Bond Portfolio: In Search of Buried Treasure

March 14, 2017 Bob Newman

 

LinkedIn Pulse: Bond Portfolio: In Search of Buried Treasure
By Bob Newman
March 14, 2017

 

When my kids were young we used to play a game we called “treasure hunt”. It consisted of me going to the end of the family room couch and lifting it off the ground while the kids scooped up toy cars, missing game pieces and other previously hidden gems. Sometimes we would pull off the cushions and find nickels, dimes and quarters that could be reinvested during a visit to the candy store. For financial institutions looking to improve their operating efficiency, a flashlight is typically pointed toward the couch cushion containing non-interest expenses with hopes of finding enough cost-saves to make a meaningful impact on the bottom line. But what if during the quest to uncover coins in the sofa there were dollar bills sitting on the coffee table in plain view?

At the recent Bank Director “Acquire or Be Acquired” conference, my colleague Dave Sweeney moderated a panel discussion entitled “Why Every Basis Point Matters Now” and he summarizes the key takeaways in this article. As it turns out, expanding the search from the P&L expense line to the balance sheet reveals several “dollar bills” of profitability growth potential via net interest margin expansion.

The investment portfolio is a great place to begin the treasure hunt since it typically makes up 20% to 25% of an institution’s earning assets. You might think that a change in asset allocation would be the best way to boost the yield of the bond portfolio. In reality, any strategy that focuses on altering the mix of securities in the portfolio to add reward will also involve increasing risks via longer duration, reduced credit quality or sold optionality. Because of these natural trade-offs, any near-term improvement in yield could prove costly later, making it difficult to count on the yield pick-up as found money.

Even without proactively changing the mix of securities, 25% to 33% of bonds in the typical FI portfolio will mature or be called away in a given year. This predictable turnover means that there will be a regular need to execute transactions with an intermediary in order to put newly idle cash back to work. This is where there may be some buried treasure to unearth.

When a bond transaction is executed the broker-dealer earns a mark-up for facilitating the purchase/sale and for providing some degree of advisory, whether it’s for the specific security being bought/sold or on the portfolio as a whole. Additionally, the broker-dealer may have a multi-faceted relationship that includes investment banking, research, ALM modeling and other services. In some cases these additional services are paid for with an explicit fee, but in others their cost of delivery is factored in when market transactions are executed.

Technically the mark-up is built into the price of the bond so there is no visible commission that hits the expense line on the P&L. But the net effect of the mark-up is a reduction in yield that impacts NIM. In Dave’s article he provides examples of transactions that were executed at prices that resulted in 6 to 12 basis points in sacrificed yield. He concludes that improving the efficiency of execution can potentially add 1 to 3 basis points to NIM which translates to nice improvement in ROA and ROE. Putting that into “couch cushion” perspective: a typical $1 billion community FI might uncover annual savings north of $100k after performing an analysis of its transaction execution history. Once an inventory has been taken and a value placed on the services received in the broker-dealer’s “bundle”, an institution can begin to determine if there is some buried treasure to be claimed by improving execution efficiency in the investment portfolio.

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About the Author

Bob Newman

Bob Newman is Managing Director for Chatham’s Financial Institutions business which specializes in interest rate risk management, hedge accounting and investment advisory for banks. Prior to joining Chatham in 2003, Bob spent 20 years in commercial banking, helping to start the derivatives operation at Maryland National Bank and expand the derivatives effort at SunTrust. He graduated from the College of William and Mary with a BA in Economics and has earned the Chartered Financial Analyst (CFA) designation.

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