Understanding the 4 Levels of Risk

Understanding the 4 Levels of Risk

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.

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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.

What to Do When You’re Not Investing

What to Do When You’re Not Investing

If you’re like most community bankers, I imagine that you’re not doing much investing right now.  After spending the past few years putting excess funds to work in the investment portfolio, the pendulum has swung the other way. 

Cash has now dried up for some bankers, so investing is a lower priority.  Others are still shellshocked and hesitant to consider investments after the wild ride of the last year.  And there are always other things to do in the day job at the community bank or credit union to keep us occupied, right?

But just because you may not be investing doesn’t mean you can ignore the investment portfolio.  In fact, quiet times on the investment front are the perfect time for other important investment activities.  These tasks might not have the urgency of needing to put funds to work in the investment portfolio, but they’re important nonetheless.

“Just because you may not be investing doesn’t mean you can ignore the investment portfolio.”

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5 Things You Can Do When You’re Not Investing

Here are five tips on things you can do for the investment portfolio when you’re not investing.  Some of these suggestions may be quick or periodic to-dos, while others are tasks that might take some time but can be squeezed in around other parts of the day job.

Tip #1 – Regularly Monitor Existing Investments

This first tip may sound pretty straightforward.  But I’m not just talking about how much your unrealized loss position or portfolio duration has changed.  Don’t get me wrong, those are important.  But there are other things to review and keep an eye on. 

It may be worthwhile to periodically check the underlying option risk (or “optionality”) of the positions in the portfolio.  It can be helpful to know how changes in interest rates will affect your investments’ behavior.

Callable Bonds

For example, have any callable bond situations changed?  If you have callable securities that are out-of-the-money and not callable right now, do you know how much interest rates would have to shift for them to become callable again? 

Many bonds will likely remain uncallable even with major shifts in the yield curve.  However, I’ve seen examples recently as I’ve reviewed investment portfolios where a change of 100-150 basis points was enough to bring the call option back into play. 

Residential Mortgage-Backed Securities

Another place where it’s worth digging a little into the optionality exposure is with residential mortgage securities.  While they don’t have calls like bonds do, they have embedded optionality that creates the prepayment and extension risk that we’ve grown too familiar with in the past few years. 

Monitoring how monthly prepayment speeds change for the pools you hold can be really helpful.  Even in the higher rate environment, you can still see differences in prepayment speeds for reasons tied to credit-related events or because of the underlying loan collateral characteristics.  If you have an MBS that behaves differently than the other holdings, it may be worth a little digging to understand why it’s happening.

Monitoring callable bond and mortgage security holdings like this might sound like a heavy lift, but it’s very doable with some help.  Your broker or someone with access to Bloomberg should be able to help pull the data together.  Once you’ve established what you’re looking for, it’s just a matter of updating the information as needed.

Credit Quality

Something else worth monitoring is any changes in the credit quality of your non-government agency-backed investments.  Whether you hold municipal or corporate bonds, private label mortgage securities or CMOs, collateralized loan obligations, or bank sub-debt, it’s worth giving them a check-up.  You’re likely doing some of this already as part of your required post-purchase due diligence, but these days it’s worth taking the time to check, especially when it’s quiet on the investment activity front.

“Quiet times on the investment front are the perfect time for other important investment activities.”

Tip #2 – Explore New and Different Security Types

Most community financial institutions are regular investors in Treasury and agency bonds, mortgage-backed securities, and municipal issues.  But other types of fixed-income investments could offer opportunities for your institution’s investment portfolio without stretching way out of your comfort zone. 

The problem is that we rarely have the time when we’re busy investing to learn about them and how they work.  When you are less active on the investment front, take the time to learn about investment types like commercial mortgage-backed securities, CMOs, SBA securities, and variable-rate investments.  Increasing your awareness of their characteristics, benefits, and risks will provide you with additional tools in the portfolio management toolbox.

Tip #3 – Review Your Institution’s Investment Policy

The investment policy is one of the main guides to how a community banker manages the investment portfolio for their community financial institution.  But how well do you know what the policy contains? 

This is a good time to review the policy and determine how well it aligns with your institution’s portfolio objectives, risk tolerance, and regulatory requirements.  In addition, you’ll want to consider if anything in the policy language needs to be added, removed, changed, or clarified. 

The goal is to have an investment policy that is robust enough to make sure the investment process stays on track without being so cumbersome that managing the portfolio becomes challenging or impossible to do effectively.

Tip #4 – Review (or Develop) Your Investment Strategy

A great time to work on your investment strategy is when you’re not as active in managing the portfolio.  It gives you the time to think and plan without having to make investment decisions simultaneously.

An investment strategy that’s customized to your institution’s needs, risks, objectives, and comfort zone gives you a road map to help you navigate the markets, no matter what’s happening.  It also enables you to communicate more effectively with your brokers and share what’s happening in the investment portfolio (and why) with management, ALCO, the board, and regulators. 

Having a solid investment strategy in place is the most important tool you can have to be a successful portfolio manager.  It’s one of the reasons I began offering live training workshops for community bankers to help them create a customized investment strategy. 

(Click here to learn more about the Bond Investment Mentor Investment Strategy Workshops and when the next one is scheduled!)

Tip #5 – Stay Informed and Educated

Even if you’re not investing, staying on top of what’s happening is important.  Doing so allows you to jump on any occasional opportunities that might come along. 

When I was managing my bank’s portfolio, some of my best investment finds happened when I wasn’t actively investing but stayed in the loop.  It allowed me to pick up some interesting bonds that I would have missed if I wasn’t paying attention. 

That doesn’t mean you need to check things as frequently as you might when actively investing.  But speaking from experience, I’d caution you against totally ignoring the markets, either.  If you’ve cultivated good relationships with your brokers and they understand the kinds of investments that interest you, they may give you a heads up occasionally when an opportunity presents itself.

Being less active in investing also gives you time to build your knowledge base and professional skills.  There are a lot of good resources available, and you can pick what works best for you.  Whether it’s self-study courses, online webinars, podcasts, conferences, schools, or other professional training, devoting some of your time to boosting your investment skills and becoming a better portfolio manager is a smart move that helps you and your community financial institution.

Don’t Ignore Your Role as Portfolio Manager!

Hands holding chalkboard with list of five things to do when you're not investing

As I mentioned, these activities can be blended around the other “day job” things you need to do.  I’m not looking to load up your to-do list, that’s for sure! 

But it’s crucial to recognize that even during periods of limited investing, you don’t want to ignore the investment portfolio and your role as a portfolio manager.  Investing time in activities like the ones I mentioned above will pay off for you and your community financial institution in the long run.

How to Build and Manage a Bond Ladder

How to Build and Manage a Bond Ladder

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Over the past couple of months, I’ve been having more conversations with community bankers about liquidity and how to manage it.  An essential part of any solid liquidity management plan is having an investment portfolio that plays its role in the process.  This is especially crucial when unforeseen challenges arise, or market conditions become more volatile.

Two Ways to Generate Investment Liquidity

There are two primary ways that the investment portfolio can be a source of liquidity for financial institutions:

Option #1: Sell Them – Selling securities to generate cash is the way that is typically most thought of when planning how to manage a bank’s or credit union’s liquidity position.  Unfortunately, that’s easier said than done these days because of the unrealized losses hanging over community bankers’ heads.  Let’s face it – nobody is thrilled about possibly realizing potentially sizable losses when trying to raise liquidity.

Option #2: The Investment Liquidity “Secret Weapon” – Fortunately, there is a way to create a source of liquidity that doesn’t involve having to sell anything.  That’s through managing the investment portfolio’s cash flow.  I consider investment cash flow the secret weapon for effective liquidity management when it comes to an institution’s investment portfolio, and it’s one of the things I focus on when I’m working with my clients.

Managing Investment Cash Flow with Bond Ladders

There are several ways to manage cash flow in the investment portfolio.  One that I’ve been getting more questions about recently is using a bond ladder.  Bond ladders are a great strategy and can be an important part of your investment liquidity management efforts.

A bond ladder is a way of structuring the bond portion of the investment portfolio so that the holdings have staggered maturities.  Basically, you stretch your investment dollars out over several years, evenly spaced like the rungs on a ladder (which is where its name comes from).

Here is a simple example of what a bond ladder might look like:

Chart showing an example of a bond ladder

Because the maturities are spaced this way, the portfolio’s principal cash flows occur at more regular and periodic intervals as bonds mature.  The benefit is that you have access to a source of liquidity without having to sell securities!

If you need the cash to fund loan growth or offset deposit runoff, it’s ready for you.  If not, you can reinvest the runoff into new bond investments in the ladder.

How to Establish a Bond Ladder Strategy

So how do you go about building a bond ladder?  Let me share with you six steps to creating one in the portfolio.

Step #1: Determine Bond Allocation

The first step is to decide what portion of the portfolio will be allocated to bonds.  For some investors, it may represent the whole portfolio.  Others may blend in additional investments like mortgage-backed securities, which are also great for cash flow given their monthly principal payments.

Step #2: Design the Ladder Structure

Once you know the total dollar amount for the bond ladder allocation, it’s time to establish the various maturity buckets representing the “rungs” on the ladder.  For example, you’d have a one-year bucket, a two-year bucket, and so on.

One question I am asked frequently is, “What is the maximum maturity I should use when setting up a bond ladder?”  In other words, how many maturity buckets should you have? 

The short answer is, “It depends.”  It depends on several factors driven by your balance sheet, its risks, your policies, and even the market you’re in.

  • For example, your ALM model and related interest rate risk exposure can provide clues.  If your institution is asset-sensitive (meaning assets reprice faster when interest rates change), you could consider building a longer bond ladder than an institution with liability sensitivity (meaning liabilities reprice faster when interest rates change).
  • The existing liquidity position is also a factor.  A bank with a lower loan-to-deposit ratio could consider building a longer bond ladder.  Other liquidity factors include your net cash or borrowing position (net borrowers are more likely to need a shorter ladder) or the degree to which you have potentially higher loan demand or large deposit withdrawals (also considerations for a shorter bond ladder).
  • You’d also want to consider credit and capital risk exposures.  If your bank or credit union has a lower level of loan charge-offs and healthier capital buffers, you could consider creating a longer bond ladder.
  • Market factors should also be considered, including competition from other institutions and customer deposit rate sensitivity.  More competition and higher customer sensitivity generally mean building a shorter bond ladder. (Side note:  You may already know this, but revisiting any assumptions regarding depositor rate sensitivity is critical.  That sensitivity is potentially higher in this environment than we’ve seen in quite some time.)
  • The last factor is one that sits above the rest – your institution’s risk appetite, or what I call its “comfort zone.”  It doesn’t matter what the numbers say – if your institution isn’t ever going to be comfortable investing in longer maturities (even if you have room to do so), then don’t do it.  It might mean you earn a slightly lower yield, but that’s the trade-off for peace of mind. 

As you review these different factors, they’ll help shape how long your bond ladder could be.  It might turn out that your ladder will only extend out a few years, such as 3-5 years, or perhaps you have the room to consider a longer ladder structure with maturities in 7-10 years.  The final decision will depend on the situation at your institution.

Step #3: Divide the Funds Evenly in the Ladder

Once you know how many maturity buckets or “ladder rungs” you have to work with, it’s time to divide the dollars evenly into each bucket.  Generally, you would allocate the same dollar amount for each maturity term that makes up the bond ladder structure.

For instance, let’s assume a community financial institution is building a $90 million bond ladder with a maximum maturity of six years.  Dividing the cash equally results in $15 million allocated each year in the ladder.

Is it okay to have more cash in a given year than the target level?  Sure, but you want to be careful not to load up or overfill a bucket with substantially more dollars than is needed.  While adding a little extra to a given year in the bond ladder may be alright, you want to avoid creating a wall of cash flow in one or two years that undoes the ladder’s purpose.

Step #4: Select Suitable Securities

Once you know how much will be allocated per year in the bond ladder, you’ll want to decide on the types of fixed-income securities to use.  There are several investment types to consider, including Treasuries, agency bonds, municipal bonds, or commercial mortgage-backed securities.  At this point, you’ll also want to consider market conditions to determine where the best yield and spread opportunities exist. 

Important! – You’ll want to be careful of using highly callable securities or bonds callable at a time that is materially different from the final maturity.  Bonds with call options can upset the cash flow you’re trying to build in a bond ladder, with bonds maturing sooner or later than you’d planned. 

Step #5: Monitor and Adjust

The last step is monitoring the bond ladder, adjusting for changes within the portfolio and your institution’s balance sheet.  As we’ve all seen in the past few years, nothing stays the same, and changing conditions may warrant you revisiting the assumptions you initially used to build the ladder. 

A Valuable Tool in the Portfolio Management Toolbox

A well-structured bond ladder can serve as a valuable tool for managing liquidity within an investment portfolio.  By diversifying maturities and strategically spacing cash flows, community financial institutions can access steady cash flow and liquidity without having to sell securities, providing a source of support for loan growth or deposit runoff.

By tailoring the bond ladder to align with the institution’s balance sheet, risk exposures, and market factors, a community banker can create an effective risk management tool and help the institution navigate challenging conditions when they arise.

6 Tips for Managing Investments During Uncertain Times

6 Tips for Managing Investments During Uncertain Times

As we all know, this year has been a wild and volatile environment for the bond market and fixed-income investment portfolio managers at community financial institutions.  The uncertain conditions has made managing the portfolio more challenging than ever, and I’ve spoken to many community bankers who just feel shell-shocked.

Almost everyone knows and expects that managing an investment portfolio will have its share of uncertainty, especially given its complexities and moving parts.  As a portfolio manager, you need to be ready for the curve balls that come your way.  But what can you do to help prepare yourself for when it happens?

I came across an article in the Harvard Business Review that I wanted to share with you.  While the topic was about leading through uncertainty, I thought it had a lot of applicability to the day-to-day challenges of investment portfolio management. 

The article talks about six tips to help you shift your perspective and adopt a good mindset when uncertainty rears its ugly head.  Here they are: 

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Tip #1: Embrace the Discomfort of Not Knowing

It can feel a little uncomfortable not to have all the answers up front, but acknowledging that you don’t know is part of the learning process and can remove some of the pressure you might feel in the moment.  This was a lesson that I learned early on as a young portfolio manager. 

At first, I pressured myself because of what I perceived as a need to anticipate and have the answers ahead of time, particularly ahead of meetings.  However, I learned that the world didn’t end when someone asked a question, and my response was, “You know, that’s a good question.  I don’t have the answer right now, but I will find out and follow up with you if that’s okay?” 

In my experience, I never had anyone disagree.  Taking this approach gave me the time to learn what I needed to know and provide a better response, and it helped reduce my internal stress in the process.

Tip #2: Distinguish Between “Complicated” and “Complex” Issues

Many of us use these two terms interchangeably, but they really represent two different situations.  In the article, the writer explains that the term “complicated” refers to something that may be difficult or highly technical but which can be broken down into parts, allowing you to work toward a solution either on your own, with help from your team, or by calling in outside help.  Examples of this might include tax laws or accounting rules.

By comparison, complex situations are made up of many interdependent elements.  In addition to the number of variables, some may change over time and in unpredictable ways.  This description sounds like many challenges we face in managing the investment portfolio. 

Finding solutions for complex challenges is different than for complicated ones.  In this case, you’ll generally get to an answer through a process of trial and error, and you have to be okay with taking a more flexible approach and be willing to learn and adapt along the way.

Tip #3: Let Go of Perfectionism

The article discusses that trying to shoot for perfection in a complex environment is a waste of time.  Instead, it is better to aim for making progress, learning from mistakes made, and acknowledging that you have the ability to make course corrections if necessary.

Personally, this is a step that I am constantly working on.  After being a “recovering perfectionist” for 30+ years, I still find myself tempted to come up with the “perfect” solution to a portfolio challenge or shift in market conditions.  But I know that because things are constantly in flux, trying to do so is a fool’s errand. 

What I’ve found is better is taking an incremental, step-by-step approach that allows me to adapt as conditions change (and they will), learn from the process and mistakes I might make, and make adjustments as I execute my investment strategy.

Tip #4: Resist Oversimplification and Quick Conclusions

It can be tempting to take a complex situation and try to boil it down to something simpler.  I think it’s just human nature, especially if we’re action-oriented – we want to make challenges easier to tackle. 

But in trying to simplify the challenge, we run the risk of oversimplifying.  When that happens, there’s a chance that we become too narrowly focused and possibly miss important and relevant information that could be critical to developing a solution.  And the more complex the environment, the more potential to want to simplify.

Think about everything that’s happened in the bond markets and your institution’s investment portfolio over the past few months.  With all the twists, turns, and moving parts, I can see how someone might want to boil things down in an effort to get on top of the situation.  But in many cases, doing so leads to making potential mistakes that only compound the existing problem and more headaches and heartburn.

The key to avoiding oversimplification is to balance the need for action with a disciplined approach that allows time to understand the core problem and any complexities or variables.  Slowing down just a little also gives you a chance to be sure that you don’t base your decisions on personal biases or a too-narrow perspective.

Tip #5: Don’t Go It Alone

As I’ve talked with many community bankers over the years, I’ve met people who have told me about feeling isolated as they try to deal with the uncertainties and challenges of managing the investment portfolio.  The article notes that some of this isolation comes from a belief that the person feels the need to solve all the issues themselves. 

However, as the workload grows and complexities increase, it becomes harder to do that, and you can begin to feel overwhelmed.  You feel like you’re drowning in a sea of uncertainty and “analysis paralysis.”

In these moments, having a network of people to whom you can reach out becomes vital.  Being able to have a conversation with someone who understands what you’re going through and can provide a fresh perspective can be so valuable, especially when times feel uncertain.

One of the best investments I’ve made in my personal and professional development is cultivating my own personal network.  It’s a blend of friends, colleagues, and other professionals that I can turn to when I have questions, need help from someone with experience, or get guidance, fresh thinking, and encouragement during challenging times. 

And it’s why I offer 1-on-1 mentoring to provide community bankers with someone they can reach out to for help with investment, banking, and finance questions.  Regardless of how you do it, take the time to create a network that you can tap into to help manage things during periods of uncertainty.

Tip #6: Zoom Out

Finally, Step #6 in managing uncertainty is to zoom out.  When you’re in the midst of facing a challenge, you can become stuck because you’re too immersed.  Zooming out, or taking a step back, provides you with a look at the “big picture.” 

This broader perspective on the issues can reveal things you might otherwise have missed.  When you zoom out, it becomes easier to see variables and other factors that might help with developing solutions or help prevent new challenges from arising.  Stepping back also allows you to be more adaptable and able to make course corrections if needed.

Reviewing the 6 Tips

Those are the six tips to managing uncertainty as an investment portfolio manager.  To recap, they are:

  1. Embrace the Discomfort of Not Knowing
  2. Distinguish Between “Complicated” and “Complex” Issues
  3. Let Go of Perfectionism
  4. Resist Oversimplification and Quick Conclusions
  5. Don’t Go It Alone
  6. Zoom Out

Lately, it seems we’ve had a constant barrage of reminders that we really can’t control much of the change, complexity, and uncertainty that’s out there and affects our investment portfolios.  But by using these six strategies, we can improve our ability to learn, reduce our stress, and navigate the complexity of the investment world in which we live.

The Return of Liquidity Management

The Return of Liquidity Management

Lately, I’ve been having more and more conversations with clients and community bankers about liquidity and liquidity management.  This is a topic that has been off the radar for the past couple of years. 

Actually, it’s not that the topic disappeared.  Instead, the focus was on figuring out what to do with excess liquidity due to the pandemic, the PPP program, and the considerable deposit growth that all financial institutions experienced.

Lately, however, community financial institutions have seen continued loan growth, while deposit growth has leveled off or shrunk a little.  Excess cash on the balance sheet has dried up, and they’re now beginning to borrow wholesale funding again in some cases. 

In addition, regulators are focusing more on bank and credit union liquidity and how institutions are managing it.  This is especially true given the loss in market value that investment portfolios experienced in the past few months, which has reduced the amount of liquidity available through the sale of investments if needed.

In some ways, this is one of those “back to the future” moments.  What I’ve been sharing with clients and other community bankers is that it’s time to dust off the practices and procedures we were using before the pandemic because we’re heading back to liquidity management as we once knew it.

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3 Factors to Liquidity Management Success

So given these circumstances, what should you be doing now to ensure your liquidity house is in order?  And what steps can we take with the investment portfolio to help out?  Here are three factors that are key to successful liquidity management for your institution.

Factor #1: Make sure you have multiple diversified sources of funding

The investment portfolio is one of these sources, but they also the Federal Home Loan Bank (FHLB), the Federal Reserve, brokered deposits, and other wholesale funding sources.  We’ll talk about the investment portfolio in more detail shortly, but let’s talk about the other types of funding I mentioned. 

FHLB Funding – Every financial institution has access to the FHLB system and can use its advances to help fund the balance sheet.  The source of the institution’s available borrowing capacity is based on the loans and securities pledged to them as collateral.  The more you have pledged to FHLB, the larger the borrowing capacity. 

As a result, you’ll want to be sure that you have pledged everything that’s eligible to them.  It’s worth checking with your FHLB rep to see if there are options for increasing your collateral and, therefore, the amount you can borrow from them.

Federal Reserve – The Federal Reserve is also a potential funding source through its Discount Window programs.  If you haven’t yet set up a borrower-in-custody (BIC) line with your local Fed bank, I recommend checking into it.  It takes a little time to get things in place and establish the Fed relationship, and you don’t want to wait until you absolutely need it to start the process.  You can learn more about setting up a line at your local Fed.

Brokered Deposits – Brokered deposits are another great source of funding.  There are different ways of raising funds through the brokered deposit markets that are beyond what we’re covering here.  But taking the time to establish the channels for tapping brokered deposits is time well spent.

Finally, you could also establish additional wholesale funding sources using Fed funds lines through correspondent and bankers’ banks and utilizing repurchase agreements. 

As I said, the key is having multiple and diversified sources available so that you have liquidity management options and flexibility.  Once those resources are in place, it’s a good practice to test them at least annually.

“It’s time to dust off the practices and procedures we were using before the pandemic because we’re heading back to liquidity management as we once knew it.”

Factor #2: Make sure you have sound policies, procedures, and tracking of your institution’s liquidity position

I know that everyone has a liquidity policy.  But when was the last time you really sat down and read it?  You might find that the policy needs updating or revising.  Your policy forms the foundation for your liquidity management efforts, so it’s worth checking it to be sure it’s structured the way you need it to be.

In addition, you want to be sure that you’ve established metrics and scorecards to know how your liquidity position is doing.  You don’t want to find out you have a liquidity problem after it’s already started and you’re forced into more of a reaction mode.  Establishing liquidity guidelines that show whether things are good, becoming a challenge, or have hit a critical level is essential. 

In addition, you want to be sure that you’re checking these metrics and scorecards regularly, sometimes even monthly.  You don’t need to have dozens of measurements in place, but you want to make sure you’ve covered your bases with enough monitoring that’s robust and helps you easily understand what’s happening on the liquidity front.

Factor #3: Conduct regular what-if and stress test scenarios

If you have a robust liquidity management reporting system in place, you’ll know where you are at any given moment.  But it’s also important to consider how changing conditions might affect your liquidity position.  That’s why it’s good to test the system and its underlying assumptions periodically. 

For example, what would happen if asset growth or deposit runoff is more aggressive than you thought?  What if you were to lose one or more of your wholesale funding sources?  These are all ways you can develop scenarios that push the boundaries of your liquidity management plan.  It’s not about trying to break the system; it’s about ensuring that the institution can weather more severe storms, whether they occur internally or systemically. 

In conjunction with a regular what-if scenario routine, you’ll want to make sure you’ve developed a solid liquidity contingency plan so that you’ll know what to do when the stuff hits the fan.  Again, you don’t want to wait until liquidity pressures emerge to decide on a response.  It’s also a good practice to occasionally test the contingency plan.

The Investment Portfolio as Part of Liquidity Management

Now that we’ve covered the three factors to managing liquidity successfully, let’s talk about how the investment portfolio fits into the liquidity management plan.  The investment portfolio is essential in managing a community financial institution’s liquidity.  There are two ways to utilize the portfolio for liquidity risk management.

Image of money bags and woman at desk with money falling to illustrate investment liquidity management concept

Option #1: Selling unencumbered liquid assets

Regulators usually consider selling investments the first line of defense in liquidity management.  It is the basis for the liquidity coverage ratio, which requires banks to hold sufficient amounts of high-quality liquid assets.  By raising cash through the sale of investments, a bank can produce a source of liquidity that it can use to offset changes in asset growth or liability runoff. 

With the recent sharp rise in interest rates and the related fall in market value, banks and credit unions have less available market value to liquidate to raise cash.  This is a major reason liquidity is getting more attention from regulators and bank examiners nowadays.  It’s also why investment liquidity in the portfolio becomes a more important consideration. 

What do I mean by investment liquidity?  I’m talking about the ease of selling a security in the market and converting it to cash.  Some securities, like US Treasuries, are highly liquid and can be easily sold.  Other securities are less liquid and may be harder to liquidate quickly depending on market conditions. 

Understanding the relative liquidity of investments in the portfolio is an integral part of managing the institution’s liquidity risk, especially if investment sales need to be involved.  Now, I’m not saying you need to concentrate your portfolio in highly liquid investments like Treasury securities; I’m saying that you’ll want to understand how liquid your existing holdings are.

Generating liquidity through investment sales does have two downsides right now.  First, if you had to liquidate investments today after the recent market selloff, you’d have to realize those losses.  In addition, one downside of selling investment securities for liquidity purposes is the loss of investment income.  Securities sold are earning assets that are no longer on the books.  The sale of investments raises cash immediately but comes at the expense of future interest income.

Option #2: Structuring Investments to Manage Cash Flow

This means building a portfolio that produces a steady stream of principal payments on a regular basis.  Unlike the first option, it does not require selling any assets. 

An investment portfolio with regular cash flow provides an ongoing and stable source of funds to meet liquidity needs on either side of the balance sheet.  If the funds are not needed when they’re received, they can simply be reinvested.  Simply put, managing investment cash flow is the foundation for good liquidity management. 

There are different ways to structure an institution’s investment portfolio to manage this cash flow.  If the portfolio is composed of traditional bonds, it could be structured to provide regular principal payments by building a bond ladder, which provides a series of staggered principal maturities.  Another way to create portfolio cash flow capability is to use mortgage-backed securities, which generate monthly principal payments.

The investment portfolio plays a significant role in liquidity management, whether by helping to mitigate liquidity risk on the balance sheet or as a means to manage excess liquidity.  By managing the underlying mix of investments and their cash flows, you can build an effective liquidity tool for your community financial institution.

Portfolio Management During Tough Markets

Portfolio Management During Tough Markets

In the past few months, I’ve spoken with a lot of clients and other community bankers about portfolio management following the bond market selloff and the surge in interest rates and market volatility.  Based on those conversations, I can tell you that there’s a lot of anxiety, paralysis, and second-guessing out there.  If that describes where you find yourself as you contemplate what to do with your institution’s investment portfolio, I can assure you that you’re not alone. 

I do what I can to support community bankers through these challenging times.  That means a lot of tough conversations, advice, and reassurance. I have one client I speak with regularly who has told me that she appreciates her “therapy sessions” with me. 

If I had to boil down all those conversations, it would come down to this: “Chris, I’m not really sure what to do with the investment portfolio right now.  I don’t need to invest as much as I have been, but I still need to put some funds to work, and I’m a little unsure how to proceed.  Honestly, I sometimes feel paralyzed when making portfolio management decisions because I don’t want to compound what’s already happening.”

Let me share some thoughts and advice with you – a Bond Investment Mentor “heart-to-heart,” if you will.  So step into my office, have a seat (or lay back on the therapy couch if that’s better for you), and let’s have a chat.

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You’re Not Alone

First, it’s important to remember that you’re not alone, as I mentioned before.  When times get tough with the bond markets and the investment portfolio, it’s easy to feel like you’re in this on your own.  But I can assure you that everyone is in the same boat. 

I also want to remind you that this isn’t the first time that conditions have gotten wild.  It was only a couple of years ago that we were dealing with a major collapse in rates following the COVID outbreak.  Then, the Fed acted aggressively to cut rates, and the market was rallying hard, with the 10-year Treasury rate eventually bottoming out around 0.53%. 

When these situations happen, and they will happen again, what’s most important is to stick to the fundamentals and play defense with the portfolio.    What do I mean by that?  Well, let me share five portfolio management tips to help when conditions are challenging.

5 Portfolio Management Tips for Trying Times

Tip #1:  Always Start with Your Balance Sheet 

It can be easy to get caught up in the moment-to-moment gyrations of interest rates, the Fed, yield curves, and the like.  These things are important, but the rate environment is still secondary to what’s happening on your institution’s balance sheet and its risk exposures.  That’s why you want to start with the balance sheet first.

For example, what’s happening with your institution’s liquidity risk and interest rate risk?  How have they changed in the past few quarters?  What risk exposures do you have on those fronts?  I can tell you that liquidity is getting much more attention on the regulatory front, particularly since the market values of bank and credit union investment portfolios have fallen. 

What’s happening with your loan and deposit growth?  Have the trends changed there recently?  As you consider these factors, they will help you to maintain a steady course when it comes to investment decision-making.

I periodically see security offerings from brokers that are described as “great opportunities” or “great values.”  And in some cases, I’d have to agree.  But what’s important to remember is that an investment candidate is only a great opportunity if it fits with what you’re trying to do on your balance sheet.  If not, then it’s time to move on.  It might be someone else’s opportunity or value, but it’s not yours.

Tip #2:  Focus Beyond Today When Making Portfolio Management Decisions

You may not realize this, but you’re really managing two portfolios – the securities you own today and those you’ll hold in the future.  The investments you purchase today are likely to be with you for a long time.  And during that time, the economy, the market, and the interest rate environment will change. 

When that happens, you may find that your investment changes, too.  Suddenly, that great investment you purchased has morphed into something you don’t recognize and is dragging down the whole portfolio.

As an investor, you’ll need to consider how an investment will perform not just today but in different situations down the road.  I’ve talked with community bankers who learned this portfolio management lesson the hard way.  They bought securities a couple of years ago that were fine at the time.  However, things changed as interest rates rose, prepayments slowed, call options fell out of the money, and bond durations extended. 

One of the reasons for this is that the focus back then was on one thing – yield.  In the uber-low rate environment, investors wanted whatever would produce the highest yield at the expense of underlying risks that were there all along.  In addition to current conditions, if the investments had also been considered in a scenario where rates were higher, it might have resulted in slightly different decisions that may have been less painful today. 

The same thing is happening in some quarters today.  With rates increasing, unrealized losses growing, and investments extending, some investors are now focusing on one thing – duration, duration, duration, and short, short, short.  Now I’m not saying that those aren’t important factors.  But they’re not the only ones.  Think beyond today and consider how changing future conditions could affect the investments you’re evaluating.

Tip #3:  Take Steps to Manage and Maintain Portfolio Cash Flow

In the first portfolio management tip, I mentioned keeping liquidity risk in mind as part of your balance sheet approach.  But this is important enough that it warrants its own tip. 

Many bankers and regulators consider the investment portfolio a primary source of liquidity because you can sell securities if necessary to raise cash.  That’s true.  But there’s another way to create liquidity in the portfolio – by structuring it to generate a stream of regular, steady principal cash flow. 

With regular cash flow, you’ll always have funds available if needed without having to liquidate positions.  And if the liquidity isn’t necessary, you can simply reinvest the funds. 

The cash flow can come from two sources:  first, by laddering traditional bond investments, you can provide regular principal payments as bonds mature.  The second source of cash flow can come from monthly payments from mortgage securities.  Because of their monthly payments, using MBS can provide a regular principal stream and a steadier source of liquidity. 

What I’ve found works well is combining the two with a portfolio utilizing laddered bonds and mortgage-backed securities.  The percentage allocated to each depends on your balance sheet and risk exposures (there I go back to Tip #1 again!).

Tip #4:  Pay Attention to a Security’s Structure and Collateral

This factor can either make managing your portfolio less stressful or potentially create more headaches for you.  So what do I mean by structure and collateral?  Here are three things to keep in mind.

The first thing is a security’s liquidity or the ease with which you can sell a security.  While we talked about managing cash flow before, there may still be situations where you decide to sell an investment. 

What you’ll find is that all securities are not created equal.  Some securities, like US Treasuries, are highly liquid and can easily be sold.  Other securities are illiquid, such as bank sub-debt, corporate bonds, private equity and CRA investments, and so forth.  Other securities will fall somewhere in between.

As you build and manage your portfolio, you’ll want to be sure that you don’t hold too much in less liquid investments.  Otherwise, you could be surprised when the bid you receive for your investment is nowhere close to its fair value.

The second thing to keep in mind is optionality.  When you own investments containing embedded options, such as callable bonds or mortgage securities, you’ve given someone else the right to pay you back differently than the base case payment schedule. 

With a callable bond, the issuer can pay off the bond early, while with a mortgage security, the borrower can prepay at any time.  This is known as option risk or optionality.  Optionality can transform what looks like a well-structured portfolio into a portfolio that pays you a lot of cash when you don’t want it and very little cash when you might like it. 

Unfortunately, it’s almost impossible to build an investment portfolio that doesn’t have some degree of optionality.  However, by considering current and future market conditions as I mentioned in Tip #2, and paying close attention to the underlying loan collateral in any mortgage securities, you can mitigate the exposure and help the portfolio stay well-behaved.

Tip #5:  Avoid the Big Bet or Hail Mary Plays

I get it.  An investor has a portfolio behaving in a way that wasn’t what was planned or wanted.  And so, they think to themselves, “I’ll figure out what type of investment will help me offset what’s happening, and I’ll buy a lot of it to force the portfolio back toward where I want it to be.” 

So they do it, and MAYBE it works.  But most of the time, it only creates a new headache or risk to handle. 

It’s like the person who walks into the casino, places all their cash on one number, and hopes for the best.  As you may have heard others say, hope is not a strategy.  And it rarely pays off. 

But investors are tempted to do this in challenging times.  Here’s my advice – DON’T DO IT!  Step away, take a break, and then get back to developing investment strategies that might not work overnight but will be more likely to get you where you want to be.

A Tip Recap

So, to recap, here are the five tips:

  1. Always Start with Your Balance Sheet
  2. Focus Beyond Today When Making Portfolio Management Decisions
  3. Take Steps to Manage and Maintain Portfolio Cash Flow
  4. Pay Attention to a Security’s Structure and Collateral
  5. Avoid the Big Bet or Hail Mary Plays

If you stick with these guidelines, it will help you develop investment strategies that should be helpful no matter what conditions the market throws at you.