In my early days of portfolio management, I learned an important lesson about the importance of my two investment portfolios. What are your two investment portfolios, and why are they important to being an effective portfolio manager?
Welcome to Bond Investment Mentor! This is a podcast dedicated to helping community financial institutions master the art of fixed income investments. In this episode, I want to share with you one of the earliest investment principles I learned that helped make me a more effective portfolio manager.
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Bond Investment Mentor – Episode 2: Managing Your Two Investment Portfolios
Bond Investment Mentor, episode two. All right, here we go!
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Hi there! Welcome to Bond Investment Mentor! My name is Chris Nelson and this is the podcast dedicated to helping community financial institutions master the art of fixed income investments. If you're working for a community bank or credit union, and you have responsibilities for the investment portfolio, you've come to the right place. I'll be your personal investment guide as we help you boost your fixed income investment knowledge, level up your portfolio management skills, and help you gain the know-how you need to help your institution achieve its financial goals. In this episode, we're going to explore an idea that helped to make me a much better portfolio manager. If you can master this concept, you'll improve your portfolio's behavior as well as your effectiveness as a fixed income Ninja. So let's get started!
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Hi there, how's it going? My name is Chris Nelson. Welcome back to Bond Investment Mentor! Here we are in the first part of November and the year-end is approaching, the holidays are approaching, and of course where I'm located in Maine, it wouldn't be late fall without an early snowfall. So, we had our first snowfall of the season. The good news is that it didn't accumulate very much. I'm always a fan of that! But winter is fast approaching, so I guess we just have to kind of live with it. Of course, it didn't help this week that I was talking with a friend of mine who lives in Tampa and he was complaining because it was so hot down there this week in the 90s with humidity. Sorry, no sympathy here!
Anyway, let's get started. Last time we met in Episode 1 we discussed the first step that you should take when making investment decisions and I won't go into all of that now. Please check out Episode 1 if you want to learn more about that first step. Today, I want to share with you one of the earliest principles I learned when I began working with my institution's fixed income portfolio. And once I learned this principle and began to apply it, it changed everything for me. My perspective shifted overnight and I found myself becoming a much better portfolio manager as a result.
Here's the scenario and this was how things were for me when I was first getting started. I'd be looking for a bond that I needed to purchase. Then the phone would ring, and it would be a broker, or I’d get an email from a broker landing in my inbox with a potential investment candidate. So I'd take a look at it, I'd check things like the current yield on the information that was there, I'd glance at other factors like the duration or the maturity or the spread, and I'd take a quick look at our existing portfolio holdings. Assuming that everything looked good, I executed the purchase transaction and I'd move on to whatever the next task was at hand. Simple, right?
That was how I managed the investment portfolio for a while. And for you, it might sound very familiar and may be the exact process that you're using when you're making your investment decisions. And while it sounds fairly straightforward, I learned an important lesson after a period of time that was really a game changer for me. And that is this: when you're managing an investment portfolio, it's important to remember that you're really dealing with two bond portfolios.
Now, you're probably sitting there going, "Wait, what? Two portfolios?" Yeah, it's true. You actually are managing two investment portfolios. And what's important about this is that not knowing that can result in a lot of potentially unpleasant surprises down the road.
So, what are these two portfolios? Well, the first one is probably one you're very familiar with and it's what I call the "today" portfolio. With it, you're making your decisions based on current investment needs, circumstances and conditions and certain elements such as yield, duration, maybe things like average life. These might be the things that you consider from a present perspective when you're making your investment decisions. You might also take into account other current factors like your current portfolio holdings, your institution's different risk exposures like credit risk, interest rate risk, liquidity risk, those types of things. And this is what most people think of when they are talking about their portfolio.
Now, let's take a look at the second portfolio and it's what I call the "future" portfolio. The "future" portfolio is just what it sounds like. It's the investments that you will be holding in the portfolio in the weeks and months to come. And when you make an investment purchase today, you're also adding a position to this "future" portfolio.
While this bond portfolio may hold many of the same bonds that you hold in your current portfolio, the "today" portfolio, the bonds in the "future" portfolio may look and act very differently compared to when you first purchased them. As market conditions shift and factors like interest rates and the yield curve change, for example, the characteristics of the bonds you hold may begin to change as well. In doing so, they may morph into something that not only fails to help your portfolio, but could actually hurt you instead.
In the world of “future portfolios,” there are those out there that are littered with the remnants of investments that have just gone wrong. Some examples of this might be callable agencies that were called too soon when rates dropped; mortgage securities that either prepaid too quickly, or extended durations and became long-term investments in a very short period of time; CMOs with negative yields; variable rate securities that were supposedly liquid until there were no buyers to be found; trust preferred securities that are valued now at pennies on the dollar, and of course with that comes the potential for impairment. The list goes on and on.
There are other bonds in these types of examples that looked good at the time when the purchase was made but became problem children, or worse! The important takeaway here is that investment decisions that you make today will have repercussions in the future. It's important to think beyond your present needs and circumstances. If you don't, you run the risk of ending up with what I call a "portfolio of unintended consequences."
Now, this approach, managing these two portfolios, becomes more critical as your portfolio's complexity increases. For example, if you had a portfolio and you were only investing in Treasuries, that's a fairly easy process because you're dealing with simple, easy investments. There's not a lot to contend with. But as you begin adding in securities that have more moving parts - callable or step-up agency bonds, mortgage-backed securities and CMOs, tax-exempt municipal bonds, variable rate securities, and other types of structured debt - it becomes important to think about how these bonds might behave or misbehave under different conditions.
That's why it's important to consider both bond portfolios as you make investment decisions. It can be very easy to find yourself focusing on the here-and-now in the investment portfolio like I mentioned in the example I used from my early days. But to the degree that you don't manage to your potential future risks and considerations, you may find that the immediate gratification you receive might eventually lead you instead to a period of investment pain and frustration.
So here's a question: how does your "future" portfolio look? What I would suggest is to take a look at some of your more recent trades that you might have made in the portfolio. Consider them based on your reasons for buying them today, but also take a look at what these bonds could look like in the future. How would changing market conditions affect their behavior or their value? And if you do find some bonds that potentially could become problematic, what would you do with them? More importantly, how would you take steps to ensure that you protect yourself down the road from having a "portfolio of unintended consequences?"
Well, that's going to wrap things up for today. If you have any questions regarding anything that I covered today, please email me at Chris @ BondInvestmentMentor.com. I will read your email and I definitely will get back to you with a response.
If you found this information helpful and you know someone who could benefit from what we were talking about in this episode, please share the episode with them and this podcast with them as well. You can find the podcast on Apple Podcasts, Spotify, Stitcher, iHeart radio, or whatever your podcast listening tool of choice is. And if you do have an opportunity, please leave a review. It will help others to discover the podcast as well.
If you're looking for more information, please check out the website, BondInvestmentMentor.com where you can find articles, tips, and resources that will help you as you manage the investment portfolio. You can also connect with me via social media. You'll find me on LinkedIn, at Christopher Nelson, CFA, on Facebook at Bond Investment Mentor, and on Twitter at BondInvMentor. I'd love to hear from you so please reach out. I look forward to catching up with you soon. Thanks for stopping by and have a good one!
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