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!

The First Step in Successful Bond Portfolio Management (and 4 Reasons Why)

The First Step in Successful Bond Portfolio Management (and 4 Reasons Why)

In my conversations with community bankers over the years, I hear one series of questions quite frequently regarding investment portfolio management. 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 the first step needs to be 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.

“. . . 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.”

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.