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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. 

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!

Understanding Your Two Bond Portfolios

Understanding Your Two Bond Portfolios

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.

Free Virtual Learning Series on Investing

Free Virtual Learning Series on Investing

With everything that’s been going on due to the COVID-19 pandemic, especially in the financial markets, it’s made managing the investment portfolio for community financial institutions more challenging than ever.  With that in mind, I want to tell you about an upcoming event that may be helpful.

The Graduate School of Banking at Colorado (GSBC) is hosting a three-part virtual learning series called “Investing During a Pandemic: The New Normal.”  This is a free event that begins on Thursday, May 14.

I’m pleased to be one of the presenters in this virtual learning series for community bankers.  In addition, Tim Koch from the Graduate School of Banking at Colorado and Jason Mork from Piper Sandler & Company will be speaking as well. 

List of speakers for the virtual learning series - Tim Koch, Chris Nelson, and Jason Mork

During the series, we’ll be discussing the impact of recent events on financial market conditions and how to craft investment strategies for financial institution portfolios.  We’ll talk about interest rates and when to factor them into making investment decisions, as well as taking a two-pronged perspective to the investment portfolio.  I’ll also be sharing three key elements to developing an effective investment strategy and four questions that you must ask as part of building that strategy.  Finally, we’ll explore sound portfolio tactics when times get tough.

The virtual learning series begins on Thursday, May 14 and will run weekly for three weeks (5/14, 5/21, and 5/28).  As I mentioned, this online series is free.  GSBC is offering this and other programs as a service to community banks experiencing unprecedented challenges amidst the COVID-19 pandemic.  To learn more and to register for the upcoming virtual series, click here.  I look forward to seeing you online!