Past Performance, No Guarantee

By David J. Sweeney

A bank’s investment manager is constantly performing a juggling act, trying to strike the right balance between earnings, liquidity and interest rate risk—all while considering the impact on capital when making investment decisions. With so many moving parts, assessing the performance of the individuals responsible for managing the investment portfolio can be a difficult task.

There is no one-size-fits-all method to assessing the performance of a bank’s investment management team. Rather, a combination of methods should be used, including:

• Arranging for an independent review of the investment portfolio by a professional independent investment adviser on a periodic basis.
• Assessing the relative performance of the investment portfolio compared to option-adjusted spread (OAS) and price sensitivity targets.
• Comparing results to a benchmark portfolio.
• Comparing results to peer group results. (This analysis usually leads to more questions than answers, as the peer groups’ policy limits, risk tolerances, portfolio structural needs, interest rate risk position, liquidity risk position and interest rate view are all unknown.)

Independent review by a professional investment adviser

Generally, at a bank only a few individuals are involved in the investment management process. Introducing an independent investment adviser can quickly enhance the process. An independent investment adviser has real-time market knowledge enabling him or her to assess the quality of the investment decision, as well as the quality of the transaction execution price.

Banks that perform an independent review draw a comparison to the independent loan review performed on the loan portfolio. Boards of directors also draw comfort from the independent review.

The frequency of an independent review depends on the portfolio activity and complexity of the bonds held in the portfolio. Typically, the adviser will perform the review on a quarterly basis, but it can occur less often depending on portfolio activity.

Option-adjusted spread (OAS) and price sensitivity – relative value analysis

Bond analysis, similar to that of any other earning asset, should focus on risk and return. Typically, bank investment managers assess risk and return by analyzing spread to Treasuries and weighted average life. However, there are two better measures to use.

In analyzing return, OAS is a superior measurement that has been popular for many years. OAS is the spread to a benchmark curve after considering the value of optionality embedded in the instrument. Take this recent real-world example pictured in Table 1: one bond with a one-time call option in one year with a 10-year final maturity, compared to a 10-year non-callable bond.

Typical analysis would focus on the first three rows, in which the one-time call bond “wins”. However, we expected to be paid more for selling the one-time call option to the issuer. Were we paid enough? The last row gives us the answer, and that answer is no. The investor in the one-time call bond yielded 5 bps less than they should have.

When analyzing risk, duration is a good starting point. However, instruments with embedded options will have cash flows that change as interest rates change. Accordingly, duration alone cannot account for the expected bond value changes for interest rate changes, and that is where convexity steps in. Instead, for the purposes of measuring risk, we will simplify the measurement by modeling percentage value change for a 300-basis-point parallel shift up in the yield curve, rather than using complex duration and convexity math.

Now that we have improved measures (OAS and price sensitivity), how should they be used in assessing the performance of the investment management team? The easiest method is to establish portfolio targets for OAS and price sensitivity in a +300 parallel shock. The targets should be based on the bank’s policy and risk tolerances, as well as the structure of the investment portfolio.

Benchmarking

The best method in assessing the performance of the investment manage team is comparing the investment portfolio to a benchmark portfolio. Implementing a benchmarking process can be quite involved and time-consuming. That said, using an adviser with the models required could serve to enhance the entire investment management process, and could improve overall portfolio returns, as well as return on assets and return on equity.

Peer group analysis

Banks often use peer group analysis when measuring the performance of an investment management team. However, a peer group analysis has many shortcomings that could cause differences between how the individual banks in the peer group construct their investment portfolio. For example:

• What is the duration and credit risk appetite of the investment portfolio of the peers?
• What is the overall interest rate risk position of the peers and how does the investment portfolio fit in their overall sensitivity position?
• What is the percentage of the investment portfolio that is held for liquidity purposes (i.e. pledging) versus for earnings invested as loan surrogates?

This example in Table 2 shows the investment portfolio breakdown for two banks that are in the same peer group based on asset size and geography.

Would you suggest that Bank A’s management team should readjust its portfolio to look more like Bank B’s? Or vice versa? The short answer: maybe. There is not enough information to make an assessment either way. A peer group analysis usually generates more questions than answers.

David J. Sweeney is managing director at Chatham Investment Advisors, an independent investment advisor.