Reinvestment risk is rearing its ugly head for investment managers everywhere, but the challenges are especially striking for depositories that have a history of investing in passive Treasury and bullet ladders. As shown in the chart below, the average $100 million ladder portfolio reinvested today would yield an average of approximately $2 – 2.2 million less than it would have earned just two short years ago. Could your institution afford that significant of a loss in investment income?
Savvy Investment Managers Seek More Competitive Options
Many investment managers are seeking more competitive alternatives, including those with more active management, now that interest rates are at or near zero and reinvestment risk is impairing the bullet ladder’s yield. As credit unions and community banks continue to serve consumers by offering payment deferrals, fee waivers, and other emergency assistance amid a high degree of economic uncertainty, it is becoming more critical than ever to effectively generate income from their investment portfolios.
In Low Rate Environments, Spread Becomes Even More Critical for Depositories
As an example of one such investment alternative, ALM First often talks about our “Core Spread” strategies which are primarily invested in Agency MBS, Agency CMBS, bank notes and RMBS both fixed and floating (the spread sectors). We also talk about keeping the duration close to home and not making any significant bets on the direction of interest rates. We compare the performance of our actively managed portfolio strategies to passive Treasury and bullet ladders, computing the “excess” returns over time. As margin compression returns and other losses may loom on the horizon, the ability to generate “excess” investment returns and avoid disproportionate reinvestment risk may prove vital.
Let’s look at how a couple of common portfolio structures hold up at differing levels of interest rates. Portfolio A is a 5-year bullet ladder comprised of 20 quarterly maturities of equal weight. Portfolio B is ALM First’s Core Spread model portfolio. Both portfolios have approximately the same duration of 2.50% and the core spread portfolio’s yield is approximately 34 basis points higher that the Treasury ladder. Exhibit 5 summarizes the composition of these two portfolio strategies.
With interest rates now at historic lows, reinvestment risk
impairs the bullet ladder’s yield by a disproportionate amount when compared
with the Core Spread strategy when both are funded with our Core Deposit
funding index. For the purposes of this simulation, the two portfolios were
both constructed in the first quarter of 2018 and then evolved following the
path of rates between then and the first quarter of 2020. The portfolios were
then reinvested forward for five years and assumed that rates continued at
their current level over that entire period.
The core spread portfolio’s 50% allocation to floaters reset
every quarter at a spread of 50 bps over an index, Fed Funds + 10 bps (to
normalize LIBOR). The 50% allocation to MBS, evenly split between 15- and
30-year MBS used the yield of the ICE BofA Indices. For the MBS, it was assumed
that 4% of the allocation ran off and was reinvested at the next quarter’s
The simulation for the bullet ladder was more straight forward. Each quarter the shortest rung of the ladder was reinvested at the next quarter’s 5-year yield.
As Exhibit 6 illustrates, the core spread portfolio sees a sharp
decline in its yield spread vs the core deposit index in the first quarter of
2020 as the floaters that make up half of the portfolio reset lower following
the decline in Fed Funds. But as the portfolios evolve through time, the bullet
ladder sees its yield spread fall below that of the core spread as more of the
ladder gets reinvested at lower rates compressing its spread. The difference is
significant as the bullet spread falls to 35 bps over the core deposit index
while the CSP spread stabilizes at 144 bps over the core deposit index. Exhibit
6 further highlights the benefit of investing in assets that provide a spread
over rates in times of very low rates. Investors in bullet ladders will see
their margins compress as there is no spread cushion to insulate their
portfolios from declining rates.
Over time, any “excess” yield on your institution’s investment
portfolio could prove critical to your overall financial performance. This is
especially true in today’s uncertain environment as annual budgets for 2020
have already been blown and consumers’ needs – and ability to repay their debts
– continue to evolve.
Today, over 300 clients depend on ALM First to manage approximately $28 billion in assets. Learn more at www.almfirst.com.
DISCLAIMERS: Returns are net of model fees, unaudited, and estimated using the Modified Dietz method. ALM First does not have complete discretionary trading authority over each account reflected in the performance discussed herein. Investments in securities are valued based on quotations obtained from independent pricing services or independent dealers. With respect to securities where independent valuations are not available on the valuation date, or where a valuation is not deemed reasonable by ALM First, ALM First will determine the fair value. The fair valuation process requires judgment and estimation by ALM First. Although ALM First uses its best judgment in estimating the fair value of investments, there are inherent limitations in any estimation technique. Future events may affect the estimates of fair value and the effect of such events on the estimates of fair value, including the ultimate liquidation of investments, could be material to returns. The production and delivery of this material to any investor/recipient does not establish any express or implied duty or obligation between ALM First and any such investor/recipient, including (without limitation) any duty to determine fair market value or update such material. Moreover, this report was prepared as of the date indicated herein. No representation or warranty is made by ALM First that any of the returns or financial metrics detailed herein will be achieved in the future, as past performance is not a reliable indicator of future results. Certain assumptions may have been made in preparing this material that have resulted in the returns and financial metrics detailed herein. Changes to the assumptions may have a material impact on any returns or financial metrics herein. Furthermore, ALM First gives no representation, warranty or undertaking, or accepts any liability, as to the accuracy or completeness of the information contained this report. This report was prepared for informational purposes only without regard to any particular user’s investment objectives, financial situation, or means, and ALM First is not soliciting any action based upon it. This material is not intended as, nor should it be construed in any way as accounting, tax, legal, or investment advice including within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Certain transactions give rise to substantial risk and are not suitable for all investors. The strategies discussed herein can have volatile performance and may employ leverage. Moreover, investment advisory fees and expenses may offset trading gains. This report was prepared by ALM First Financial Advisors, LLC. The hereto mentioned report contains information which is confidential and may also be privileged. It is for the exclusive use of the intended recipient(s). If you are not the intended recipient(s), please note that any distribution, copying, or use of this report or the information contained herein is strictly prohibited. If you have received this report in error, please notify the sender immediately and then destroy any copies of it. ALM First neither owes nor accepts any duty or responsibility to the unauthorized reader. ALM First shall not be liable in respect of any loss, damage, or expense of whatsoever nature which is caused by any use the unauthorized reader may choose to make of this report, or which is otherwise a result of gaining access to the report by the unauthorized reader.
ALM First Financial Advisors is an SEC registered investment advisor with a fiduciary duty that requires it to act in the best interests of clients and to place the interests of clients before its own; however, registration as an investment advisor does not imply any level of skill or training. ALM First Financial Advisors, LLC (“ALM First Financial Advisors”), an affiliate of ALM First Group, LLC (“ALM First”), is a separate entity and all investment decisions are made independently by the asset managers at ALM First Financial Advisors. Access to ALM First Financial Advisors is only available to clients pursuant to an Investment Advisory Agreement and acceptance of ALM First Financial Advisors’ Brochure. You are encouraged to read these documents carefully. All investing is subject to risk, including the possible loss of your entire investment.
MODEL FEE DISCLAIMERS: Performance figures are net of fees charged to customers. For each strategy shown, the performance has been reduced by the amount of the highest fee charged to any ALM First Financial Advisors, LLC customer employing that particular strategy during the period under consideration (the “Model Fee”). Actual fees will vary depending on, among other things, the applicable fee schedule and portfolio size. ALM First’s fees are available upon request and also may be found in its Form ADV Part 2A. Past performance does not guarantee future results.
About the Authors: Robert Perry