As Financial institutions across the nation cope with market and economic challenges created by COVID-19, anticipating next steps to manage balance sheet “risks” AND improve or protect profitability is becoming increasingly more difficult.
In Part 1 of our miniseries, we discussed the importance of robust stress testing, a comprehensive contingency funding plan, and anticipating potential changes in loan and deposit portfolios.
In Part 2, we discussed potential impact on capital from asset quality deterioration, margin compression, and other balance sheet changes.
In Part 3, we turn our attention to investment strategies as portfolios and cash usually make a meaningful contribution to institution’s overall interest income. Below are some key considerations to help guide the investment process in today’s challenging environment:
- Cost of carrying excess cash just increased – Most institutions are now earning just 0.10% on their overnight funds. There are alternatives available in the market to increase income on short-term liquidity. Also, strategic liquidity planning may allow for deployment of more funds on the intermediate part of the curve to further boost income.
- Consider pre-investing – Many institutions have been very busy with PPP loans, and investments have taken a back seat. However, we anticipate this program having a short-term impact on liquidity and resources. Currently, spreads are still attractive in select sectors of the market. Once liquidity returns from SBA pay-offs, spreads are likely to compress as a wave of investible funds floods the market at once.
- Do not compete with the Fed – With several asset purchase and lending programs currently in effect, prices on various types of investments are distorted. For example, many plain-vanilla agency MBS are trading at elevated prices with very low yields. Additionally, prepayment risk is increasing as mortgage rates look to set new lows. Investors are advised to avoid rich sectors (or be sellers) and look for value elsewhere.
- Call protection – Focus on investments that offer some degree of call protection. With low rates expected to last for some time and potential spread tightening leading to even lower yields, choosing investments with less near-term principal cash flow while managing extension risk is a prudent approach.
- Be mindful of trade execution – Be on alert for excessive price mark ups when executing portfolio trades. Lack of access to investment technology can lead to occasional abuses that negatively impact investment performance for the life of the bond.
- Focus on high-grade credits in the municipal market – COVID-19 lockdown is likely to have an impact on financial health of various municipal issuers, at least in the short-term. Ultrahigh-grade issuers generally have healthy rainy-day funds and/or dedicated sources of revenue that will help them weather the storm much better than weaker credits. Credit rating downgrades are likely, and investors are encouraged to monitor their portfolios for changes in quality and have a documented action plan.
Taylor Advisors’ Take: Overnight rates are expected to stay low for the foreseeable future. Institutions should look to optimize the mix of on-balance sheet liquidity to improve earnings. Be aware of the Fed’s distortion of certain market sectors and look to take advantage of this phenomenon. Relative value is changing frequently in the market and staying abreast of spreads and risks will be key to generating returns. Investors should be mindful of trade execution costs and continue to maintain ultrahigh-grade credit quality bias in the municipal bond sector.
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