A critical part of portfolio management for a community financial institution is staying on top of the different investment risks that could be present. It’s important to be aware of those risks and understand what the investment risk exposures are.
In my years as a portfolio manager, I have found five investment risks that are important to keep in mind. The presence and effect of these risks vary depending on current and proposed investment holdings.
Table of Contents
- Investment Risk #1: Credit-Related Risk
- Investment Risk #2: Interest Rate Risk
- Investment Risk #3: Option Risk
- Investment Risk #4: Liquidity Risk
- Investment Risk #5: Reinvestment Risk
- “Your Investment Risks May Vary”
Let’s explore these five investment risks:
Investment Risk #1: Credit-Related Risk
As you might expect, credit risk exposure in the investment portfolio is similar to the credit risk contained in a financial institution’s loan portfolio. There are two types of credit-related risk to consider:
Default Risk
Default risk happens when the bond issuer fails to meet its obligations to make timely interest and principal payments. Basically, the issuer doesn’t pay you back or delays payment. If the bond issuer defaults, the investor can lose some or all of their original investment and any interest owed.
Investing in securities with longer maturities could potentially compound the credit risk, as the uncertainty stretches out over a more extended time. This extension can create a higher default risk exposure in the process.
Generally speaking, most community bankers do not have a lot of exposure to default risk in the investment portfolio. Most financial institutions hold fixed-income securities issued by the U. S. government, its agencies, or state and local governments. These issuers have the ability and means to meet their financial obligations through tax revenues or printing money, which makes a default extremely unlikely.
However, other investment types may not carry the same high creditworthiness, so the probability of default risk can be higher. Examples would include private-label mortgage-backed securities, corporate bonds, and subordinated debt securities.
Downgrade Risk
Downgrade risk occurs when the reduction in a security’s credit rating results in a price decline. When a bond receives a downgrade from a rating agency such as Moody’s, Standard & Poors, or Fitch, it means that the perceived credit quality of the issuer has weakened.
Because of the higher underlying credit risk, the credit spread, which is part of the investment’s yield, needs to adjust to reflect the new higher risk. For example, if a bond that originally carried an A credit rating receives a credit downgrade to BBB, it needs to trade at similar levels to other triple-B rated bonds. All fixed-income investments trade at a spread to Treasuries. This yield spread incorporates many factors, including the underlying credit risk of the issuer.
If the issuer’s creditworthiness is reduced, the credit spread should widen, meaning the bond would now trade at a higher yield. With the higher investment yield and the inverse relationship between yield and price, the investment’s price drops as a result.
An investor holding a bond subject to a downgrade will see the value of their investment fall as the security adjusts to its new credit conditions. They experience a price decline simply because the security’s credit spread, and its yield, increased.
Investment Risk #2: Interest Rate Risk
Interest rate risk refers to the sensitivity of a fixed-income security’s price caused by a change in interest rates. As the rate environment shifts, the market value of the portfolio’s holdings will adjust based on two factors.
The first is the yield-price relationship, where bond prices move in the opposite direction from interest rates. Higher interest rates result in lower prices and vice versa.
The other factor that determines the rate sensitivity of a fixed-income security is its duration. Duration measures the degree that a security’s price moves when interest rates change. Duration is the primary way of measuring interest rate risk for both individual securities as well as an entire investment portfolio. A higher duration results in a higher level of price sensitivity.
Investment Risk #3: Option Risk
When a portfolio has exposure to option risk (otherwise known as “optionality”), the principal cash flows of the securities it holds may vary from what the original payment schedule would indicate. This variation is due to the presence of embedded options, which can cause principal payments to either speed up or slow down. As a result, an investor’s principal cash flows may be faster or slower than expected. The change in cash flow speed is primarily driven by changes in interest rates, though other factors can influence it.
Option risk primarily shows up in the investment portfolio in the form of bonds with call options and mortgage-backed securities with principal paydowns that vary. Depending on whether interest rates are rising or falling, optionality shows up in two ways:
Prepayment risk – The risk that investment principal is returned sooner than the stated final maturity or scheduled amortization.
Extension risk – The risk that principal payments are returned more slowly than expected or scheduled. It’s the “flip side” of prepayment risk.
Investment Risk #4: Liquidity Risk
Investment liquidity is how easily a fixed-income security can be bought or sold in the market and converted to cash. Liquidity risk refers to a situation where an investor has to sell a fixed-income security at a lower price than its indicated actual value (think “fire sale”). In the worst-case scenario, it could mean the inability to sell a security in the financial markets.
It should be noted that the liquidity risk described here is different from the definition of a financial institution’s liquidity and liquidity management. In that case, liquidity refers to the ability of the institution to meet funding needs caused by asset growth or liability runoff.
The degree of liquidity will vary depending on the type of security involved. U. S. Treasury securities are the most liquid investments available. Other more liquid investments include government securities like agency bonds and agency-backed mortgage-backed securities.
There is less relative liquidity as we move into more complex securities or securities with higher relative risks. These investments include CMOs, private-label mortgage securities, and municipal and corporate bonds.
Finally, some investments have almost no liquidity or are considered illiquid. Examples include bank sub-debt, private equity, CRA-related investments, and private placements.
One way to determine the relative liquidity of a fixed-income security is to look at the investment’s bid-ask spread. The bid-ask spread is the difference between the current bid and ask prices on a fixed-income security.
A good rule of thumb is that the smaller the bid-ask spread between the two prices, the greater the level of liquidity. For example, the bid-ask spread on highly liquid U. S. Treasury securities is exceptionally narrow, with sometimes no more than a 1/32 price difference.
Other fixed-income securities will have increasingly wider spreads as their relative level of liquidity decreases. Of course, the bid-ask spread is highly correlated with the volume of transactions associated with the underlying security.
Investment Risk #5: Reinvestment Risk
Reinvestment risk is the risk of reinvesting proceeds at a lower interest rate than the initial investment. This becomes a challenge when interest rates decline.
The idea of reinvestment is one of the key assumptions associated with a security’s yield to maturity (YTM). To earn the YTM, it is assumed that all income is reinvested over the bond’s life at the original YTM rate.
Since community financial institution investors are neither likely to reinvest the income nor guaranteed to get the same initial yield, this means that they’d always have some level of reinvestment risk exposure. The only way to avoid reinvestment risk is to invest in securities like zero-coupon bonds, which do not have coupon interest payments, and accrue their return at the yield to maturity rate.
The presence of optionality can also increase reinvestment risk. Fixed-income securities containing option risk are more likely to pay off or pay down when interest rates decline. Examples of this would be bond calls and mortgage prepayments. If that happens, an investor would be forced to reinvest at lower rates based on the new lower rate conditions.
“Your Investment Risks May Vary”
As I mentioned, exposure to these investment risks will vary depending on the portfolio holdings or the type of security. The key to managing these risk exposures is not to eliminate them but to limit their impact on the portfolio’s behavior.
Keeping these five investment risks in mind while developing strategies and evaluating investment securities won’t make your portfolio bulletproof. But it might save you a world of pain and headache later! In the end, understanding the risks you may be taking on – and making sure that you’re being rewarded sufficiently for taking those risks – will help make you a successful portfolio manager.
