Pub. 4 2015 Issue 1

11 S P R I N G | 2015 F E A T U R E agency, with an intermediate maturity and some decent call protection. All of these are present in a recent Fannie Mae is- sue, with a coupon of 1.63, a stated final maturity of five years and a first call date in 12 months. This bond was issued in early February, at a price of 100.00. Two things certain about this bond are that 1.) Today it has a duration of about 4.7 years, and 2.) a year from now, it won’t. It will either be in the money to be called away very soon (and the duration will be near zero), or it will not be expected to be called, and the duration will be about 3.7 years. In the eyes of many community bankers, the salvation for this security is that the maturity date is getting ever closer, just with the passage of time, which puts a limit on the uncertainty of when you get your money back. Example MBS Mortgage securities aren’t so cut and dried. In fact, the lapse of time doesn’t change much in terms of average lives and duration. A good illustration is a new 15-year pool with a 3 percent rate, also issued by Fannie Mae. Today, it is estimated to have a duration of about 4.5 years, but that’s predicated on a certain amount of refinance activity. Many fi- nancial models expect about 10 percent of the loans to prepay each year, so that’s what we’ll use here. If that’s what happens, a year from now the duration will still be about 4.3 years. This is due to the mechanics behind the duration calculation. It weights the average remaining time to receive your principal and interest, and the number does not decline lock-step with the passage of time. The fea- ture of a mortgage security that helps make up for this seem- ing anomaly is that some principal is prepaid each month, starting immediately. In fact, half the principal will be paid off in about four years. What’s best for your bank? Do you prefer wet or dry ribs? It all depends, on a lot of variables. Such as, the deposit base of your community bank. If there are large blocks of time deposits in certain months or quarters, you may want to buy non-amortizing bonds whose durations mirror those blocks, and control for the call features. If your interest rate risk position needs some help in becom- ing more rate sensitive, the certainty of the cash flow from mortgage bonds can help. Regardless, keep in mind that your community bank’s investment portfolio has an effective duration that is chang- ing constantly. A shift in rates of even 20 or 25 basis points can cause certain bonds to be called, or to be extended. Most seasoned portfolio managers own a range of different sectors, so that no one segment can materially alter the performance of the whole. Finally, a piece of advice: Review your bond port- folio’s duration regularly, with some help from your brokers. It will help your bank stay fully invested, in the right mix, to achieve its income and risk-containment goals. Jim Reber is president and CEO of ICBA Securities and can be reached at 800-422-6442 or jreber@icbasecurities.com. Cash Flow Tables Available Vining Sparks, ICBA Securities’ exclusive bro- ker, has an interactive website that allows a com- munity banker to access a number of custom reports for his or her portfolio. Included are cash flow ladders, value at risk and mortgage prepayment histories. Contact your Vining Sparks sales rep, or visit www.viningparks. com for more details.