How to Spot the Risks in Your Investment Portfolio

By Leonard J. DeRoma

Understanding the risks in an investment portfolio may not be second nature to most community banks. Lending officers are trained in credit analysis, not bond performance. To know the risks, you must first have a feel for the bond buying process.

1. Bond houses are not storage facilities. They make money by moving bonds. Your friendly local bond salesman working for a good regional firm or the local office of a national firm is generally compensated on selling products. Many bond salesmen will make multiples of what a community bank CEO earns. Regional firms get a lot of product from national firms. The more they sell, the more access to better product they get, and thus the more they can be paid.
2. Bond salesmen are not created equal. Some have a very deep understanding of the product they are selling. Others do not.
3. Disclosure requirements, while institutionalized, vary widely. Some bond houses will provide you with a prospectus and expect your organization, as a sophisticated investor, to do the homework. Other shops or salesmen will take the time to walk through various aspects of the bonds they are selling.
4. Many banks are “passive buyers.” They look at what’s on the shelf and make a purchase. This is opposed to the bank that says, “I want to add some variable rate, short duration, low factor GNMAs to my portfolio to offset a certain risk.”  Bond houses like passive buyers.
5. Markets are always thinner when you want to sell. As much as the bond house has a moral responsibility to make a market in something it sold you, there is no hard and fast rule as to how “tight” that market should be. In periods of difficult liquidity, bond desks will make a bid based on how long they think they are going to end up getting stuck with inventory. See point 1 above.
6. Mortgage-backed securities can be very complicated. Much PhD mathematical ink has been spilled trying to understand and model the behavior of bonds and aspects such as negative convexity, extension risk, and modified duration. During times of rapidly changing rate environments or expectations, most of those models (a) break down, and (b) if they don’t, bond houses will probably not be sharing their proprietary information.
7. Municipal securities are often underwritten by local bond houses with an expectation that local banks will invest in them. The taxing power of the municipality or the authority provides ostensible comfort against default. Other municipal bonds are issued on a private or semi-private basis. In times of liquidity crunches, there will be almost no liquidity in these securities at any (reasonable) price. The market in municipal bonds by its very definition is primarily local, reducing the potential buying population.

Now that we have presented the pitfalls, most bond salesmen are actually serious, dedicated people who truly want the investments to work out. It’s not in their best interest to have a client complain. However, the salesman is contending both with his management and the market.

Given the enormous increase in deposits, which has outstripped the growth in loans in the past 15 years and particularly over the last 5 years, almost every bank will have some need for a “sponge” to soak up excess liquidity.  That will be intensified as liquidity oversight moves toward a Basel III-style Liquidity coverage ratio, which counts some securities as High Quality Liquid Assets. Here are some suggestions to keep your portfolio safe, especially for banks that don’t have the appropriate level of expertise in-house:

1. Establish an investment portfolio policy.  This is required. Be clear as to what the purpose is and to what pieces of the portfolio are assumed to be stores of liquidity, yield enhancements, or loan replacements.
2. Translate the profile into meaningful buckets—types of assets, maturity bands, duration bands, credit quality, fixed versus floating.
3. This a primary CEO responsibility. It should be clear that the overall picture necessitates CEO involvement. The CEO sets the tone.  ALCO translates, executes, and monitors it.
4. Take the time to thoroughly know the firm and individual with whom you are dealing. Use FINRA’s BrokerCheck®. It provides backgrounds on the licenses held by the sales force, including violations. The same goes for the sales force and firm. Make sure you also meet the salesman’s manager.
5. Be very clear with the salesperson as to what the objectives are. Be honest. If you’re a buyer of $20mm don’t think you’ll impress him if you tell him you’re a buyer of $100mm. Make sure the salesman is an institutional salesman. Retail brokers often try to sell bond product, but it is a rare one that takes the time to understand this market. If he handles your personal portfolio, he probably isn’t the right salesman for the bank.
6. Have more than one dealer.  This just keeps everyone honest. One of those dealers should be a national firm, if your volume warrants it.
7. Always remember that you’re the customer. Don’t be afraid to ask a lot of questions. Don’t be afraid to miss a trade.
8. Have a view on interest rates. It’s often unbelievable how portfolios can be constructed without anyone having a direct view of interest rates. This will prevent buying things that obviously don’t fit the policy.
9. Stay on top of your AOCI. Monitor the portfolio.
10. Don’t be afraid about changing the portfolio if your view of interest rates changes.
11. If you don’t feel comfortable managing a bond portfolio and don’t feel that the necessary expertise is resident, consider engaging an outside investment manager to handle the process.
12. While the investment portfolio is generally a much smaller piece of the balance sheet than loans, it can’t be ignored and left to run itself. The above points should give senior management some confidence in beginning to get a better handle on what they own.

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