26 Hoosier Banker June 2016 As time and circumstances move the domestic economy and its financial markets into an environment that most believe will be characterized by gradually rising interest rates, many portfolio managers find themselves wondering how best to manage that condition. Having a portfolio that is unable to efficiently respond to a higher-rate environment can result in a big chunk of underperforming assets, along with an uncomfortably high level of market depreciation. Recognizing that some level of price depreciation may be unavoidable as rates rise, the efficient portfolio is able to minimize that decline by keeping up with the market. In order to keep up with the market, portfolios must participate in the market, and there’s more than one way to do so. Fixed or Floating:Which Makes More Sense? On the surface, it might appear that the best way of ensure that a portfolio is efficiently participating in a risingrate environment is to acquire individual securities that, structurally, have the ability to adjust or rise with the market. Adjustable-rate securities have been around for a long time and come in a variety of shapes and sizes. A look at the menu of floatingrate alternatives finds that some securities adjust to the prime rate, others float with Treasury yields, while some track various money market indices, to name a few. There are even some that incorporate more than one index in arriving at their rate-adjusted coupon. As a concept, what’s not to love? A portfolio full of adjustable-rate securities could keep a portfolio’s yield in line with market changes and, in doing so, protect against a loss in market value. It seems an easy way to have the best of both worlds. While having some adjustable-rate component in one’s portfolio may not be inappropriate, floating-rate securities are not a cure-all for the ills of market risk. Digging deeper into the world of floating-rate securities, one soon discovers their yields in this environment are well below that of other traditional fixed-rate alternatives, such as municipal bonds or mortgage-backed securities. That’s the price to be paid for adjustability, and that price is not small. Opportunity cost now becomes a variable in making a fixed versus floating decision and, despite perceptions of the inevitability of higher rates in the future, let’s not forget about the “inevitability” of those perceptions in recent years. For that opportunity cost to become less costly, market rates need to rise both rapidly and substantially; however, evidence to support such a move is tough to come by. One major consideration when evaluating the potential efficacy of an adjustable-rate security is how timely its adjustments will be. A security that limits itself to annual adjustments has plenty of time to fall out of step with a fast-moving market, and thus loses the very characteristics that were sought in the first place. There also exists the concept of basis risk, which recognizes that not all interest rates move at the same time by the same amount. A risk manager who thinks he or she has successfully hedged an adjustablerate liability with an adjustable-rate security may find out differently, when disparate indices drive the adjustments. Nor should a risk manager forget about caps, floors and collars, which can interfere with, or About the Author Lester F. Murray, associate partner of The Baker Group, joined the firm in 1986. His focus is on developing community bank portfolio and interestrate risk management strategies. Murray previously worked for the Office of the Comptroller of the Currency as an assistant national bank examiner. He is a graduate of Oklahoma State University. The author can be reached at 800-937-2257, email: lester@GoBaker.com. The Baker Group is a Diamond Associate Member of the Indiana Bankers Association and an IBA Preferred Service Provider. When Interest Rates Rise, Will Your Portfolio’s Yield Follow? DIRECTORS / SENIOR MANAGEMENT
RkJQdWJsaXNoZXIy MTg3NDExNQ==