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FEATURE

Avoiding the Pitfalls

Sound Investment Management

for Community Banks

JEFFREY F. CAUGHRON

ommunity banks are wise to use purchase decisions without first delving
the bond portfolio in the tradi- into the asset/liability position of the
Ctional manner: as an earning as- overall institution.
set, a store of liquidity and safety, and a
vehicle with which to manage interest Yield, Cash Flow and Market Value:
rate risk. This is the essence of the “sys- Managing the Moving Targets decide what bonds or bond-sectors we
tems approach” or the “Baker Method” Once we clearly understand the bal- should consider. In many cases there are
of investment portfolio management. ance sheet profile, we can drill down to clear-cut reasons for choosing one sector
The portfolio is not a place in which to the investment portfolio to assess our over another. For example, a bank’s tax
“time” the market, hold illiquid assets strategic options there. In this phase, we position may dictate that it can use more
(or those not easily modeled), or take focus on the management of three vari- tax-exempt income, so it should take a
on undue credit risk. The bonds held in ables: yield, cash flow, and market value good look at municipals. Another bank
the portfolio should have some sort of (or price sensitivity). The essential prob- might need to smooth out its cash flow
government sponsorship or backing (e.g. lem is that all of these variables are mov- profile over a period of years, so a clean
high-grade municipals, agencies, MBS), ing targets. The portfolio yield will drift structure mortgage-backed security
up and down depending on cash flow
and should be highly salable in the sec- fluctuations, reinvestment rates, and the might be the best vehicle for accomplish-
ondary market—that is, easily converted premium versus discount prices of the ing that. There are times, however, when
to cash. Importantly, purchase decisions bonds that are owned. Cash flows fluctu- there is no obvious sector for a bank
should be made based on the posture of ate because of the options risk attached that has funds to invest. At these times,
the total balance sheet, liquidity needs, to or embedded within bond structures we look at the relative yield spreads
and other macro metrics of the total themselves. The market value of indi- between and among different types of
bank, not on a directional “bet” on inter- vidual bonds (and entire portfolios for bonds to see what is rich or cheap at a
est rates or the Fed. that matter) will rise and fall in tandem point in time.
with the variation in cash flows and the Use the portfolio as a means of achiev-
Begin with a Bird’s Eye View
degree of yield drift. ing high performance for the bank over-
Assuming we’ve made the commit- It is critical that banks have an invest- all. Define, measure, and manage the
ment to stick with high quality bonds, ment portfolio reporting system that interest rate risk of the total bank, then
how should we manage the investment contains good analytics for measuring structure the investment portfolio in a
portfolio in terms of risk and reward? cash flow, price sensitivity, and options manner that will enhance earnings and
The first order of business is to look at risk. Ideally, this type of system will inte- build long-term shareholder value for the
the big picture. We must determine how grate with a sound asset/liability man- institution. 
the bank’s balance sheet is situated with agement model to produce investment
respect to re-pricing and maturing vol- analysis that helps us make decisions Jeffrey F. Caughron is a Managing Director
umes of assets versus liabilities. What that are optimal for the entire balance with The Baker Group, where he serves
are the rate differentials between what sheet and overall financial performance. as President and Chief Executive Officer.
is rolling off and the new balances being Caughron has worked in financial markets
added? How does our forward liquidity Relative Value Analysis – Making and the securities industry since 1985,
look and how stable is that liquidity? Do Purchase Decisions always with an emphasis on banking,
we have an exposure to rising rates or to investments, and interest rate risk
falling rates in terms of projected chang- After reviewing the balance sheet and management. Contact: 800-937-2257,
es in net interest margin and capital at portfolio analytics, we can then move to [email protected].
risk? We simply cannot make good bond the security selection phase where we

18 The Texas Independent Banker