Michael Benedict: Putting the 'Strategy' in 'Portfolio Strategy'

As the final days of summer draw to a close and the season for budgeting and strategic planning ramps up, it seems appropriate to spend some time talking through the strategic role the portfolio plays on the balance sheet.

It is likely that some readers of this column will view the investment portfolio as nonstrategic. After all, most of the franchise value of a depository institution relates to other balance sheet items: the strength of its deposit base, the yield or credit quality of its lending book, growth trajectory or some combination of these factors.

While this is certainly true, the counterargument is that the strategic value of the portfolio lies in how it complements or enhances the franchise value of the institution. Almost by definition, this means that there is no single portfolio strategy that is appropriate for every community bank given the wide range of balance sheet structures and core competencies across the industry. However, a well-constructed portfolio can enhance operational flexibility in ways that are difficult to replicate with other balance sheet items.

A matter of circumstance

Though balance sheet composition will often influence the appropriate size and general interest rate risk position of the securities portfolio, it is typically ill-advised to put all your eggs in one basket. 

The past several years have witnessed a number of historical extremes, and while the five-year treasury yield—a key factor in the performance of many community bank investment portfolios—has spent most of the past two years in a broad range of about 3.50% to 4.50%, intraday volatility remains high and the market outlook can change quickly. Markets are notoriously difficult to predict, and incorporating a reasonable mix of products into the portfolio increases the likelihood that a certain pocket of the portfolio will perform well regardless of what happens with interest rates.

In certain cases, this may mean making purchase decisions where yield is not the primary motivation. Interest rates move around constantly, and portfolio managers should consider how investments perform across a range of interest rate shifts before making purchase decisions. Investments that offer a great yield today may struggle under a different set of circumstances, and it is important to understand both where those gaps might be and why they occur to fully assess whether an individual instrument is a good fit for your institution’s portfolio.

As an example of this, our July column referenced how the yield differential between agency mortgage-backed securities (MBS) and agency commercial mortgage-backed securities (CMBS) was the largest it has been over the past 10 years. This indicates that investor demand for the structural features of agency CMBS—which include relatively short final maturities, limited amounts of principal cash flow and robust forms of prepayment protection—is high. This is likely because agency CMBS perform well in downwards rate shifts, which aligns well with market expectations for the Federal Reserve to continue reducing short-term policy rates in the coming months.

Taking another angle

However, these same structural features also cause agency CMBS to perform well in scenarios featuring large changes in interest rates (think +/-200 basis points or greater). In contrast, agency MBS perform well in scenarios where interest rates stay relatively stable. So, while the current environment ostensibly favors investing in MBS, CMBS still have a place in portfolios because they drive performance in scenarios where MBS might underperform. The appropriate allocation may be somewhat higher or lower based on factors specific to your institution, but the presence of both MBS and CMBS in portfolios creates a more balanced performance profile that maintains operational flexibility across the full spectrum of interest rate scenarios (rates up, rates down, flat/inverted curve or steep curve).

The paragraphs above focus on agency MBS/CMBS, but a similar exercise could be repeated for many other common depository investments, including collateralized mortgage obligations (CMOs), municipals, corporate bonds, various non-agency securitizations and agency debentures. Each sector has a unique set of cash flow characteristics and performance drivers, and finding the right mix of those features will maximize the utility of the portfolio across a range of interest rate environments.

That adaptability is really where the strategic impact of the portfolio can be felt. The bulk of portfolio activity over the past several years has focused on repositioning lower-yielding securities, but there is a variety of other options available in different interest rate environments. It is tempting to think that there’s a single “set it and forget it” portfolio strategy that works well across all interest rate environments, but to get the most out of your portfolio, ensure its size, interest rate risk positioning and composition evolve over time based on both market conditions and your institution’s balance sheet needs. And that seems like something worth talking about!