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.
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.
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.
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 “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:
Interest rate 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.
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:
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.
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:
What are we buying, and why are we buying it?
Do I have the information and analysis necessary to make a purchase decision?
What risks are present in the proposed investment? How could holding this security in the portfolio potentially “go wrong?”
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.
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!
Actress Rachael Taylor once said, “we live in a world of instant gratification, the world of the quick fix.” In this age of immediate and on-demand delivery of goods and services, I suppose it’s hard to argue against that point. For many people, the focus is on dealing with what’s happening now and handling the challenges of the present moment. As bond portfolio managers, it’s easy for us to give in to this temptation as well. However, this perspective fails to consider the two portfolios for which you’re responsible. That’s right – you are managing two bond portfolios!
Typically, the scenario might go something like this: you are searching for a bond to purchase when the phone rings or an email lands in your inbox with a potential investment candidate. You check the current yield, glance at other factors like the duration, the maturity and spread, and quickly consider your existing holdings. If everything looks good, you execute the purchase transaction and move on to the next task at hand. Simple, right?
While it sounds straightforward, it is important to remember that you are dealing with two bond portfolios. Forgetting this can result in a lot of potentially unpleasant surprises down the road. What are these two portfolios, and why do they matter?
Portfolio #1: The “Today” Portfolio
The first bond portfolio is called the “today” portfolio. With it, you are making investment decisions based on current needs, circumstances, and conditions. Elements such as yield, duration, and average life are all considered from a present perspective. You might also consider factors that include the existing investment structure and current portfolio holdings, as well as your institution’s present interest rate and liquidity risk exposures.
While it’s okay to evaluate investments from a current perspective, you can’t stop there. It’s also important to consider your other investment portfolio.
Portfolio #2: The “Future” Portfolio
When you make an investment purchase, you are also adding a position to your “future” portfolio. The “future” portfolio is just that: the investments you will be holding and managing in the weeks and months ahead. While this portfolio may contain many of the same bonds found in the “today” portfolio, they may look and act very differently compared to when you first purchased them.
As market conditions shift and interest rates change, the characteristics of the bonds you hold may begin to change also. In doing so, they may morph into something that not only fails to help your portfolio but could hurt you instead.
The world of “future” portfolios is littered with the remnants of bonds gone wrong. Examples could be callable agencies that were called too soon, mortgage securities that prepaid to quickly or extended durations, CMOs with negative yields, or supposedly liquid variable rate securities with no available buyers. While they most likely represented situations that looked good at the time of purchase, they eventually evolved into toxic situations for their owners.
Investment Decisions Made Today Have Consequences Later
The key takeaway is that the investment decisions you make today will have repercussions in the future. Because of this, thinking beyond your present needs and circumstances is critical. To the degree that you don’t do that at the time that you are performing your due diligence and making the purchase, you run the risk of ending up with a “portfolio of unintended consequences.”
This approach becomes more critical as your portfolio complexity increases. For example, if you’re managing a bond portfolio that holds Treasury securities exclusively, portfolio management is relatively easy because it involves more basic investments. As you begin to add in securities with more moving parts, such as callable agency bonds, mortgage-backed securities, CMOs, and variable rate securities, it becomes crucial to consider how these bonds might behave (or misbehave) under different conditions.
That is why it is important to consider both bond portfolios as you make investment decisions. It can be easy to find yourself focusing on the here and now in the investment portfolio. But to the degree that you don’t manage to your potential future risks and considerations, you may find that the immediate gratification you receive might eventually lead you instead to a period of investment pain and frustration.
In my conversations with community bankers over the years, I hear one series of questions quite frequently. It usually goes something like this: “What do you think will happen with interest rates? What is the Fed going to do, and when? What should our first step be?”
Questions like these have become more prevalent recently as the Federal Reserve wrestles with the current economic and market environments. Wall Street is watching, the banking and finance industry is watching, and — most importantly — financial industry regulators are watching.
As a result, your institution’s investment portfolio might be getting a little more attention right now. Asset-liability management and investment committees are discussing what to do now and what comes next concerning interest rates. And with the constant drumbeat from the financial media, it’s easy to start planning an investment strategy from that perspective.
However, before you begin positioning your portfolio based on an interest rate forecast, there is one essential factor to consider. When it comes to bond portfolio management, the first step is to assess your current balance sheet and its risks and not base your strategy or decision making on an interest rate bet.
4 Reasons for Considering Your Balance Sheet First
Here are four reasons why you need to start with making your balance sheet the primary focus as you develop your investment portfolio strategies:
1. Interest rate forecasts and expectations are not always correct
It’s important to keep in mind that just because someone has released a forecast or there’s a market consensus about interest rates means that it is correct. I don’t know how many times I’ve seen various interest rate forecasts and expectations go totally by the boards because, frankly, they were wrong. I recall an example a few years ago where the outlook was that the Federal Open Market Committee (FOMC) would hold steady for the foreseeable future. In just over two weeks, those expectations fell apart as the FOMC began raising short-term interest rates. And no one anticipated the sharp decline in interest rates in a matter of weeks recently due to the COVID-19 pandemic. That’s how fast these things can change. So making an investment decision based solely on a rate forecast won’t necessarily pan out for you if it turns out those forecasts were incorrect.
2. The investment portfolio is a critical part of balance sheet risk management
Some community bankers believe that managing the balance sheet is about loans and deposits. They see the investment portfolio as something extra, a place to park funds while earning some additional yield in the process. Nothing could be further from the truth. Your investment portfolio is a valuable risk management tool. For example, let’s assume your loan portfolio is made up primarily of variable or shorter-term loans. By investing in longer-term investments, you create an offset and change your interest rate risk exposure in the process.
With effective investment portfolio management, you can mitigate the risk exposures created in other areas of the balance sheet, while still providing liquidity and earnings. By blending your loan and investment portfolios, you create an overall asset mix that helps you meet your desired objectives.
3. Not all balance sheets are created equal
Depending on your institution’s balance sheet mix, its sensitivity to changes in interest rates will present itself in different ways. On a “liability-sensitive” balance sheet, the liabilities will reprice more rapidly when interest rates change. This sensitivity can create challenges when interest rates rise. Other banks might see their assets reprice faster, otherwise known as being “asset sensitive.” For them, the challenge is a declining interest rate environment.
As a result, what you might need in your investment portfolio could be very different from what other financial institutions are holding. There is no “one size fits all” solution in any interest rate environment. The key is not trying to figure out what interest rates might do. Instead, your first step is determining how they will affect your balance sheet and financial performance.
4. Risk appetites vary between financial institutions
A report from accounting firm Ernst & Young touched on the importance of a company understanding its risk appetite. According to the report, “A company needs to know how much risk it is willing to take and how it wants to balance risks and opportunities.”
Your institution’s risk appetite will be unique to your organization. Financial institutions can use the components of the CAMELS ratings — capital adequacy, asset quality, management capability, earnings, liquidity, and rate sensitivity — as a starting point. An institution with a lower overall risk appetite might decide to hold more conservative securities to offset higher risk levels in the loan portfolio. Another might choose to invest in “riskier” investments given their ability to accept and consider additional risk on their balance sheet.
Does the Federal Reserve Matter?
Does this mean that you should ignore the actions and comments coming from the Federal Reserve? Of course not. The Fed represents the “800-pound gorilla” in the room and is the keeper of monetary policy. For that reason, we still need to pay attention to what Jerome Powell and other Fed representatives have to say.
But while interest rates are a factor, they are not the first thing to think about. Reviewing your balance sheet and the risks it already contains should be your first step in managing your bond portfolio effectively.