As far as the financial markets are concerned, 2011 had more than its fair share of ups and downs. From the European debt crisis to the downgrade of US government debt, community bankers and portfolio managers alike had to react to a number of significant events during the year. Through the summer and fall, investors witnessed a rapid, sharp drop in equity indexes reminiscent of the market of 2008-2009. Often, when equities stumble, investors flee to safer fixed-income investments, driving their prices up. Most fixed income investments experienced a great degree of spread and price volatility. However, by the end of the year, the financial markets had settled in with lower levels of volatility.
Current Bond Market
The FOMC, which cut the Fed Funds target rate by 400 basis points during 2008, has left the overnight rate in the 0-0.25% range since that time, and recently, Fed Chairman Ben Bernanke stated that he intends to keep this rate at its current level until at least late-2014. Between the “Operation Twist”, European debt crisis, and a struggling economy, bonds of all types showed, and continue to show, elevated levels of market price volatility.
After staying in a relatively stable range during the first quarter of 2011, yields on bonds exhibited increasingly larger swings for the remainder of the year. From their highs in early February through their lows in mid September, Treasury yields fell sharply, with yield on the 2 Year Treasury falling from 0.85% to 0.16%, and the yield on the 10 Year Treasury falling from 3.74% to 1.69%. Immediately after this rally in prices, bonds completely reversed course and sold off through the end of October. However, by the end of the year yields had declined again, with the 2 Year Treasury yield near 0.25% and the 10 Year Treasury yield near 1.90%.
Investing in 2012
These uncertain times can be daunting and frustrating for the bond portfolio manager. As rates remain at historic lows and banks’ earning asset yields remain under pressure, investors should remain cautious but also act opportunistically to take advantage of the slope in the yield curve and relative value ideas in certain sectors.
However, the biggest mistake portfolio managers can make in this environment is to do nothing and allow idle cash to continue piling up on the balance sheet. With already dismal returns on cash, yields on overnight investments could go to zero if the Fed decides to remove the 0.25% earned on excess reserves. This would cause the yields on the short end of the curve to fall even further. A large, essentially non-earning asset would continue to put pressure on banks’ margins that are already under pressure from declining loan yields and funding costs that have little room to reprice lower.
Cautious Bias
Portfolio managers should consider potential bond price volatility when making investments in the currently low interest rate environment. Therefore, defensive assets should comprise a certain percentage of bank portfolios. A defensive asset could be described as an investment that has cash flow within a short period of time and/or exhibits low price volatility during a rate rise. A longer duration asset could experience a market value loss, which would hamper the ability to reinvest the funds in a higher interest-rate environment and usually leave the investor with a below-market yield.
There are a variety of economic and interest rate forecasts available in the marketplace. It is important not to fall into the pitfall of basing all major investment decisions on any particular forecast. Rather, investment decisions should be evaluated within the context of the entire balance sheet. For example, if the balance sheet is asset sensitive, but needs to maintain its asset liquidity, then an intermediate duration pledgible agency-backed or GNMA amortizing security might be a good fit.
Relative Value and Diversification
Due to extensive Fed buying during QE1, QE2, and most recently, Operation Twist, 1-4 family collateral MBS and CMO spreads have continued to tighten. Therefore, investors should remain diligent when evaluating longer maturity mortgage-related securities because of the cash flow extension risk. Diversifying among the types of collateral should also be considered. In addition to 1-4 family, banks are able to invest in SBA pools, Fannie Mae DUS bonds, Ginnie Mae securities backed by multi-family collateral and even reverse mortgages, among others. This is especially important for portfolios with heavier allocations in higher coupon 1-4 family collateral MBS and CMO due to higher prepayment and premium risk.
With low short-term rates, investment portfolio yields will continue to decline if maturities, calls, and mortgage cash flow are reinvested into mostly defensive assets. To help alleviate some of the yield and margin compression, portfolio managers should not ignore some good relative value intermediate duration assets. Investors could employ a barbell strategy investing in shorter-term sectors described in the previous section and also some longer maturity call-protected bonds. Shorter securities provide the ability to reposition/reinvest if and when rates rise with significant pick up in yield versus the current Fed Funds rate of 0.25%. The longer-dated securities provide higher current income with some duration risk.
Fixed-income portfolio management analytics, such as sector, cash flow, and scenario analyses, can provide the tools that management needs to evaluate different types of investments. Portfolio managers should maintain a defensive bias; however, stable, call protected, intermediate horizon products with limited extension risk should be added to the asset mix to take advantage of the slope in the yield curve.
Conclusion
Prudent investors must evaluate all the risks embedded in a security or a portfolio of securities before making an investment decision. Portfolio managers must also consider the bank’s asset/liability makeup when designing fixed-income investment strategies. A community bank’s investment portfolio is not a standalone group of assets. Rather, it is an integral part of a bank’s balance sheet along with loans, deposits and equity capital. Moreover, more often than not, the role of the investment portfolio as an A/L management tool is simply overlooked. Before making investment decisions, it is critical to have a solid understanding of the institution’s A/L sensitivity, overall balance sheet composition, and short- and long-term goals.
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