
" The other part of the answer is
that effective duration also accounts
for optionality. Most of your bonds
have some uncertainty as to when
your money's coming back to you.
Take your callables, for example. Last
October, a lot of your callable bonds
would have been called at the earliest
date, if rates hadn't spiked 50-something
basis points, or 0.5 percent,
in two months. Since your callables
are not, at the moment, in danger of
being called, all of our models are
estimating that they'll be around for
a while. And that causes an extension
in your duration. "
" But I don't want my bonds to
extend on me. I've got loan demand
I'm trying to fund. How can I get
around this? "
" First of all, Charlie, every single
community bank in the country struggles
with this. Somewhere around 80
percent of all the bonds in all the investment
portfolios have some optionality
to them. This means you'll get your
money back sooner when rates are low
or falling, and later when rates are high
or rising. So if you're asking why you
decided to create this countercyclical
cash-fl ow profi le, I have a one-word
answer for you: 'Yield.' "
" So you're telling me I'm greedy? "
" Heck no. In fact, if your bond
portfolio had no optionality, you'd
have an awful return compared with
your peers. It's the management of
the cash fl ows that makes the risk/
Independent Banker - August 2017

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