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.
