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Cash Flows in the Investment Portfolio
Prudent management of a banks investment portfolio requires a clear understanding of the dynamics of cash flows. A bond, or any financial asset for that matter, is essentially a set of future payments that are purchased with the expectation of a positive return when the entire principal is repaid. And a portfolio of bonds is simply the collective sum of those cash flows from each individual security. If you avoid credit risk and focus only on high-grade securities, you can concentrate on the management of those cash flows to produce a reasonably predictable stream of liquidity, which can be re-invested in future months or years and provide an optimal reward relative to acceptable price risk. This is the essence of the Baker Method of investment portfolio management for community banks. Avoid credit risk, manage the stream of re-investable cash flow and build a portfolio that will provide earnings without an excessive degree of price risk.
Security Selection Cash Flow and Price Risk
In making security selection decisions, portfolio managers should begin with a determination of acceptable risk tolerance. We know that in general, the degree of price sensitivity tends to vary directly with the degree of cash flow uncertainty (assuming good credit). So we begin by asking how much price volatility we are willing to accept and how much cash flow volatility. Then we can turn to the individual security and ask, If we buy this bond, when will principal be returned and is that return of principal a moving target? We can then define a specific measurable threshold of risk and use it as a guideline. For example, we may decide that we do not want to accept greater than 10 percent depreciation in the underlying value of our bond should rates rise by 300 basis points. This is the sort of thing that should be clear in the mind of the decision-maker prior to the pre-purchase review of bonds.
If a bond has a call option attached to it, or a prepayment option embedded into its structure, the cash flow is indeed a moving target, and price risk will be relatively higher. To be sure, issuers will offer a greater reward to investors for holding securities with such cash flow uncertainty, but buyers must understand the trade-offs.
Callable bonds are notorious for offering relatively high yields (often enhanced by some sort of step-up coupon feature), while containing a similarly high degree of cash flow uncertainty and price risk. Indeed, it is our experience that the more creative the structure, the more disadvantaged will be the bondholder. Step-up bonds with long final maturities and short first calls, for example, often contain higher degrees of optionality and price risk than many investors realize, particularly if the call feature is continuously exercisable by the issuer.
Managing Streams of Cash Flow
An important characteristic of any portfolio is the laddered schedule of maturing bonds and principal paydowns (scheduled and unscheduled) which provide dollars for re-investment. Think in terms of managing this stream of cash flow on an ongoing basis, knowing that it will ebb and flow as market interest rates move up and down. This can be seen most easily in the cash flow behavior of an individual mortgage-backed security that returns principal incrementally in monthly payments. As market interest rates fall and individual bondholders see their refinancing incentives increase, expect to see a faster return of principal and therefore a concentration of cash flow in the near-term. This shortens the average life of the bond. Conversely, if rates rise, we see the cash flows slow down and average life extends. The bond portfolio in aggregate should be viewed similarly as a pool of liquidity that sloshes back and forth depending on the exercise of options.
This piece of the puzzle, the behavior of options, differs in important ways when we compare MBS to step-up or callable GSE bonds. In the case of step-up or callable GSE securities, early repayment of principal is determined by professional traders who exercise the explicit option attached to the bond whenever the market allows them to do so to the benefit of the GSE (and to the detriment of the bondholder).
The exercise of prepayment options embedded in MBS is controlled by homeowners, however, who are much less efficient for a variety of reasons, particularly in the current economic climate. Indeed, the less-efficient exercise of MBS prepayment options makes those bonds notably more beneficial to investors who are willing to do a little pre-purchase homework. There are a number of specific identifiable characteristics of MBS collateral that can enhance relative value simply by reducing the likelihood of prepay risk. All that is needed is access to the collateral information in a useable format or a reporting system that gives such information.
Reporting Systems and Tools
To manage cash flow volatility and other risks, create tools that allow you to define and monitor those risks. Be able to measure potential fluctuation in cash flow, average life, yield and market value for various changes in interest rates. The analysis should not be limited only to extreme rate changes (such as up or down 300bps), but should also look at moderate changes in rates. Consider two bonds that show the same degree of cash flow variation for large changes in rates. It may be the case that one of those bonds also shows high variation for very small rate changes as well. It is important to have the wherewithal to analyze such risks in advance of making portfolio management decisions.
Portfolio managers need to have a good understanding of the dynamic interaction of interest rates, options risk and cash flow volatility. This requires access to resources for analyzing information about the risk/reward characteristics of the bonds that they buy. Managing an investment portfolio without such tools can result in underperformance and unpleasant surprises. A risk management approach that captures the most important elements of analysis and gives a clear picture of risk and reward is recommended. Otherwise, investment managers may find that they are flying blind in a market full of uncertainty.
Jeffrey F. Caughron is associate partner at The Baker Group, Oklahoma City. Contact him at jcaughron(at)gobaker.com.
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