ABA Banking Journal - July/August 2015 - (Page 48)

> INVESTOR PERSPECTIVE Is Volatility the New Normal? BY MoNICA SoNNIER ThE FEd'S SOmEWhAT expected removal of its "patient" language, combined with an unexpected lowering of growth and inflation expectations in its March 18 Federal Open Market Committee statement, left the market not quite knowing what to do. At the end of the day, the market took it as an indication that liftoff is not inevitable in the short-term and rallied, sending the 10-year rate back below 2 percent. Confusing economic statistics, Fed wordsmithing, continuing pushback of the timeline for tightening, and challenges to global growth all signal more volatility to come until the market becomes clearer on the prospects for real recovery. It seems that volatility may be the "new normal" that everyone has been asking about since the early days of the financial crisis. Interest rate volatility will obviously impact bank portfolios by creating shifts in market values, and thus impacting the adjustment to the Other Comprehensive Income (OCI) component of equity from monthto-month. Negative convexity is the characteristic of callable or prepayable bonds that causes them to shorten in dutation when rates fall or lengthen when rates rise, thus increasing price risk. Reducing negative convexity and/or shortening the duration of the portfolio can help to lessen the pain from changing market values, but it is important to remember that this almost 48 ABA BANKING JOURNAL | JULY/AUGUST 2015 unavoidably means a reduction in income as well. For some, giving up real book income that goes to the bottom line versus a benefit of reduced potential "paper loss" will not be an attractive trade-off. If your preferred method of dealing with volatility, however, is to reduce the overall estimated change in market value for a given change in rates, we can certainly help you quantify the consequences of that risk reduction and find ways to achieve that risk reduction with the least amount of income concession possible. Another way to protect against market volatility is to anticipate the ways that different securities will be impacted differently as rates change. That is, various securities will experience dissimilar changes in spreads even as rates change and also may experience dissimilar effects if there are embedded calls or prepayments. With that in mind, bankers managing portfolios through an environment of high volatility should: 1 Avoid items where spread will suffer due to the Fed discontinuing its buying. 2 Avoid amortizing items in the short end of the curve where spreads seem unjustifiably tight. 3 Concentrate on items with good roll down on the long end of the curve (multifamily MBS, longer reset hybrid ARMS, non-callable municipals or those call dates further out into the future). TABLE 1 Sector percent of portfolio concentrations Agency & Treasury 10%-15% Four- to 10-year Agency bullets and discount or par callables Corporates 10% Short-term and floating-rate, CLOs Agency MBS 40%-50% Minimal allocations to 10- and 15-year, particularly TBA eligible. Higher allocations to five- to 10-year Hybrids, 20-year and well-structured CMOs SBA 10%-15% Mix of floating SBA pools, fixed SBICs Municipal 20%-25% Eight- to 15-year maturity, mix of taxable/BQ/GM determined by tax situation Cash 1%-5%

Table of Contents for the Digital Edition of ABA Banking Journal - July/August 2015

CHAIRMAN'S VIEW
UPFRONT
OPERATIONS
ECONOMIC OUTLOOK
PICTURE THIS
BANKING’S APPALLING REGULATORY STRUCTURE
HOW BANK CULTURE DRIVES SUCCESS
KEY CONSIDERATIONS FOR CREATING SUCCESSFUL BOARDS
VENDOR RISK MANAGEMENT
FIVE RISKS THAT WILL SHAPE BANKING’S FUTURE
CEO SYMPOSIUM
MOBILE BANKING
PAYMENTS
ABA COMPLIANCE CENTER INBOX
INVESTOR PERSPECTIVE
COMMUNICATIONS
REAL ESTATE LENDING
LEGAL BRIEFS
FROM THE STATES
BANKER RECOMMENDED READING
INNOVATIONS IN SOCIAL RESPONSIBILITY
INDEX OF ADVERTISERS

ABA Banking Journal - July/August 2015

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