🧠 Investment Security Selection and Risks: How Banks Choose Their Wingmen

Imagine a banker sitting at a financial buffet. Every dish $($a security$)$ looks tempting—some are spicy with yield, others are bland but safe. Which one do you pick when you don’t want indigestion $($a.k.a. risk$)$? That’s where investment security selection kicks in.

🏦 Who Invests, and Why?

Banks hold investment securities for:

Generating income
Providing liquidity
Managing risk
Financing loans
Selling for customer withdrawals

Roughly 20% of bank assets are in investments. But small banks? They invest even more. Why? Because their loan books are riskier, so they play it safe elsewhere. Large banks go bolder—they invest in private debt, foreign securities, and more exotic dishes on the menu.

👉 But what helps banks choose between government bonds and corporate paper? Time to dive into the key decision factors.

📈 Expected Rate of Return

For most bonds, Yield to Maturity $($YTM$)$ is the go-to metric. It’s like calculating how many coffee punches you’ll get from a loyalty card—based on expected cash flows and price.

If you’re not holding till maturity? Use Holding Period Yield $($HPY$)$, which captures returns during a shorter investment window.

🧠 Remember:

YTM = Total return assuming bond is held to maturity
HPY = Return over the actual holding period

👉 So returns are important—but banks also care about taxes. How do taxes affect their appetite for securities?

🧾 Tax Exposure

Banks are not tax-exempt superheroes. So they look at after-tax returns, especially when choosing between:

Taxable bonds $($e.g., corporate$)$
Tax-exempt bonds $($e.g., municipal$)$

🧮 Example:

Corporate AA bond: 6% $($1 – 0.35$)$ = 3.9%
Municipal AA bond: 4.4%$($1 – 0$)$ = 4.4%

➡️ Municipal bond wins, thanks to tax-exempt status.

Tax Equivalent Yield $($TEY$)$:

TEY = Municipal yield $/$ $($1 – tax rate$)$
For a $4.4%$ muni bond: TEY = 4.4% / $($1 – 0.35$)$ = 6.8%

Bank-Qualified Bonds:

Issued by smaller municipalities $($<\$10M annually$)$
Let banks deduct 80% of the interest cost used to fund purchases
Require special care under post-1986 tax reform

Net After-Tax Return Formula:

$\text{Net After-Tax Return} = \text{Municipal Bond Return} – \text{Interest Expense} + \text{Tax Advantage}$

Where:

Tax Advantage = Marginal tax rate $×$ Deductible portion $×$ Interest expense

👉 But what if banks want to get creative with taxes, especially in profitable years?

🔄 Tax Swapping and Portfolio Shifting

Banks sometimes sell low-yield securities at a loss to reduce taxable income. This is known as tax swapping. It’s like cleaning your closet to write off old clothes—and buying flashier ones for future gain.

Portfolio shifting follows a similar theme—replace outdated securities with higher-yielding ones, even if it hurts in the short term.

🧠 Caution: Tax authorities aren’t fans of creative accounting. You can’t swap everything forever!

👉 But taxes aren’t the only concern. What about the dangers lurking in interest rate swings?

📉 Interest Rate Risk

This is the chameleon risk—you may not see it, but it changes color with every rate movement:

Rising rates ➝ Fall in bond prices
Falling rates ➝ Prepayment or reinvestment at lower rates

Solution? Derivatives like interest rate swaps help hedge this risk.

👉 Speaking of risk—what if the borrower can’t pay you back at all?

🚨 Credit Risk

The risk that the issuer will:

Miss a payment, or
Default altogether

Banks rely on credit rating agencies like Moody’s, S&P, and Fitch, who give us:

Investment Grade $($BBB/Baa1 or higher$)$
Junk Grade $($BB/Ba or lower$)$

Modifiers like $+$, $−$, or $1$, $2$, $3$ show where in the band you fall. Many institutions are legally restricted to investment grade only.

Hedge your risk: via credit default swaps $($CDS$)$ or credit options.

👉 But what if the business just… slows down? Not defaulting, just struggling?

🏭 Business Risk

If a bank operates in an area with an economic downturn, even well-rated borrowers may suffer. That’s business risk.

Solution: Geographical diversification—don’t put all your municipal eggs in one state’s basket.

👉 But even a strong borrower’s bond isn’t useful if you can’t sell it fast. What then?

💦 Liquidity Risk

Can you sell a security quickly and at fair price?

Highly liquid: T-Bills, T-Notes, T-Bonds
Illiquid: Private placements, exotic structured notes

But here’s the twist: High liquidity = Low return.

👉 What if an issuer can take your bond away before maturity? Welcome to call risk.

📞 Call Risk

When interest rates fall, issuers call $($repurchase$)$ bonds to refinance at cheaper rates. Now you, the investor, must reinvest at… yawn… lower rates.

Defenses:

Buy non-callable bonds
Or pick those with deferment periods

👉 Mortgage-backed securities have a similar cousin: prepayment risk. How is it different?

🚪 Prepayment Risk

Mortgage borrowers refinance when rates fall. This causes your cash flows to:

Arrive too early, and
Reinvest at low yields

Banks model this risk using the Public Securities Association $($PSA$)$ curve:

Month 1 prepayment: $0.2
Month 30+: Prepayments level off at $6

100% PSA means the loan pool follows this pattern exactly.

👉 Now let’s ask—what happens to returns when inflation kicks in?

📈 Inflation Risk

Inflation reduces purchasing power—your fixed interest income buys fewer snacks.

Solution: Treasury Inflation-Protected Securities $($TIPS$)$

Principal adjusts with inflation
Coupon = Fixed rate × Adjusted principal

Popular when inflation surges, though less favored in low-inflation eras.

👉 Now, imagine you’re a bank accepting public funds. What must you post in return?

🧾 Pledging Requirements

Banks accepting deposits from:

Federal
State
Local governments

…must pledge high-quality securities as collateral. Common ones:

U.S. Treasury securities
Municipal bonds

Also used in repurchase agreements, where collateral makes lenders feel warm and fuzzy.

🧠 Final Thought: It’s Not Just About Yield

For banks, security selection is like assembling a football team:

Quarterback: High-yield security
Defense: T-Bills for liquidity
Coaching: Tax strategies and hedges

You win not just by scoring points $($yield$)$—but by avoiding sacks $($risk$)$.