Defense Wins Championships

Geetika Bansal

Fixed Income Strategies

07.24.17

West Virginia Banking Landscape

W. Virginia vs. National

National (%)W. Virginia

(%)

Yield on E. Assets 4.08 3.86

COF 0.45 0.43

NIM 3.62 3.43

ROA 1.07 0.95

ROE 9.43 8.06

Efficiency Ratio 64 63

Loans/Assets 67 69

Bonds/Assets 19 18

How do Bonds contribute to Performance?

Bonds/

Assets Assets ROA ROE

Efficiency

Ratio

Top Half 28% 516,186 0.69 6.14 76%

Bottom Half 11% 713,665 0.72 6.40 72%

• Loans are a “costly” investment

• Overhead expenses impact efficiency ratio

• Bonds are efficient

Investment Portfolio Allocation

32.31 52.08

39.45

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

West Virginia Insured Banks National Banks Top 25% of Banks

Treasuries & Agencies *

Municipals

Pass Through MBS

CMBS

CMO & REMIC

ABS

Other

Investment Portfolio Performance

FDIC UBPR Classifications

West Virginia

Insured Banks

National

Banks

Top 25% of

Banks

Yield (TEY) 2.36% 2.39% 2.79% +

Treasuries & Agencies * 39.45% 26.93% 14.62%

Municipals 27.35% 32.31% 52.08%

Pass Through MBS 22.67% 24.31% 18.31%

CMBS .99% 2.15% 1.87%

CMO & REMIC 6.72% 8.91% 6.93%

ABS .00% .46% .48%

Other 2.82% 4.94% 5.73%

Total Securities 100.00% 100.00% 100.00%

W. Virginia Quartile Performance

FDIC UBPR Classifications Bottom 25%

West Virginia

Insured Banks

Top 25% of

Banks

Yield (TEY) 1.49% 2.36% 3.30%

Treasuries & Agencies * 77.01% 39.45% 7.31%

Municipals 11.97% 27.35% 33.54%

Pass Through MBS 4.12% 22.67% 24.90%

CMBS 0.00% 0.99% 5.08%

CMO & REMIC 0.17% 6.27% 24.92%

ABS 0.00% .00% 0.00%

Other 6.35% 2.82% 4.25%

Total Securities 100.00% 100.00% 100.00%

The Market

• Growth is low (GDP = 1.4%)

• Inflation is low (PCE = 1.4%, Wages 2.5%)

• Unemployment is low (4.3% ~ a 16 year low)

• But so is participation….(62%)

• Fed wants to remove accommodation

• But the market seems to disagree…..

Market Backdrop

Fed is Fueling Uncertainty

3 Year Fed Dots

1.91

1.15

3.00

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

Jul-

17

Se

p-1

7

No

v-1

7

Jan

-18

Ma

r-1

8

Ma

y-1

8

Jul-

18

Se

p-1

8

No

v-1

8

Jan

-19

Ma

r-1

9

Ma

y-1

9

Jul-

19

Se

p-1

9

No

v-1

9

Jan

-20

Ma

r-2

0

FF Futures vs Fed Dot Plot Forecast

Market = FF Futures

• CNBC July 11th, 2017: Bottom State for Business

• 2016: GDP shrank by 0.9%

Meanwhile in West Virginia

• Decline in coal production

• Mining employment down 40% in the past 5 years

Meanwhile in West Virginia

Why Should Rates Rise?

The Trump Effect is Diminishing….

0.65

1.78

2.58

1.21

2.36

0.50

1.00

1.50

2.00

2.50

1 2 3 4 5 6 7 8 9 10Years

UST

Current

Jan 17

Banking Concerns? Deposit Pricing

Deposit / COF Pressure

Asset Yields

Deposit Sensitivity (2004-2006)

• WV Banks = 94% Corr. Coef. & 31.5bps per 100 FF

• National Banks = 96% Corr. Coef. & 43. bps per 100 FF

If Fed funds rise from 1.16% to 1.76% by March 2020 WV banks will

go from .43 to .62 COF based off past sensitivity

1.00

5.25

1.73

3.08

-

1.00

2.00

3.00

4.00

5.00

6.00

De

c-0

3

Feb

-04

Ap

r-0

4

Jun

-04

Au

g-0

4

Oct

-04

De

c-0

4

Feb

-05

Ap

r-0

5

Jun

-05

Au

g-0

5

Oct

-05

De

c-0

5

Feb

-06

Ap

r-0

6

Jun

-06

Au

g-0

6

Oct

-06

De

c-0

6

Feb

-07

Ap

r-0

7

Jun

-07

Au

g-0

7

Oct

-07

De

c-0

7

Fed Funds

West Virginia Banks

Defense Wins Championships

Know the Plays

�Understand the Curve

� Know the purpose of the portfolio

�Determine average life/duration

�Diversify within sectors

�Develop structure

� Layer in credit exposure

� Yield Matters: Spread Matters too

�Manage with a Reward-to-Risk mindset

The Shape of the Yield Curve Matters

• A steep curve creates opportunities– SCORE

� Rewards Extension

� Allows for potential gains with “roll down”

Steep Curve Opportunities Raise Earnings

• Rewards Extension

(3.00)

(2.00)

(1.00)

-

1.00

2.00

3.00

4.00

2-10 Spread

Buy here

Stay Short

Steep Curve Opportunities Raise Earnings

� Allows for potential gains with “roll down”

1.21

1.41

1.59

1.78

1.94

2.08 2.20

2.27 2.32 2.36

0.50

0.70

0.90

1.10

1.30

1.50

1.70

1.90

2.10

2.30

2.50

1 2 3 4 5 6 7 8 9 10

Years

UST

6yr UST 10yr UST

Par $ 1,000,000 $ 1,000,000

Yield 2.08% 2.36%

2yr Forward Price $ 101.15 $ 100.62

2yr Forward Income 41,600 47,200

2yr Forward Gain $ 11,500 $ 6,200

Total Return 53,100 53,400

Price Vol +300 $ (148,900) $ (279,000)

The Credit Hierarchy

Credit Risk

• Treasuries (0%)

• FDIC guaranteed debt (0%)

• TVA/GNMA/SBA (0%)

• US agency bonds (20%)

• US agency MBS/CMO (20%)

• Municipal bond (20-50%)

• Corporates (100%)

High performing portfolios have credit risk

Credit Risk Pays

Steeper, Wider, Higher

10y7y

1y

3y

5y

UST

AA Corp

IG Corp

Credit Spreads are Wide

But Vol is Low……

Vol is falling; Corp Spreads are

wide; low payup for the risk

Historical Outperformance

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

12/31/201612/31/201312/31/201012/31/200712/31/200412/31/200112/31/199812/29/199512/31/1992

Barclays Aggregate Index Barclays Corp Index Barclays MBS Index

• Agg. = 6.14%

• MBS = 6.15%

• Corp. = 7.12%

AAA MMD to Treasury Ratio Change

60

70

80

90

100

110

120

130

1 year 5 year 10 Year 15 Year 20 Year 30 Year

AA

A M

MD

% o

f Tr

ea

sury

Maturity

AAA Muni/

Treasury Ratio

Dec. 2016

AAA Muni/

Treasury Ratio

June 2017

Long Term

Average

*Source: Bloomberg, and Reuters

Expectations for 2017

• The “Other” Trump Effect

Expectations for 2017

• Muni Outperformance during rate hike cycles

Yield Matters: Spread Matters too

Sell when spreads tighten

Buy wider spreads

• Extend out the curve

• Sell short, low coupon MBS and reinvest in higher coupon

MBS/CMOs

• Sell short Munis (<5yr) and reinvest out the curve

• Sell short bullet agencies and reinvest out the curve

• Sells short CDs(<2) and reinvest out the curve (5)

Spread Opportunities

Spread Opportunities

1.51

1.77

2.27

3.40

4.49

4.72

1.22 1.40

1.95

2.39

2.61

2.93

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

5.00

1yr 2yr 5yr 10yr 20yr 30yr

Muni AAA (TEY) Treasury

3.25% TEY – 2yrs remaining

$102.88

Spread Opportunities

Par Yield (TEY)

Years

Remaining Book Price Mkt Price

Earnings for

2 yrs

Current: $1,000,000 3.25% 2 $ 100.00 $ 102.88 $65,000

unrealized gain: $28,800

Sell & Reinvest: $1,028,800 3.40% 2 $ 100.00 $ 100.00 $69,958

Current Earnings: $65,000

Sell & Reinvest Earnings: $69,958 + $28,800 = $98,758

Net Income Increase: $33,758

% Income Increase: 52%

Portfolio Mgmt Concepts & Strategies

Waiting is Expensive

-

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

900,000

3 6 9 12 15 18 21 24 27 30 33 36

Short Cash/MMKT position

20yr 3.50% MBS

Cumulative Interest Income Comparison

$10mm invested in intermediate MBS yielding 2.54% or Short funds replicating FF

projected path

$201k over 36 Months

+33.4% increase

Basic Components of Earnings Enhancement Strategies

• Reward

� Book Yield

� Earnings/Income

� Function of absolute yield (where interest rates are) and spread (incremental

yield)

• Risk

� Extension Risk

� Price Risk

� Interest Rate Risk is captured by Effective Duration

What is the Reward/Risk Ratio?

Yield

Effective

Duration Rew/Risk

1.25 2.75 45

1.50 2.75 55

2.25 2.75 82

• Reading the Index

� Ratio under 50: More risk (Extension, price) for the reward

� Ratio between 50 and 75: Average reward for the risk

� Ratio higher than 75: Greater reward (yield/income) for the

risk

How to Evaluate and Apply Earnings Enhancement

Strategies?• Applying the Reward/Risk Ratio

� Puts comparable sector investments on a level playing field

• Shape of the Yield Curve Matters

� Extending out the Curve within Sectors

� Structured Product “Rolls Down”

• Value shifts between sectors over time

� MBS vs. CMOs

� DUS vs. Bullets

� CDs vs Bullets

• Tracking Gains/Losses

� “Roll Down”

� Underperforming the market / Too Tight

� Extension Risk (Callables, Amortizing Product)

Agency Bullets - Reward for Risk Analysis

• Hypothetical Portfolio: Agency Bullet Allocation

� Book Yield: 1.66%

� Effective Duration: 2.96

� Reward/Risk: 56%

• Assume we are comfortable with 2.96 Effective Duration

Sector Yield Rew/Risk

Bullets 1.65 56

CDs 1.90 64

10yr 3.0% MBS 2.01 68

Brokered CDs- Reward for Risk Analysis

• Hypothetical Portfolio: Brokered CD Allocation

� Book Yield: 1.63%

� Effective Duration: 2.30

� Reward/Risk: 71%

• Assume we are comfortable with 2.30 Effective Duration

Sector Yield Rew/Risk

Seas 10yr 2.5% MBS 1.92 83

CDs 1.65 72

2yr CMO Seq 1.97 86

Shape of the Yield Curve Matters: Steep Curve Strategies

• A Steep Curve Rewards Extension

� Absolute yields are higher in the belly of the curve from one month ago

2yr

7yr

Curve is Steep between 2-7 yrs

Steep Curve – Capture the “Roll Down”

• Capture the “Roll Down” – Sell lower coupon seasoned CDs under a 2.0

yrs avg life

� Absolute yields are higher; Fed Funds earns approximately 1.20%

� Get Rewarded for Extension (steep yield curve)

� Position yourself to take advantage of opportunities without having

to grow the balance sheet

Cusip Par Value Description Coupon Maturity Bk Price

Mkt

Price Gain/Loss TEY Mkt Yld Avg Life Eff Dur R/R

46176PDJ1 250,000 INVESTORS BK SHORT HILLS NJ 1.65 9/26/18 100.00 100.08 188 1.64 1.57 1.42 1.40 117

20451PEV4 250,000 COMPASS BK BIRMINGHAM ALA 2.00 10/2/18 100.00 100.30 738 2.00 1.76 1.44 1.42 141

080515AT6 250,000 BELMONT SVGS BK MASS 1.55 11/13/18 100.00 100.00 0 1.55 1.55 1.56 1.52 102

984308BE5 250,000 YADKIN VY BK & TR CO ELKIN N 1.75 1/30/19 100.00 100.00 0 1.75 1.75 1.77 1.73 102

1,000,000 1.74 100.00 100.09 925 1.74 1.66 1.55 1.52 114

The Takeaway: Steep Curve Rewards Extension

• Capture the “Roll Down” – Extend into the same product

� The steep yield curve rewards a “roll down” strategy

Sell Buy

1.74 2.40

1.55 5.02

1.52 4.74

0.02 0.13

114 51

6,600

1,800

Yield:

Avg Life:

Eff Duration:

Convexity:

Annual Income Change:

Gain/Loss:

Reward To Risk:

3.22

0.11

0.66

3.47

Change 1. Improve income

(Yield) and take a

gain

2. Rew/Risk

improves as CDs

“roll down” and

provide gains

Sector 1 Cusip Orig Face Par Value Description Coupon Maturity Eff Dur Conv Mkt Price Mkt Value

Market

Yield Avg Life

MM 1404203A6 250,000 250,000 Capital One Bank Usa Na 2.400 05/24/2022 4.74 0.13 100.000 250,000 2.394 5.02

MM 14042RFW6 250,000 250,000 Capital One Na 2.400 05/24/2022 4.74 0.13 100.000 250,000 2.394 5.02

MM 02587DS66 250,000 250,000 American Expr Centurion 2.400 05/24/2022 4.74 0.13 100.000 250,000 2.394 5.02

MM 02587CFG0 250,000 250,000 AMERICAN EXPRESS BANK FSB 2.400 05/24/2022 4.74 0.13 100.000 250,000 2.400 5.00

1,000,000 1,000,000 2.400 4.74 0.13 100.000 1,000,000 2.396 5.02

Steep Curve: Structured Product “Rolls Down”

• Shape of the Yield Curve Matters

� No extension risk; Yield maintenance provision for call protection

Steep Curve and Structured Product : Reduce

Extension Risk

• Structured Product “rolls down” - DUS compares favorably to bullets

for yield and cash flow

� Rates Unchanged: Better total return and Reward/Risk

� Rates Up 75 bps: Higher yield profile, similar rew/risk, slightly lower

total return but added monthly cash flow

1yr Forward (Unch)

Yield Avg Life Eff Dur Rew/Risk Yield Avg Life Eff Dur Rew/Risk

Tot

Return

5.5yr DUS 2.25 5.50 5.05 45 2.12 4.55 4.2 50 2.79

5yr bullet 2.00 5.00 4.77 42 1.82 4.00 3.8 48 2.71

1yr Forward (Up 75 bps)

Yield Avg Life Eff Dur Rew/Risk Yield Avg Life Eff Dur Rew/Risk

Tot

Return

5.5yr DUS 2.25 5.50 5.05 45 2.88 4.53 4.2 69 -0.28

5yr bullet 2.00 5.00 4.77 42 2.60 4.01 3.8 68 -0.13

Relative Value: No Extension, More Cash Flow

• Value Shifts Between Sectors Over Time

� Agency Bullets are Tight

� DUS provides more cash flow and no extension

� Improve income with reallocation within the portfolio

Par Value Description Coupon Maturity Bk Price

Mkt

Price Gain/Loss TEY Mkt Yld Avg Life Eff Dur Conv R/R

1,000,000 FNMA 1.25 05/06/2021 1.25 5/6/21 98.36 98.00 -3,600 1.67 1.77 4.00 3.91 0.09 43

1,000,000 FHLB 2.25 03/11/2022 2.25 3/11/22 100.46 101.00 5,400 2.15 2.03 4.92 4.63 0.12 46

2,000,000 1.75 99.92 99.11 1,800 1.91 1.90 4.46 4.28 0.11 45

The Takeaway: Eliminate Extension, Increase Yield

• Value Shifts Between Sectors Over Time

� DUS improves yield and cash flow for no extension

1. No new money

needed

2. Eliminate

extension

3. Add cash flow

Swap Buy Candidates

Sector 1 Cusip Orig Face Par Value Description Coupon Maturity

Eff

Dur Conv Mkt Price Mkt Value

Market

Yield Avg Life

DUS 3138L7CV6 2,025,000 1,935,646 FN AM6383 2.800 04/01/2023 5.05 0.15 103.313 1,999,774 2.248 5.46

Relative Value – MBS vs. CMOs

• Value Shifts Between Sectors Over time

� Value shifts between sectors over time

� MBS vs CMOs: what sectors provide value right now?

� Improve income with reallocation within the portfolio

The Takeaway: Spreads reflect value for a given level of

risk/avg life

• Value shifts between sectors over time

� Sell seasoned lower yield, lower coupon MBS

� Reduce credit risk concentration (Goldman Corp and MS Munis)

� Take gains in longer duration Municipals ahead of Fed Meeting

1. No new money

needed

2. Buy Defensive

Coupons

3. Add monthly

Principal and

interest

4. Protect “value”

into rising rates

Sell Buy

2.37 2.48

5.45 4.04

3.21 1.66

-0.06 -1.51

(1.55)

(1.45)

0.11

(1.40)

Change

Yield:

Avg Life:

Eff Duration:

Convexity:

Annual Income Change:

Gross Income Change: 35,260

8,853

(551)

0.75

Gain/Loss:

Time to make up loss:

Sector 1 Cusip Par Value Description Coupon Maturity

Eff

Dur Bk Price Bk Value

Tax Bk

Yld

Avg

Life Mkt Price Mkt Value

Market

Yield Gain/Loss

OGVT 60535QLZ1 337,247 MISSISSIPPI HOME CORP SINGL 3.050 12/01/2034 10.13 100.000 337,247 3.068 17.42 99.500 335,561 3.107 -1,686.24

FIN 38141EB81 2,500,000 GOLDMAN SACHS GRP INC MTN BE 2.800 11/29/2023 0.21 101.940 2,548,500 2.580 6.42 103.050 2,576,250 2.393 27,750.02

PASS 31417DCC5 661,320 FNMA POOL - AB6366 2.500 10/01/2027 3.42 102.380 677,059 1.796 3.75 100.875 667,106 2.214 -9,952.85

PASS 31294UAT0 1,006,640 FHLMC GOLD POOL - E09018 2.500 01/01/2028 3.41 103.350 1,040,362 1.544 3.75 100.875 1,015,448 2.232 -24,914.32

PASS 3138AVRH0 938,540 FNMA POOL - AJ4087 3.000 10/01/2026 2.97 103.780 974,017 1.771 3.33 102.625 963,177 2.118 -10,840.13

PASS 3128PYAC8 853,023 FHLMC GOLD POOL - J18103 2.500 02/01/2027 3.13 101.800 868,377 1.932 3.42 100.938 861,020 2.192 -7,357.35

PASS 3138AVRH0 602,346 FNMA POOL - AJ4087 3.000 10/01/2026 2.97 104.080 626,922 1.681 3.33 102.625 618,158 2.118 -8,764.15

PASS 3138WVW31 1,099,787 FNMA POOL - AT7865 3.000 06/01/2028 3.28 103.500 1,138,280 1.997 3.83 102.625 1,128,657 2.227 -9,623.14

MUNI 223129BW6 365,000 COVINGTON CNTY MISS GO REF 3.000 07/01/2025 7.10 100.710 367,591 4.393 8.00 104.406 381,083 2.392 13,491.51

MUNI 888253AH4 330,000 TISHOMINGO CNTY MISS GO REF 2.625 12/01/2025 7.62 99.430 328,119 4.093 8.42 101.000 333,300 2.492 5,181.00

MUNI 241559TX1 625,000 DE SOTO CNTY MISS SCH DIST 3.000 04/01/2025 6.98 103.070 644,187 3.877 7.75 107.256 670,352 1.985 26,164.39

9,318,903 2.800 3.21 102.500 9,550,661 2.368 5.45 102.509 9,550,112 2.280 -551.26

Credit Risk: Where is the reward?

• Value Shifts within a sector over time

� Municipal yield curve is steep: Short Munis vs Long Munis

� Sell Underperforming, higher premium taxables

� Reduce exposure to certain “troubled” states

Swap Sale Candidates

Cusip Orig Face Description Coupon Call Date Maturity Eff Dur Bk Price Bk Value

Tax Bk

Yld

Avg

Life Mkt Price

Market

Yield Gain/Loss

341271AC8 1,000,000 FLORIDA ST BRD ADMIN FIN CO 2.638 07/01/2021 3.78 101.244 1,012,440 2.309 4.00 100.700 2.452 -5,440.06

349545K44 500,000 FORT ZUMWALT MO SCH DIST GO 4.450 03/01/2020 03/01/2022 2.62 105.244 526,220 2.395 2.67 105.220 2.404 -120.01

084509QQ4 385,000 BERKS CNTY PA GO BDS 2010B 5.085 11/15/2020 11/15/2022 3.13 107.950 415,607 2.595 3.33 108.850 2.327 3,465.01

1,885,000 3.618 3.33 103.747 1,954,267 2.393 3.50 103.668 2.412 -2,095.06

Swap Buy Candidates

Sector 1 Cusip Par Value Description Coupon Call Date Maturity Eff Dur Mkt Price Mkt Value

Market

Yield Avg Life

MUNI 150213FC5 500,000 CEDAR FALLS IOWA CMNTY SCH 3.375 06/01/2026 06/01/2034 12.66 101.400 507,000 4.836 8.92

MUNI 082761VP9 750,000 BENTON ARK SCH DIST NO 008 3.125 08/01/2022 02/01/2031 9.26 100.578 754,335 4.492 5.08

MUNI 181059XF8 1,000,000 CLARK CNTY NEV SCH DIST FOR 4.000 06/15/2027 06/15/2035 12.66 105.800 1,058,000 5.015 9.92

2,250,000 3.569 11.55 103.140 2,319,335 4.806 8.13

Credit Risk: Where is the reward?

• Value Shifts within a sector over time

� Extending out the Municipal yield curve picks up 241 bps

� Add tax free income

� Reduce exposure to certain “troubled” states

� Sell taxable (credit risk) investments that are underperforming the

market

Reward/Risk - Total Return Performance

• Total Return Performance

� Reward/Risk is simply a tool

� Buy where it is “cheap” (value)

� Extend when the curve provides rewards (incremental yield pick up)

� Capture the “roll down” (gains on seasoned positions)

� Amortizing Cash flow provides more re-investable liquidity into rising rates

which also increases/improves total return

Purchases Unch +75 bps

Tot Return - 3.00 0.03

Yield 2.88 2.68 3.64

Avg Life 4.97 4.18 5.82

Prc Change - 0.11 -3.00

Eff Dur 3.87 3.21 4.31

Rew/Risk 74 83 84

1yr forward

Sales Unch +75 bps

Tot Return - 2.31 0.27

Yield 2.26 2.21 2.88

Avg Life 4.76 4.00 4.05

Prc Change - 0.00 -1.85

Eff Dur 3.22 2.69 2.73

Rew/Risk 70 82 105

1yr forward

1. Seasoning

creates this

effect of

attractive

returns as

bonds near

maturity

2. Don’t pay up for

seasoning, pay

up for structure

and value