Pub. 3 2015 Issue 1

www.uba.org 24 B ank investment strategies must be developed within a framework that considers multiple dimensions of risk and reward. We begin with a "big picture" view of the bank and its balance sheet. The asset/liability posture, liquidity position, tax considerations, and expecta- tions for loan demand and deposit growth must all be taken into account. Along with these factors, management must also consider the shape of the yield curve and the cash flow profile of the investment portfolio. This is important since there are separate and distinct strategies that make sense for a steepening versus flattening yield curve. Textbook portfolio manage- ment tells us that when the slope of the yield curve flattens, a duration-weighted combination of short and long maturities will generally perform better than contin- uous cash flows across the time horizon. On the other hand, if the curve steepens a laddered cash flow of maturities is preferred. As an example, we can examine the effects of a change in yield curve slope on positions in three Treasury Notes: a 2-year maturi- ty, a 10-year maturity, and a 4-year maturity which has a duration that is roughly the average of a weighted combination of the 2- and 10-year positions. We can focus on the relative price changes for the three different bonds and assess the change in price or market value for a combination of 2-year and 10-year bonds versus the 4-year bond. If we look at the actual behavior of Treasury yields from year- end 2013 through 2014, we see a substantial flattening of the curve. For the three bonds in our example, the 2-year yield rose by 28 bps, while the 10-year fell by 85 bps. Meanwhile, the 4-year maturity was virtually unchanged. So when we do the math, we can see the duration-weighted barbell combination of 2s and 10s outperformed the single 4-year maturity. This is because the price appreciation of the 10-year more than offset the depreciation of the 2-year, so that the net effect was an unrealized gain on the combination. All the while, the middling 4-year maturity sat quietly and ended the period at precisely the same yield with no change in price. Even if the duration weighting requires a four-to- one ratio of 2 years vs. 10 years, the combined position wins. There is much more to the "modified barbell" structure that we generally recommend for bank portfolios. The short end of the barbell provides a source of re-investable liquidity; the longer end of the barbell can be populated with high-grade bank-qualified municipal bonds (assuming the bank is fully taxable); and the portfolio can achieve high tax-equivalent yield to meld with the liquidity ladder. In combination, this "modified barbell" provides the optimal mix of liquidity and yield, making it a high-perfor- mance strategy. n Yield Curve Changes and Management of the Investment Portfolio In Praise of the “Modified” Barbell Jeffrey F. Caughron, Chief Operating Officer/Managing Director of The Baker Group LP, has worked banking, investments, and interest-rate risk management since 1985 and currently serves as a market analyst and portfolio strategist. Contact: 800-937-2257, jcaughron@GoBaker. com. By Jeffrey F. Caughron