Independent Banker - December 2018 - 30

PORTFOLIO
manager could sell. For one, if a bank is interested in
gains, it should look primarily to the taxable portion of
the inventory. Just as losses defer income, gains cause
immediate recognition, which also accelerates income tax
liability. This condition is further aggravated if the bonds
sold at a gain are otherwise tax-free.
This brings us to the concept of a tax swap. Any bond sold
at a price less than its carrying (or " book " ) value is considered
an ordinary loss, deductible in arriving at taxable income. If
the proceeds are then reinvested into tax-free securities, the
period of time to make up that original loss is lessened. The
investor will only be hit with the net-of-tax loss, but 100 percent
of the reinvestment earnings are tax-free. So don't be
too quick to look at your muni portfolio for gains.
Also, don't forget about assets other than bonds that can
be sold. Many community banks own portfolios of performing,
non-conforming loans, which have an actively traded
secondary market. High-quality jumbo mortgage loans in
particular can be quickly liquidated. And government-guaranteed
loans, such as SBA 7(a) loans and FmHA guarantees,
can be sold servicing retained, often at substantial gains.
Consider these
Portfolio managers should pay close attention to the " takeout
yield. " Take-out yield can go by several names (such as
market yield and give-up yield), but its definition is the
yield that the buyer of your bonds will earn. The reason it's
important is that the take-out yield is the benchmark reinvestment
yield that must be met or exceeded for a swap
to have economic value. A bank may still elect to execute
a swap even if the take-out yield is not improved upon,
as long as some other objective is achieved. An example
would be a duration-shortening swap that reduces exposure
to rising rates.
The classification of Available for Sale (AFS) versus Held
to Maturity (HTM), as mandated by Financial Accounting
Standard 115, must be considered as well. For some
of the holdout investors who still put some or all of their
bonds into HTM, the ability to sell may be severely limited,
depending on the attitude of the external auditor. I would
recommend prior consultation with the auditors if the bank
wants to take this route. And I absolutely would recommend
classifying all future purchases as AFS to provide
maximum flexibility.
As the new year approaches
Now, a word about current market opportunities. As the
year-end draws near, and yields are at or near highs from
the last decade, most community banks have losses in their
portfolios. Many, in fact, don't own a single bond at a gain.
30 Q ICBA Independent Banker Q December 2018
Coupled with the banking industry's strong performance
in 2018 (partly the result of tax reform), most community
banks have the opportunity to take some losses and defer
income to future periods.
Another challenge for portfolio managers at the present
is the availability of liquidity. The replacement of " bullet "
securities with amortizing bonds like mortgage-backed securities
can potentially improve the take-out yield, increase
cash flow and come close to matching average durations.
It is also true that the flatness of the yield curve will make
it necessary to have some duration extension to " beat the
take-out, " but many community banks are well-balanced
from an interest rate risk standpoint.
Your broker should create full documentation of the
costs and benefits of a particular swap transaction well
before the play is put in motion. I strongly recommend that
a portfolio manager review, analyze and critique the data
in the swap analysis before executing any swap. And don't
be afraid to take a retrospective look at the swap to see if it
performed as modeled.
Finally, if 2018 isn't the year to execute a bond swap, perhaps
2019 is the perfect time to do so. One advantage of
taking a loss early in a fiscal year is that there is almost a
full year to be earning higher income from the reinvestment
bonds. In many cases, the full loss can be recouped before
the next year-end. All of which would help ensure that
2019's business year is merry and bright.
Education on Tap
Investment column library
For access to " Portfolio Management " columns
dating back to 2001, visit icbasecurities.com/
independentbankerarticles/ to see the ICBA
Securities website archive. Included are several
years of columns by ICBA Securities president
emeritus C.J. Pickering.
Webinar series for 2019
ICBA Securities and its exclusive broker, Vining
Sparks, will again host an eight-part webinar
series, " Community Banking Matters. " It will
feature eight different speakers on a variety of
balance sheet topics of interest to community
banks. Look out for an announcement about the
calendar and topics early in 2019.
http://www.icbasecurities.com/
Independent Banker - December 2018

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