The Mentor Journal
Portfolio Management | Risk Management
Understanding the 4 Levels of Risk
businessman leaping up four bars in a bar chart, showing the concept of four levels of risk
By Chris Nelson
July 10, 2023
Reading Time: 9 minutes

We all know that achieving a decent return or yield is important, but risk management is also crucial.  Simply put, it’s just not something you can overlook. 

What complicates matters is that there are so many risk factors to keep in mind!  It can make your head spin as you try to stay on top of them all. 

But over the 20+ years I’ve managed portfolios for my bank and clients, I’ve found a way to make the process more manageable.  I’ve identified four levels of risk that need attention as you analyze investment ideas and consider how to position the investment portfolio.

Table of Contents

Risk Level 1 – The Security Level

The first level of risk to consider is the security level.  As you might expect, we’re focusing on the specific risks of an individual fixed-income investment. 

Depending on the security type, there are four security-level risks to evaluate:

Interest rate risk – Given the interest rate environment, this has gotten its share of attention in the past year!  As you’re evaluating a security, you’ll want to use its duration to gauge the sensitivity to changes in interest rates.  The higher the duration, the more price sensitivity you’ll experience. 

In addition, you’ll want to determine whether the duration can change based on other factors.  If so, ensure you’re comfortable with how the bond performs in all scenarios, not just the current ones or the most likely ones.

Also, remember that just because an investment has a short duration doesn’t necessarily mean it won’t experience price volatility.  When interest rates change, the investment’s duration and the degree of the interest rate change both play a role. 

For example, a two-year Treasury has a shorter duration than a five-year Treasury.  But if the two-year part of the yield curve experiences a bigger shift, it could create more price volatility for an investor holding the shorter maturity bond.  Just ask anyone that’s purchased or held short-term bonds in the past few months, as that part of the yield curve rose more than others.

Liquidity risk – This risk involves the ability to easily sell the security at its fair value to raise cash.  Not all fixed-income securities are easy to liquidate, and some can be downright challenging, if not near impossible, to sell!  As you evaluate an investment, consider the ease of selling it in the future. 

Many investors were surprised in the past year when they discovered that their municipal bonds, which they thought were more liquid securities, turned out to be less liquid.  This created surprises for them when the bids they received were far below what they expected. 

In addition to a security’s liquidity based on its potential sale, you’ll also want to consider how easy it may be to pledge the security.  Certain fixed-income investments may not be eligible to be pledged, including some muni bonds, some CMO tranches, corporate bonds, reverse mortgage pools, and private placement securities.  In addition to a security’s “saleability,” it’s important to consider this aspect of its liquidity.

Option risk – Option risk, or optionality, happens when a security’s cash flows change due to embedded options that are present.  Not all securities have option risk, but if you’re considering an investment in callable bonds or mortgage securities, you’ll need to evaluate the effect of optionality.

For example, how does the investment behave in different scenarios and rate environments?  Does the callable bond get redeemed early or extend to its final maturity (or somewhere in between)?  With a mortgage-backed security, what does the embedded optionality mean in terms of potential prepayment or extension risk?  These are things to analyze and consider before you pull the trigger on a purchase.

Credit risk – The last security-level risk is credit risk, which is less of a factor if your investments are only government and government agency issues.  Otherwise, you’ll want to consider the degree of potential credit risk you’re taking on, whether that’s with municipal bonds, corporate bonds, or private label issues.  The key to managing these four security-level risks is having a process to ensure you capture the pertinent information before the security trade is done.  If you’re looking for a starting point for such a process, or if you’d like to fine-tune the process you already have, check out my free fixed-income pre-purchase checklists.

Risk Level 2 – The Portfolio Level

At the portfolio level, we’re not as concerned about the individual holdings but more about the whole portfolio.  There are three primary risks to consider at this level.  We discussed two of these risks at the security level, but we’re going to take a different perspective at the portfolio level. 

Interest rate risk – As we discussed before, we want to understand the sensitivity to changes in interest rates.  But now, we’re looking at the total portfolio’s duration. 

I view managing duration as primarily a portfolio-level exercise.  While it’s important to understand how the individual securities will behave when interest rates shift, it’s the portfolio’s duration that guides a lot of the decision-making process. 

For example, you may purchase a bond that has a longer duration – but if it’s part of a diversified bond ladder, it could be less of a factor.  When working with client portfolios, managing and targeting the portfolio duration is one of the key parameters I use when developing an investment strategy.

Liquidity risk – Similar to interest rate risk, we want to look at it slightly differently than at the portfolio level.  Instead of considering the ease of selling or pledging, we want to focus on managing the portfolio to generate cash flow. 

A steady and stable principal cash flow is a source of liquidity you can use as part of your bank or credit union’s broader liquidity management efforts.  If the current cash flow from the investment portfolio is more “choppy,” with wide swings in its cash flow, this is a portfolio-level risk to consider addressing sooner rather than later. 

And the best part of this strategy is that you can receive cash from the portfolio without having to sell anything!  This is especially helpful in times like community bankers are experiencing today, where they’re hesitant to sell securities due to unrealized losses. 

Concentration risk – This refers to having a larger percentage of the portfolio in one type of investment.  Looking at this risk in the investment portfolio is just like considering concentration risk in the loan portfolio.

Concentration risk is a form of credit risk and can occur on two levels in the portfolio – the issuer level and the sector or asset class level.  Concentration risk at the issuer level becomes problematic if the issuer defaults on their outstanding obligations. 

This risk exposure is less of an issue with U. S. government and U. S. government-backed investments. But if you invest in other types of securities, it’s prudent to consider how much exposure you want to have to any single issuer.

In the same way, you’ll want to consider what level of exposure is acceptable at the sector or asset class level.  While having multiple issuers of a specific bond type provides some protection, it doesn’t necessarily mitigate the exposure to the group that the security belongs to. 

For example, it’s worth evaluating exposure levels for concentrations of muni bonds based on the state they’re in or the industry exposure for corporate bonds.  And you may also want to consider maximum exposure guidelines for private-label mortgage issues.

The best way to manage risks at the portfolio level is through any investment portfolio analytics you manage or receive from outside parties.  By keeping an eye on the metrics I mentioned in these reports – portfolio duration, cash flow trends, and concentration risk – you can understand better how things are behaving at a higher overall level.  It will also help you as you make decisions and consider course corrections to your investment strategy.

“Managing risk is like fighting one of those mythical multi-headed hydras.  It seems like a constant battle – and it is.”

Risk Level 3 – The Balance Sheet Level

We’re now going to begin evaluating what’s happening outside the investment portfolio.  Doing this allows us to factor relevant “bigger picture” conditions into the investment decision-making process.  There are four risk exposures to consider at the balance sheet level: interest rate, liquidity, credit, and capital risk. 

Your institution’s asset-liability management reports are your best resource to analyze interest rate and liquidity risk at the balance sheet level.  They will provide the overview and detail you need to understand the impact interest rates have on your institution, which allows you to make decisions within the investment portfolio to mitigate the risk.  I tend to focus on the net interest income or earnings at risk scenarios to understand what’s happening on the balance sheet.

In addition, the ALM reports provide insight into the institution’s ability to manage its liquidity.  Typically, the focus is on addressing liquidity shortfalls created by asset growth or deposit runoff. However, as we saw a few years ago, managing liquidity is also about handling excess cash balances effectively.  Liquidity cash flow scenarios and stress tests provide good information to help you determine how the institution’s liquidity risk exposures can be mitigated through the investment portfolio.

To get a handle on the institution’s credit and capital risk exposures, you’ll want to review any financial and other internal reports that contain the metrics related to these areas.  Monitoring the various credit and capital ratios and gaining perspective about what’s happening at the balance sheet level will directly shape how the investment portfolio needs to be structured and the types of investments to consider.

As I’ve said frequently, the balance sheet is the starting point for managing the investment portfolio.  By staying on top of the risks at the balance sheet level for your bank or credit union, you’ll lay the foundation for the investment decision-making process.

Risk Level 4 – The Systemic Level

What do I mean by the systemic level?  I’m referring to the financial system and capital markets.  While it’s important to ensure you’ve covered your bases for the risks facing your community financial institution, you must also remember and consider risks associated with the market itself, especially given its interconnectedness.

For the investment portfolio, the one systemic risk exposure to consider is liquidity risk.  When a major financial event or crisis occurs, market liquidity can dry up quickly as everyone pulls back. 

This makes selling almost any security more difficult, as market volatility causes everyone to become extremely conservative to protect themselves.  As someone who was around for the financial crisis in 2008, I can remember situations where even agency-backed mortgage securities were receiving poor bids. 

The one security that holds up best in situations like these is U. S. Treasuries.  As the most liquid security available, they provide some protection even in wild markets.  While there’s no guarantee that a Treasury bond wouldn’t suffer from some price pressure, it’s the least likely to be affected.

The other systemic risk factor is counterparty risk.  Like any credit risk, counterparty risk refers to the risk that one party in a financial transaction may fail to fulfill their obligations, causing financial harm to the other party involved. 

While this is generally less of an issue directly related to the investment portfolio, this risk can affect other areas in your finance day job.  For example, if you suddenly lost access to a liquidity funding source, such as a correspondent bank line or Fed funds line, because the organization got into trouble, it could create additional challenges for your institution.  Similarly, it could create a major headache if the counterparty on a derivative transaction, such as a swap, cap, or floor, could no longer meet its obligations.

How do you manage risks at the systemic level?   The best way is through planning and redundancy.  Make sure you take the time to identify and consider how financial risks outside the institution might affect the portfolio and other operations.  Then, determine the steps to create backups, just in case.  For example, you could consider allocating a portion of the investment portfolio to Treasuries as protection against systemic liquidity risk. 

Managing counterparty risk starts before the relationship begins.  Conducting thorough due diligence and risk assessments when selecting counterparties, and updating that information periodically, can help to mitigate potential risk exposures, possibly even before they happen.  You also might want to explore having more than one counterparty available for your third-party financial transactions, whether that be Fed funds lines, brokered deposits, or derivatives.

How you protect against systemic levels of risk will vary from institution to institution, so the ideas I mentioned are just that – ideas.  You’ll want to craft a response that works best for your institution based on its needs and objectives.  In addition, when evaluating any of these four levels of risk, any decisions need to be aligned with your institution’s policies and other accounting, legal, compliance, or regulatory guidelines.

When working with the investment portfolio, managing risk is like fighting one of those mythical multi-headed hydras.  It seems like a constant battle – and it is.  Risk management is always a continuous and ongoing process.  But approaching it through the four levels I’ve shared can make the job easier to understand and tackle as you work to protect the institution from potential threats and take advantage of opportunities that may arise.

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