Master Bond Swaps

By Pickering, C. J. | Independent Banker, October 1997 | Go to article overview

Master Bond Swaps


Pickering, C. J., Independent Banker


Learn take-out yield and improve your portfolio's performance

Bond swaps have once again become one of the bank portfolio manager's most popular management techniques. They fell out of favor a few years back when the sale of any bond for any reason was a signal for bank examiners to question whether the bank was "trading." If examiners decided a bank was trading, the bank might be required to mark the entire bank portfolio to market and to deduct any losses against the bank's regulatory capital. As you can imagine, most banks quit selling bondsperiod.

The passage of Financial Accounting Standard 115 (mark-tomarket accounting) clarified the difference between trading and the active management of a bank's available-for-sale investment portfolio. The Office of the Comptroller of the Currency's Owen Carney said it best when he commented that trading is the purchase and sale of securities, whether over the course of minutes or days, to take advantage of imminent market moves. A purchase and subsequent sale that takes place over the course of weeks or months is not really trading.

In other words, the FAS 115 definitions of trading versus availablefor-sale allow bankers to once again use bond swaps to improve their portfolios' performances without running the risk of having their capital impaired.

This month's Bank Investments column shows how to decide when to try a bond swap and why. The column also attempts to explain "take-out yield," a very useful concept, but one that many bankers do not fully understand.

EXAMPLE BOND SWAPS

First of all, most good swaps will make sense intuitively, even before they are analyzed. Example 1 in Table I on page 15 shows that selling a three-year, 4.5 percent Treasury at a loss and repurchasing a three-year, 5 percent Treasury is a break-even trade, since the effective yields on the bond sold and the bond purchased are virtually identical. Any loss on the sale ($909) can be expected to be made up over the life of the replacement bond ($300 per year X 3 years = $900).

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