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Michael J. Maita, Justin J. Ayre, Thomas Luciano
Mike Maita, head of the bank channel within PIMCO’s Financial Institutions Group, along with colleagues Justin Ayre and Thomas Luciano, spoke with banking publication SNL Financial recently about the firm's efforts to partner with regional and community banks to manage their investment portfolios – which have grown to 21% of assets in 2013 from 16% just a few years ago. They also discussed investment portfolio strategies for periods of volatile interest rates. The following is an edited and abridged version of the Q&A.
SNL: Mike, we had a chance to discuss PIMCO at our SNL Community Bankers Conference in April of this year. Can you elaborate further on the bank team, how your team partners with community and regional banks, and where you see opportunities for your business today? Mike Maita: We are a focused U.S. bank team within our broader financial institutions group. That group comprises an insurance team, which focuses on general account and variable annuity clients, a bank team and an advisory team. For U.S. banks, PIMCO manages investment portfolio assets, as well as bank-owned life insurance and pension assets (defined benefit and defined contribution).
Our bank team includes seasoned industry professionals focused on partnering with banks that are interested in having PIMCO manage a portion of their investment portfolio. Our objective is to harness PIMCO’s investment process to help banks better manage risk and focus on improving performance. In this capacity, we work as an investment manager for our clients, not as a broker-dealer of securities.
Since the financial crisis, we have seen a shift in the way banks have approached the management of their investment portfolios. With interest rates hovering at historical lows, uneven loan growth throughout local and regional markets and continued inflows of deposits, investment portfolios have become larger and more critical to bank earnings. Moreover, as today’s economy and capital markets – not to mention the regulatory environment – have become more complex to navigate, we have experienced increased demand from banks seeking to reduce risk and optimize capital.
SNL: In today’s market environment, what are some of the strategies banks can consider that may help optimize earnings without taking undue rate or credit risk in their portfolios? Justin Ayre: There’s been talk of banks reducing interest rate risk and positioning to become more asset-sensitive. As we have seen with rising rates in May and June, the significant unrealized gains position that banks have built up came down from a peak of more than $40 billion in late 2012 to negative $3 billion by August 2013, with most of the decline in May and June 2013. These losses, in combination with increased focus from the investor community, underscore the need for banks to consider positioning their investment portfolios more conservatively for rising rates, which we expect to occur gradually over the next several years. In our view, there are opportunities to continue shortening portfolio duration and maintaining income through a diversified set of high-quality spread sectors.
Most banks invest primarily in U.S. government-backed debt. These investments represent approximately 20% of the $100 trillion global bond market. We encourage clients to broaden their opportunity set, which we believe will better align investment portfolios with their primary objectives: liquidity, income and principal preservation. The opportunity set beyond U.S. government-backed debt includes many positions with the high quality and liquidity characteristics appropriate for bank investment portfolios. Plus, some of these positions would be expected to respond more favorably than U.S. government-backed debt in the event that a further rise in rates corresponds to an improving economy.
Some banks, particularly the regional and multi-national banks, have added credit positions to their portfolios (collateralized loan obligations [CLOs], U.S. and non-U.S. corporate debt). However, this raises challenges for smaller banks with limited credit resources or expertise to conduct the required due diligence under Dodd-Frank (Section 939A). And while many of these sectors have recently traded at record low yields, we believe market volatility has created an opportunity for better entry points.
Additionally, we think the philosophy for managing investment portfolios is beginning to change, driven by (1) low yields and risk of rising rates over the next several years, (2) increased investor and shareholder emphasis on tangible common equity and (3) Basel III’s definition of capital (for large banks), which includes unrealized gains/losses on the available-for-sale (AFS) portfolio. These factors warrant more focus on the overall market value of the investment portfolio, or total return, in addition to the traditional focus on yield. These can be competing objectives. To address this challenge, some banks have been adding high-quality credit positions that have the potential to offset interest rate risk (as empirical data suggest that spreads may decline when rates rise) and offer good income in the meantime.
SNL: How have banks been positioning their investment portfolios in preparation for rising rates? Thomas Luciano: Many banks have been shortening the duration of their portfolios over the past few quarters, either by rotating or redeploying into shorter maturity positions within their existing asset allocations (reducing yields) or adding/diversifying into spread sectors to maintain yields while reducing overall duration. Most of the banks we speak with have reduced their portfolio duration to around three years.
Others have been placing new purchases directly into their held-to-maturity accounts or reclassifying current AFS holdings into held-to-maturity. However, there is a natural limit to how much can be added to held-to-maturity given accounting and liquidity limitations. Some banks have chosen to hold portfolio loans that they would otherwise sell or securitize. Others have opted to keep more in cash at the Federal Reserve. Given the recent backup in rates and continued weakness in loan demand, this may be a decent opportunity to begin reallocating into the securities portfolio in the near term.
Justin Ayre: As we have seen during the middle of 2013, rates often move in a non-parallel manner. Banks should understand the impact that curve positioning has on the portfolio. For example, if rates were to rise in the belly of the curve (five to seven years), but short-term rates remain anchored, how does that affect the market value and income-generation capability of the investment portfolio – and what does that suggest for optimal portfolio positioning?
A gradual rise in interest rates may actually benefit the securities portfolio as positions run off and are reinvested in higher-yielding instruments. Another critical element is how spread sectors will perform in these rate scenarios. For example, spreads often tighten when rates rise and may offer some cushion for duration risk. While this may be true historically, the market activity in June illustrated the potential for rates to rise as spreads widen. Banks should consider how these risk factors interact when modeling rate scenarios.
SNL: What concerns you the most in banks' investment portfolios? Thomas Luciano: Concentration in sectors with duration risk and negative convexity. In response to low yields, favorable risk-based capital rules and new regulations, banks have significantly increased holdings in agency mortgage-backed securities (MBS). This sector has been highly influenced by central bank actions and is very sensitive to the continued role of the government in financial markets. When we step back and look at bank investment portfolios holistically, we see the most opportunities in sectors that are less commonly held by banks. Examples are high-quality securitized assets (e.g., commercial mortgage-backed securities [CMBS] and CLOs) and U.S. dollar-denominated sovereign and supranational debt backed by countries with strong balance sheets. Others include certain low/intermediate duration corporate debt backed by hard assets and industries/companies that stand to benefit from some of the strengths in the U.S. economy (e.g., housing and energy). We believe a strong investment process and an understanding of the interaction that these credit risks may have with other elements of the bank's balance sheet, as well as rigorous security selection, are critical to being able to prudently invest in these sectors, particularly given the new regulatory requirements related to ratings alternatives.
SNL: What should banks do with excess liquidity on their balance sheets today? Thomas Luciano: Liquidity is a challenging concept, particularly in today’s unusually uncertain economic environment. In particular, historical models of how deposits will behave under various rate scenarios may not explain the time period ahead. Recently, we have observed fairly stable deposit balances while seeing improving equity markets and rising rates. Fed H.8 data show deposit balances up slightly, by more than $100 billion (to a total of $8.5 trillion) from the beginning of 2013 in spite of a more than 15% rise in the S&P 500 by the third quarter of 2013. With that said, opportunities exist to identify and deploy excess liquidity into sectors that may garner a liquidity risk premium – and may also offer diversification benefits relative to their existing portfolio and overall balance sheet. In fact, we’ve seen opportunities to work with banks to manage short duration portfolios that target active management opportunities using a range of bank-eligible asset classes.
Some banks may have the infrastructure and expertise that allow them to achieve an optimal investment portfolio and risk/return profile. For those that don’t, it may make sense to consider outsourcing a portion of the portfolio to quickly access resources and expertise to target these opportunities. The bank may benefit in terms of cost (i.e., relative to building an internal team and infrastructure to manage these sectors) as well as potentially adding performance, or alpha, over what the market offers. Additionally, this partnership offers a unique perspective that can be useful to challenge the internal views of the bank. At PIMCO, our clients find our investment process, the cornerstone to how and where we invest our clients’ capital, a useful input to how they manage the rest of their balance sheet.
SNL: What issues do you see that are not getting enough attention by community and regional banks? Mike Maita: Banks have typically relied on their internal treasury and credit teams, in conjunction with broker-dealers, to manage the investment portfolio. We’ve observed others within the financial sector and broader corporate universe that have migrated to a model where third-party investment managers play a valuable role in fulfilling the objectives of the investment team – and also help to support their fiduciary duties in an effective and efficient manner. For example, the insurance industry went through a transition early in the last decade in which insurance companies began using specialized outside managers to supplement their internal teams. This is a model that has begun to gain some traction with banks. Clearly, banks have unique requirements, but we are starting to see banks recognize the added value of using a third-party manager. Boards are beginning to appreciate the potential for adding performance, improved risk management and the different perspectives that an experienced external manager can offer.
Past performance is not a guarantee or reliable indicator of future results.
A word about risk: Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Collateralized Loan Obligations (CLOs) may involve a high degree of risk and are intended for sale to qualified investors only. Investors may lose some or all of the investment and there may be periods where no cash flow distributions are received. CLOs are exposed to risks such as credit, default, liquidity, management, volatility, interest rate and credit risk. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. All investments contain risk and may lose value.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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