Robert Segal

Bank investment portfolios are an increasingly important part of balance sheet management. As portfolios have grown by 5.9 percent over the past year, according to the FDIC, they also produce a larger share of earnings. Regulatory challenges and the low interest rate environment, however, have pushed some into lopsided positions, such as high concentrations of Agency notes and collateralized mortgage obligations (CMOs). As result, those financial institutions are dealing with what are now sub-optimal portfolio allocations.

These investment portfolios show heightened risk exposures, whether through maturity extension, early call features or declining levels of income. The current industry focus on improving earnings may make these sources of risk less palatable. In order to boost long-term performance while mitigating risk, investment officers may wish to consider the following tips.

Target duration. Investment policy statements describe the framework by which the institution manages its portfolio. One goal is to enhance profitability within the overall asset/liability management objectives. A second aim is to establish a process for implementing specific measures to manage sensitivity to interest rate changes.

Accordingly, management should establish a duration target which reflects the institution’s asset/liability position, income requirements and risk tolerance. Academic studies consistently show that longer-duration portfolios provide higher levels of income. At the same time, highly-leveraged institutions need liquidity to fund loans, and this may reduce the desired level of price sensitivity, causing the investment officer to “shorten up.”

Maintaining duration is an essential factor in preserving margin and maximizing net interest income. As portfolios age, duration can decline unless cash flows are reinvested back out on the curve; this “opportunity cost” limits earnings potential. Similarly, portfolios comprised exclusively of mortgage securities can extend if prepayments lag initial projections, creating unexpected interest rate risk. Investment officers should closely monitor their portfolio and take steps to ensure target durations are preserved to protect net interest income.

Diversification. Many portfolios become heavily weighted toward certain sectors with which the institution is comfortable. The returns fixed-income investors receive are determined by various factors, such as volatility of rates, credit, and yield curve slope. An emphasis on callable Agencies, for example, implies a reliance on returns from taking extension risk or prepayment risk.

With an expected drop in market rates, this institution will receive unwanted funds that must be reinvested at lower yields. Conversely, calls slow down in a rising rate environment, providing less cash to put to work at better yields or to fund loans. A diversified portfolio (more call-protected assets in this case) would keep cash flow fluctuations to a minimum, leading to improved portfolio performance.

Marketable securities. Referring again to the investment policy, the portfolio should help provide the liquidity necessary to conduct day-to-day operations and be comprised of assets for which there is a resilient secondary market. Some investment officers eschew these principles and acquire a large amount of illiquid securities, such as 10/1 ARMs. While these issues may offer the potential of higher yields, their limited marketability hinders the ability to effectively manage the balance sheet. When attractive opportunities become available, the investment officer cannot get out of existing positions, hurting profitability. Institutions, therefore, may wish to keep their allotment of illiquid securities at a minimum.

Monitor cash flow. It is recommended that the treasury group prepare cash flow projections in a base case, as well as several alternate scenarios. An institution exposed to mortgage security prepayments, for example, can act in advance to protect against a decline in income in a falling rate environment, by pre-investing or realigning the portfolio. The cash flow projections provide the information necessary to understand the position and evaluate suitable strategies, with the ultimate goal of establishing an optimal cash flow profile.

Best execution. In light of recent advances in technology, regulatory agencies such as FINRA have reiterated their commitment to ensuring best execution as a key investor protection requirement. FINRA stated in a November 2015 regulatory notice, for example, that the market for fixed income securities has evolved significantly and transaction prices for most securities are widely available to market participants.

Broker/dealer transaction costs can vary greatly based on the scope of the transaction and access to the most liquid dealers. For example, the Bid-Ask Spread Index from MarketAxess shows that block trades on actively traded corporate bonds currently have a 3-basis-point bid-ask spread and “odd lots” trade at 7 basis points. Individual transactions often trade at higher spreads, indicating that investors may be “leaving money on the table.” A more diligent approach toward trading efficiencies could help support the bottom line.

Taking some of these steps may enable management to build more efficient investment portfolios which generate higher levels of income over time. Building predictable cash flow characteristics provides the flexibility to manage the portfolio effectively within the context of the balance sheet, while also leading to stable returns. Of course, the institution should consider their asset-liability position when making these decisions. Investment officers should continue to maintain robust risk management practices, keeping interest rate risk exposure at reasonable levels.

Robert B. Segal is president of Atlantic Capital Strategies Inc., an investment advisor located in Bedford. He can be reached at
bob@atlanticcapitalstrategies.com.