Portfolio Management

Investing on the peripheries for greater portfolio success

By Jim Reber

Community bank portfolio managers have now had a full quarter to digest the rapid spike in interest rates earlier in 2013.

The upshot is a mixed bag of results:

  • investment portfolio yields have finally quit falling;
  • liquidity has somewhat dried up, thanks to a substantial decline in mortgage-backed security (MBS) prepayments and, to a lesser extent, deposit runoff;
  • market values have gone from a net gain to a net loss; and
  • average durations have extended.

The factor that should be of most concern to a portfolio manager is the last one. Duration extensions have myriad implications, and in a rising rate environment they are mostly negative. A very real positive, however, is that a strategy has emerged that allows a community bank to greatly limit its future duration creep and at the same time invest in securities that have very recently been repriced downward.

Duration matters

Not all duration extensions are bad. For example, the trillions of dollars invested in MBSs in the last five years have almost all been priced above par. As prepayments slow, the book yield will rise. This is the “cushion” in a cushion bond, which is an investment with imbedded call options purchased at a price above par.

But it’s also an unwelcome development for a community banker who is depending on the cash flow from the investment portfolio to fund burgeoning loan demand or deposit runoff. And a corrollary to duration extension is a decline in market values. So having to mine the portfolio for securities to sell at a gain has suddenly become, shall we say, ambitious.

Better perhaps to purchase securities that have virtually no extension risk, if in fact an investor is concerned about (or exposed to) continued rising rates. The remainder of this month’s column will be discussing such items. In fact, we’re talking about a combination of two similar and yet very different bonds.

Backed by Uncle Sam

A regular reader of this column has been inundated by Small Business Administration (SBA) recommendations. Well, here are several more. The SBA offers two main security options. Both of them have timely payment of principal and interest guaranteed by the federal government and are therefore 0 percent risk-weighted.

Floating rate pools, also known as 7(a)s, adjust based on the Prime rate (which is perfectly correlated to Fed Funds). Their popularity is enhanced by the fact that they reset very frequently (monthly or quarterly) and have no caps or floors, either periodically or lifetime. Their durations will only be about three months.

The distant cousin is Development Company Participation Certificates (DCPCs), which are fixed-rate pools that amortize over 10- or 20-year periods. DCPCs are collateralized by debentures issued as part of the SBA’s 504 program financing. They will have long-ish durations, especially the 20-year pools, although prepayments are typically very slow, so the chances of extension are remote.