Pub. 4 2016 Issue 2

20 The Community Banker www.mibonline.org T his just in: The Fed, and economists, and the bond market all agree on the future path of Fed Funds, at least through 2016. And within a range. As of the start of 2016, Federal Reserve board members’ comments seem to anticipate three to four additional bumps to overnight rates this year. Several recent surveys of econo- mists show that their expectations are for about three more tighten- ings. And even the futures con- tracts, which have very grudgingly built in prospects for Fed action, are now forecasting about three more hikes. So, if that happens, what will be the impact on your community bank investment portfolio’s cash flow? Most managers have access to financial models that will tell themprospectively howmuch liquidity will be produced each month, over a range of interest rate shocks. What we can add to the dialogue is that an investor can take out a lot of the guesswork (a bond wonk would call it “optionality”), by choosing securities with certain characteristics. Premium callables In government agency land, the best way tomake certain of your liquidity is to buy bonds with no call options. The case has been made by your correspondent that it is now very inexpensive to do so. Nonetheless, by purchasing high coupon callables at a premium, you can improve your chances of getting short-term cash flow, with a payoff in case the bondmarket gives you a head fake. The chance of your bond being called improves if the call feature is one time only. Here’s a recent example: The Federal Home Loan Bank Systemhas an issue with a 2.20 percent coupon that matures Jan. 28, 2021 that can be called only once, on July 29, 2016. It’s priced a premiumof 100.597 to create a yield to the call date of 1.00 percent. If it’s not called, the yield tomaturity jumps to 2.07 percent. These “cush- ion callables” are very popular with short-term investors. Short maturity MBS In the case of a security that has an amortizing balance, like most any mortgage-backed security (MBS), the stated final maturity has a great deal to do with howmuch principal you can expect over the next fewmonths or years. For a relatively short final (say, less than 15 years), the “scheduled” principal, which ignores any prepaid cash flow, will be significant and will in - crease noticeably just with passage of time. For example, an MBS with a stat- edmaturity in 12 years will return about 15 percent of its principal in the next year, even if prepayments slow down further from their cur- rently slow “speeds.” This extension protection, which is built into short maturity MBS, will also provide the investor with ready cash to reinvest at (presumably) higher rates. True floaters Bonds whose interest rates fluc - tuate with the general market can be beneficial for several reasons. First, if short-term rates rise, the periodic coupon payments will too, resulting inmore cash flow. For another, history has shown that for some adjustable MBSs, the homeowners will refinance their mortgages into fixed-rate vehicles, even if in the near-term their rates are locked in at higher levels, so as to not be exposed to further “rate drift.” This refi activity produces additional cash flow for the investor and can be directed to its best and highest use. The advice, then, is to antici- pate a slowdown in your portfolio cash flow, even if it is running at a fraction of its pace from 2012. The “more is better” adage certainly holds true when investing in a rising rate scenario. Carefully selecting your bonds can keep you posi- tioned to do just that. Jim Reber is president and CEO of ICBA Securities and can be reached at 800-422-6442 or jreber@icbasecurities.com . KEEP THE CASH FLOWING TECHNIQUES TO CREATE ADEQUATE LIQUIDITY By Jim Reber, President and CEO of ICBA Track Record Vining Sparks, ICBA Secu- rities’ exclusive broker, can create a scenario cash flow report for any community bank, based on up to seven future interest paths. To re- quest this document for your community bank, contact your Vining Sparks sales rep, or visit www.viningsparks. com.