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The Mentor Journal
Portfolio Management
Portfolio Management During Tough Markets
Investor worried by tough markets
By Chris Nelson
June 20, 2022
Reading Time: 7 minutes

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.

Table of Contents

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. 

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