The Mentor Journal
Portfolio Management
The First Step in Successful Bond Portfolio Management (and 4 Reasons Why)
First Step to Bank Portfolio Management
By Chris Nelson
April 28, 2020
Reading Time: 4 minutes

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.

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