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The investment portfolio: active management as an ALM tool

Advanced TopicsModule 89 of 111
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The Investment Portfolio: Active Management as an ALM Tool

The securities portfolio isn't separate from ALM; it's core to it. When you buy a 10-year Treasury, you're taking a 10-year interest rate bet. When you buy agency MBS, you're taking prepayment risk. When you buy corporate bonds, you're taking credit risk. Every decision is an ALM decision.

For an ALM professional, the investment portfolio is the primary tool for managing interest rate risk, duration, and reinvestment risk. Understanding how to manage it actively is essential.

The Portfolio's Multiple Functions

1. Liquidity: HQLA (Treasuries, agency MBS) provides liquid assets you can sell quickly
2. Earnings: The portfolio generates net interest income and trading gains
3. Risk management: The portfolio is your primary tool for managing interest rate risk
4. Balance sheet management: Portfolio positioning affects EVE and NII sensitivity

Active Management Strategies

Strategy 1: Duration Management

If you believe rates will rise, you want to shorten duration (sell long-duration bonds, buy short-duration). If you believe rates will fall, you want to extend duration (buy long-duration).

Example:

  • Current portfolio: $10B with 3.5-year duration

  • Belief: Rates will rise from 5% to 5.5% in next 6 months

  • Action: Sell $3B long-duration MBS (5-year duration), buy $3B 2-year Treasuries

  • New portfolio duration: ~2.8 years

  • Benefit: If rates rise to 5.5%, mark-to-market loss is less


Strategy 2: Curve Positioning

If you believe the curve will flatten (long rates will fall relative to short rates), you want to own long bonds. If you believe the curve will steepen, you want to own short bonds and reduce long bond exposure.

Strategy 3: Sector Rotation

If you believe corporate credit is expensive relative to government, sell corporates and buy Treasuries. If you believe mortgage prepayment risk is low, buy MBS. If you believe MBS is cheap relative to Treasuries, overweight MBS.

Strategy 4: Rebalancing

Monthly or quarterly, rebalance the portfolio back to target allocation. This forces you to "sell high" (after strong performers) and "buy low" (after weak performers).

Real Example: Portfolio Repositioning for Rate Expectations

October 2023 View:

  • Current rates: Fed funds at 5.25%

  • Market expectation: No more hikes; rates stay at 5.25% for 12 months

  • CIO view: Market is wrong; one more hike to 5.50% is likely

  • Action: Reduce long-duration exposure


Portfolio changes:
  • Sell $2B in 10-year Treasury (duration 8 years): Realize $2M loss (opportunity cost)

  • Buy $2B in 2-year Treasury (duration 1.8 years)

  • New overall duration: 3.2 years (was 3.5)


Result:
  • December 2023: Fed does hike to 5.50% (CIO was right)

  • 10-year rates rise to 5.10%

  • The $2B in 10-year Treasuries sold would have lost $160M in value; by selling, we avoided that loss

  • The $2B in 2-year Treasuries we bought lost $20M (but much less)

  • Net benefit: ~$140M vs. staying with old allocation


The Takeaway

The investment portfolio is not a passive holding; it's an active ALM tool. Use it to manage duration, position for rate expectations, and rebalance risk.