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. 

Watch Out for These 5 Investment Risks

Watch Out for These 5 Investment Risks

A critical part of portfolio management for a community financial institution is staying on top of the different investment risks that could be present.  It’s important to be aware of those risks and understand what the investment risk exposures are.

In my years as a portfolio manager, I have found five investment risks that are important to keep in mind.  The presence and effect of these risks vary depending on current and proposed investment holdings. 

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Let’s explore these five investment risks:

Investment Risk #1:  Credit-Related Risk

As you might expect, credit risk exposure in the investment portfolio is similar to the credit risk contained in a financial institution’s loan portfolio.  There are two types of credit-related risk to consider:

Default Risk

Default risk happens when the bond issuer fails to meet its obligations to make timely interest and principal payments.  Basically, the issuer doesn’t pay you back or delays payment.  If the bond issuer defaults, the investor can lose some or all of their original investment and any interest owed.

Investing in securities with longer maturities could potentially compound the credit risk, as the uncertainty stretches out over a more extended time.  This extension can create a higher default risk exposure in the process.

Generally speaking, most community bankers do not have a lot of exposure to default risk in the investment portfolio.  Most financial institutions hold fixed-income securities issued by the U. S. government, its agencies, or state and local governments.  These issuers have the ability and means to meet their financial obligations through tax revenues or printing money, which makes a default extremely unlikely. 

However, other investment types may not carry the same high creditworthiness, so the probability of default risk can be higher.  Examples would include private-label mortgage-backed securities, corporate bonds, and subordinated debt securities.

Downgrade Risk

Downgrade risk occurs when the reduction in a security’s credit rating results in a price decline.  When a bond receives a downgrade from a rating agency such as Moody’s, Standard & Poors, or Fitch, it means that the perceived credit quality of the issuer has weakened. 

Because of the higher underlying credit risk, the credit spread, which is part of the investment’s yield, needs to adjust to reflect the new higher risk.  For example, if a bond that originally carried an A credit rating receives a credit downgrade to BBB, it needs to trade at similar levels to other triple-B rated bonds.  All fixed-income investments trade at a spread to Treasuries.  This yield spread incorporates many factors, including the underlying credit risk of the issuer.

Comparison of risk-free Treasury yield with other bond yields that have a yield spread

If the issuer’s creditworthiness is reduced, the credit spread should widen, meaning the bond would now trade at a higher yield.  With the higher investment yield and the inverse relationship between yield and price, the investment’s price drops as a result. 

An investor holding a bond subject to a downgrade will see the value of their investment fall as the security adjusts to its new credit conditions.  They experience a price decline simply because the security’s credit spread, and its yield, increased.

Investment Risk #2: Interest Rate Risk

Interest rate risk refers to the sensitivity of a fixed-income security’s price caused by a change in interest rates.  As the rate environment shifts, the market value of the portfolio’s holdings will adjust based on two factors.

The first is the yield-price relationship, where bond prices move in the opposite direction from interest rates.  Higher interest rates result in lower prices and vice versa.

The other factor that determines the rate sensitivity of a fixed-income security is its duration.  Duration measures the degree that a security’s price moves when interest rates change.   Duration is the primary way of measuring interest rate risk for both individual securities as well as an entire investment portfolio.  A higher duration results in a higher level of price sensitivity.

Investment Risk #3: Option Risk

When a portfolio has exposure to option risk (otherwise known as “optionality”), the principal cash flows of the securities it holds may vary from what the original payment schedule would indicate.  This variation is due to the presence of embedded options, which can cause principal payments to either speed up or slow down.  As a result, an investor’s principal cash flows may be faster or slower than expected.  The change in cash flow speed is primarily driven by changes in interest rates, though other factors can influence it.

Option risk primarily shows up in the investment portfolio in the form of bonds with call options and mortgage-backed securities with principal paydowns that vary.  Depending on whether interest rates are rising or falling, optionality shows up in two ways:

Prepayment risk – The risk that investment principal is returned sooner than the stated final maturity or scheduled amortization.

Extension risk – The risk that principal payments are returned more slowly than expected or scheduled.  It’s the “flip side” of prepayment risk. 

Investment Risk #4: Liquidity Risk

Investment liquidity is how easily a fixed-income security can be bought or sold in the market and converted to cash.  Liquidity risk refers to a situation where an investor has to sell a fixed-income security at a lower price than its indicated actual value (think “fire sale”).  In the worst-case scenario, it could mean the inability to sell a security in the financial markets. 

It should be noted that the liquidity risk described here is different from the definition of a financial institution’s liquidity and liquidity management.  In that case, liquidity refers to the ability of the institution to meet funding needs caused by asset growth or liability runoff. 

The degree of liquidity will vary depending on the type of security involved.  U. S. Treasury securities are the most liquid investments available.  Other more liquid investments include government securities like agency bonds and agency-backed mortgage-backed securities.

There is less relative liquidity as we move into more complex securities or securities with higher relative risks.  These investments include CMOs, private-label mortgage securities, and municipal and corporate bonds.

Finally, some investments have almost no liquidity or are considered illiquid.  Examples include bank sub-debt, private equity, CRA-related investments, and private placements.

One way to determine the relative liquidity of a fixed-income security is to look at the investment’s bid-ask spread.  The bid-ask spread is the difference between the current bid and ask prices on a fixed-income security. 

A good rule of thumb is that the smaller the bid-ask spread between the two prices, the greater the level of liquidity.  For example, the bid-ask spread on highly liquid U. S. Treasury securities is exceptionally narrow, with sometimes no more than a 1/32 price difference. 

Other fixed-income securities will have increasingly wider spreads as their relative level of liquidity decreases.  Of course, the bid-ask spread is highly correlated with the volume of transactions associated with the underlying security.

Investment Risk #5: Reinvestment Risk

Reinvestment risk is the risk of reinvesting proceeds at a lower interest rate than the initial investment.  This becomes a challenge when interest rates decline. 

The idea of reinvestment is one of the key assumptions associated with a security’s yield to maturity (YTM).  To earn the YTM, it is assumed that all income is reinvested over the bond’s life at the original YTM rate.

Since community financial institution investors are neither likely to reinvest the income nor guaranteed to get the same initial yield, this means that they’d always have some level of reinvestment risk exposure.  The only way to avoid reinvestment risk is to invest in securities like zero-coupon bonds, which do not have coupon interest payments, and accrue their return at the yield to maturity rate. 

The presence of optionality can also increase reinvestment risk.  Fixed-income securities containing option risk are more likely to pay off or pay down when interest rates decline.  Examples of this would be bond calls and mortgage prepayments.  If that happens, an investor would be forced to reinvest at lower rates based on the new lower rate conditions.

“Your Investment Risks May Vary”

As I mentioned, exposure to these investment risks will vary depending on the portfolio holdings or the type of security.  The key to managing these risk exposures is not to eliminate them but to limit their impact on the portfolio’s behavior. 

Keeping these five investment risks in mind while developing strategies and evaluating investment securities won’t make your portfolio bulletproof.  But it might save you a world of pain and headache later!  In the end, understanding the risks you may be taking on – and making sure that you’re being rewarded sufficiently for taking those risks – will help make you a successful portfolio manager.

4 Simple Questions to Help Navigate Volatile Markets

4 Simple Questions to Help Navigate Volatile Markets

It’s really easy for a community banker’s head to be spinning right now.  To say that a lot has happened in the past few months is an understatement.  We’ve experienced a global pandemic, an economy that ground to a halt before slowly starting up again, a collapse in interest rates, and moves in Washington to launch unprecedented fiscal and monetary stimulus programs (really more like rescue missions).

In the midst of all this, community bankers have had their own juggling act to manage. Deciphering the Small Business Administration’s new Paycheck Protection Program (PPP), reviewing loan forbearance and deferral requests, figuring out how to manage shifts in core deposits and liquidity (both growth and shrinkage), all while working to keep the lights on in a limited work-from-home environment.

Frustrated businessman
Photo courtesy of iStockphoto.com

Is anyone ready to hit the pause button yet?

A Case of Sticker Shock

Now, bankers have begun focusing on their institutions’ investment portfolios and the bond markets.  Many have experienced a heavy dose of “sticker shock” after seeing how low bond yields have gone in such a short time.  New challenges have also arisen in the current rate environment, with bond calls and mortgage prepayments creating portfolio headaches.  And concerns about potential rising credit risks for municipal bonds in a post-pandemic environment have started to draw attention as well.

Man frustrated with financial markets
Photo courtesy of Daniil Peshkov/123rf.com

It can be downright frustrating for community banks and credit unions that are trying to manage their investment portfolio right now.  The temptation is just to grab whatever yield you can and hold on for the wild ride.  

Where we are now is what I refer to as the “messy middle.”  We still don’t know how things will play out in the months ahead.  Furthermore, we don’t know what “normal” will look like in a post-pandemic world because it’s still being shaped and formed.  As a result, we find ourselves in this transition phase, this limbo, feeling uncertain and second-guessing our decisions.

4 Simple Questions

As you begin to consider what to do with your investment portfolio in this new world, I want to share with you something that was helpful for me over the years as I managed my bank’s investment portfolio. These four questions helped me stay the course when market conditions got murky.

Four questions

The “What” and the “Why”

The first two questions usually are teamed up:

Question #1: “What are we doing?”

Question #2 “Why are we doing it?”

These two questions form the foundation of good strategy development. 

As you consider your answers to these two questions, it is important to take the time to define exactly what the objective is with your investment strategy. You want to be as detailed as possible in your responses.  

For example, instead of saying, “We’re putting money to work,” your answer to the questions might be, “We’re temporarily putting excess funds to work in bonds that will produce liquidity cash flow to help pay for loan growth later this year.” Another example might be, “We have excess deposit growth and limited loan origination options, so we’re investing to generate better income than leaving the money at the Fed.”

As you can see, taking the time to answer the “what” and the “why” clearly lays the groundwork for a good investment strategy.  

“The questions have been helpful to me, forming the cornerstones of a solid strategy development plan.”

The “What If” Moment

The third question is one that sometimes get lost in the decision-making process.

Question #3: “How can it go wrong?”

Many people will answer Questions #1 and #2 as they build their investment strategy and stop there. But Question #3 is important to consider upfront as well.

This question is all about risk assessment and predetermining the risks associated with the investment transaction or strategy. Before you move ahead with the trade, ask yourself, “What risks are present?” 

Depending on the security, you could be facing one or more of the following:

  • Credit risk
  • Optionality
  • Prepayment risk
  • Extension risk
  • Interest rate risk
  • Liquidity risk

Additionally, you’ll want to think beyond the present moment.  It’s not just about how the investment looks and behaves today. How will changing market conditions affect the behavior of this bond that’s about to be purchased? 

It’s better to consider these things now before you pull the trigger rather than when the investment starts to cause problems. It’s also a good idea to make a note of the answers to this question, so you have them as a handy reference later. 

Now What?

We’re almost there!  But first, we need to answer the final question:

Question #4: “What will we do if it does?”

In other words, how will you respond if the risks that were identified in Question #3 become a reality? You have identified potential risks; given those risks, what will you do if they occur?

This question addresses contingency planning. If you had to face the situation, what would you do? Would you sell the bond or ride the situation out? Would you make adjustments within the portfolio to offset the situation? Like Question #3, it’s better to think about how you would respond now instead of waiting for the fire drill later.  

RECAP: 4 Simple but Powerful Questions

So, let’s review the four questions:

List of four questions:
1. What are we doing?
2. Why are we doing it?
3. How can it go wrong?
4. What will we do if it does?

They are so simple but so powerful. The key is to think about these questions beforehand and have the answers to them before you begin implementing your investment strategy. 

I’m going to share a little secret with you. These questions are not just for the current conditions, as uncertain as the markets might be.  They are timeless guidance and can be used anytime. 

I have let these questions guide me through many different markets and many changes and shifts in conditions. The questions have been helpful to me, forming the cornerstones of a solid strategy development plan.  

Try them out yourself! I think you will find them useful, allowing you to proceed confidently with your decision making while helping to cover your bases if something goes wrong.

How to Level Up Your Pre-Purchase Decisions

How to Level Up Your Pre-Purchase Decisions

When it comes to managing the investment portfolio, finding enough time to analyze securities can be challenging. While your desire might be to deep dive into a potential bond’s characteristics, it isn’t always possible. Unfortunately, the rest of the “day job” also requires attention. The result could be having to make a pre-purchase investment decision with limited time, hoping that your due diligence efforts were thorough enough.

In addition to time constraints, there’s a desire to be confident in your decision making. Before you make an investment purchase, you want to be able to answer these important questions:

  1. What are we buying, and why are we buying it?
  2. Do I have the information and analysis necessary to make a purchase decision?
  3. What risks are present in the proposed investment? How could holding this security in the portfolio potentially “go wrong?”
  4. What’s the response if the bond doesn’t perform as expected or the potential risks become a reality?

Looking Back After the Trade Is Completed

An effective due diligence process is an integral part of making sound investment decisions before executing the trade. But without a system in place to capture your thoughts about the investment and the background research that went into the decision, you could end up second-guessing yourself after you have completed the trade.

“A well-developed pre-purchase process can help ensure that you have the answers you need both before and after the investment purchase.”

It is essential to have a process to record and organize your pre-purchase analysis so you can look back later. You’ll also want to be able to show that you completed a proper level of due diligence.

Occasionally, questions about past investment decisions may arise, whether from management, an auditor, or a regulator. Having the information available to provide historical context is very valuable. Why scurry around to explain the reasoning behind a particular bond trade? What about being able to demonstrate why an investment was a good fit for your balance sheet strategy and objectives? A well-developed pre-purchase process can help ensure that you have the answers you need both before and after the investment purchase.

The Search for a Solution

When I first became a portfolio manager, I wrestled with many of these same issues. While I’d feel good about investment decisions, I sometimes wondered if I’d covered all my due diligence bases. As I gained experience, I began to create mental and physical “checklists” to ensure that I had gathered the information I needed. I also took steps to organize my data to make it easier to retrieve if I needed it later.

As I began to follow these procedures, I found that I became faster at analyzing the bonds that came my way. I was quicker in making investment decisions while also feeling confident in doing so.

The routine also allowed me to organize my investment due diligence files since I used a standard, uniform approach for all security types. I found that follow-up investment conversations went more smoothly when I could retrieve the information that led to the decision. It was a great feeling when a conversation with an examiner went well because I could show the due diligence that I had completed, even if the trade had happened months before.

Introducing the Pre-Purchase Checklists

As I’ve helped others learn more about fixed-income investments, they’ve often asked me if I know of any tools or resources to improve investment due diligence and decision-making. As a result, I’ve created something to help manage that process.

Pre-purchase checklist pages

I’ve designed a package of pre-purchase checklists for the following fixed income security types:

  • U. S. Treasuries
  • U. S. government agency bonds
  • Municipal bonds
  • Residential mortgage-backed securities (MBS)
  • CMOs
  • Commercial mortgage-backed securities (CMBS)
  • SBA pools
  • Corporate bonds

Each worksheet has areas to record general trade and security information as a reference. There’s also a section to record your reasons for purchasing the investment, its risk factors, and your plans for an exit if needed. Finally, each worksheet contains a list of resources to help you analyze and evaluate the security.

As you might expect, many of the items on the checklists are screenshots from Bloomberg. If you don’t own a Bloomberg, that’s okay. Ask your broker to forward you the screens you need (after all, that is part of the service they should provide!).

While the checklists contain many items to help in your due diligence, they’re not all-inclusive. Instead, use them as part of a routine that includes your existing investment policy or decision-making procedures. Make the process your own, and it will make it that much easier to administer and maintain.

Get the Pre-Purchase Checklists Delivered to Your Inbox

To get your free copy of the fixed income pre-purchase checklists, click the button below to download them. Also, by signing up as a member of the Bond Investment Mentor community, you’ll receive my weekly email, where I share resources, tips, and updates about investments, portfolio management, and other related topics.

I hope that you’ll find the checklists to be a helpful tool in fine-tuning your investment process. They’ll help you perform a meaningful, organized evaluation of fixed-income securities before you pull the trigger. Additionally, you’ll have a record of the factors that went into the decision, which will help you when you need to review a past trade.

So, what are you waiting for?  Sign up now and you’ll have the pre-purchase checklists in your hands in no time!