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“Year-End Investment Check-Up” with Chris Nelson, CFA

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The Mentor Journal
Portfolio Management
4 Simple Questions to Help Navigate Volatile Markets
By Chris Nelson
July 15, 2020
Reading Time: 5 minutes

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.

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