In this edition of our e-Brief newsletter, Taylor Advisors would like to reinforce the importance of managing the investment portfolio in the context of the overall institution. It is hard to overstate the importance of the investment portfolio, as it is often a key source of income and liquidity. However, it is just as important to keep in mind that the portfolio is only one of several interrelated key balance sheet areas, and therefore it should not be managed in isolation.
Bond Mutual Funds vs. Bank Fixed-Income Portfolios
A bond mutual fund and a community bank’s fixed-income portfolio operate under different objectives, constraints, and regulations, requiring distinct and customized management procedures. When it comes to bond mutual funds, the portfolio manager often makes decisions with one goal in mind: to outperform a particular benchmark or index. Additionally, most of these mutual funds are unconstrained discretionary accounts, which means that these managers have a significant amount of freedom to invest in assets in a variety of sectors with distinctly different risk profiles.
In contrast to bond mutual funds, a community bank’s bond portfolio should not be managed as a stand-alone group of assets. Instead, it should be viewed as a key component of the balance sheet along with other assets and liabilities, and its performance should be evaluated by its potential effect on the performance of the overall institution. Furthermore, the objectives held by community banks should be different than those held by mutual fund managers. A list of the major objectives for most community bank’s fixed income portfolios would probably include the following:
- Generate Income
- Provide Pledgable Securities
- Supply Liquidity
- Manage Interest Rate Risk
Interest Rate Risk Management
While the first three objectives are common to most banks, it is the last one, Interest Rate Risk Management, that is often overlooked. The idea that a fixed-income portfolio can act as a tool to manage interest rate risk is a crucial concept that can best be explained by an example.
Example 1: Customer preference will often dictate the loan mix. It is nearly impossible to change the preferences of your customers, but you can control the composition of your bank’s investment portfolio. For this example let’s assume our bank has an overweighting in variable rate loans. You can reduce your bank’s asset sensitivity by lengthening the duration of the portfolio, buying call-protected bonds, reducing prepayment risk in mortgage products, and replacing floating-rate with fixed-rate bonds. Repositioning your portfolio in this way should reduce your concern about both interest rate risk and reinvestment risk.
On-Balance-Sheet Hedge
As demonstrated by the previous example, a solid understanding of the institution’s asset/liability sensitivity, the overall balance sheet composition, and the unique features of the local market are critical before making investment decisions. Consider another example.
Example 2: The president of a community bank is looking to invest $5 million and has a strong rates up bias. The bank is asset sensitive and would sustain significant net interest margin compression should rates decline or stay low and would enjoy higher margins should rates rise. An emotional decision would be to stay concentrated in short-term securities due to the rates up bias. However, in our case it is more prudent to invest out on the curve as it would protect the institution where it is vulnerable – in rates down or in a prolonged low rate environment.
In this case, the bank’s president, by looking at the loan mix and deposit structure of the institution, was able to determine the types of assets best suited for the investment portfolio given the asset/liability profile. By doing so, the banker is effectively engaging in an on-balance-sheet hedge.
This example is particularly relevant to the low rate environment we see today. The Federal Funds target rate has been at 0.00 – 0.25% for over 2 years and is expected to stay in that range through 2011. However, most economists expect that rates will have to rise sooner or later. This assumption that interest rates will remain low for the time being has led many bank portfolio managers to do one of two things:
- Leave a significant percentage of assets in cash to position themselves for rising rates, thus increasing asset-sensitivity.
- Invest more heavily in long-term securities to try to obtain higher yields, thus decreasing asset sensitivity.
Neither one of these strategies is necessarily right or wrong. In fact, it is possible to use each one to create an on-balance-sheet hedge – it all depends on the asset/liability profile of the individual institution.
Conclusion: All banking professionals recognize that an institution’s investment portfolio, asset/liability profile, and risk management issues are not isolated, but rather form complex and dynamic interrelationships. By analyzing the asset/liability make-up and institution-specific profile, banks can develop, implement, and document their fixed-income investment strategies. But the process does not end here. As the institution’s interest rate risk and investment portfolio change, portfolio managers and bank managers alike must review, monitor, and modify their investment strategies accordingly.
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