2012 was another volatile year in the financial markets. From the European debt crisis, to a number of Quantitative Easing programs, and the Fiscal Cliff drama in the United States, community bankers and portfolio managers alike had to react to a number of significant events during the year. Though equities generally trended upward, investors witnessed a rapid, sharp drop in equity indexes in the early summer and late fall. 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.
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. Recently, Fed Chairman Ben Bernanke stated that he intends to keep this rate at its current level until unemployment falls below 6.5% or inflation is projected to remain above 2.0%. Between an extended quantitative easing program, the European debt crisis, and an economy struggling to gain traction, bonds of all types showed, and continue to show, elevated levels of market price volatility.
After exhibiting fairly large swings during the first few months of 2012, yields on bonds stayed in a relatively stable range for the remainder of the year. From their highs in March through their lows in July, Treasury yields fell sharply, with yield on the 2 Year Treasury falling from 0.39% to 0.20%, and the yield on the 10 Year Treasury falling from 2.38% to 1.39%. After this rally in prices, bonds reversed course and sold off slightly, with the 2 Year Treasury ranging from 0.25-0.30% and the 10 Yr Treasury ranging from 1.60-1.80% for much of the remainder of the year.
Investing in 2013
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. 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 re-price lower.
Another challenge in 2013 will be complying with the new OCC due diligence guidance on investments. There is a higher regulatory expectation in the area of investment analysis, documentation, and monitoring. The extent of the required analysis will depend on the asset class. For mortgage-related assets, cash flow and duration analysis will be important. For municipal and corporate securities, investors may no longer rely solely on credit ratings but must supplement their analysis with other relevant credit research and documentation.
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, Operation Twist, and most recently, QE3 (which has no timetable for expiring), 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 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 low 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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