Most asset owners aren’t looking for the ‘bond du jour’ for their investment portfolios...
Most asset owners aren’t looking for the ‘bond du jour’ for their investment portfolios.
They prefer a partner to work with as a financial consultant to discuss and review the portfolio, and provide the necessary products and services to achieve their financial goals.
Whether managing a bank portfolio or a captive investment portfolio, investors are faced with a complex financial marketplace and most recognise the need for specialised guidance to help them determine which investment options are best suited for them.
Working with a brokerage firm and an individual financial consultant can offer several benefits. The captive (be that the investment portfolio, the manager or a combination of both) and the financial consultant work closely together to design an investment strategy that is custom-tailored to match each individual captive’s goals and objectives.
The financial consultant has access to a wide breadth of market resources to build a portfolio specifically aligned to specific collateral guidelines. For example, if the investments secure a letter of credit (LOC) or reinsurance trusts, it is crucial to adhere to the restrictions placed by the LOC provider or the fronting insurance company that is the beneficiary of the trust.
An investment policy statement
In order to structure an investment portfolio, having an investment policy statement (IPS) is an essential tool. The IPS will outline general rules for the captive’s portfolio. It provides the investment goals and objectives for a captive and describes the strategies that the financial consultant will abide by to meet those objectives. If an IPS is absent, the financial consultant can help to construct and implement an appropriate IPS.
An IPS should have specific information on matters such as asset allocation, risk tolerance, and liquidity requirements. As the IPS is developed, the financial consultant can provide a captive with choices, advice and strategies to help reduce risk and maximise return with a range of products and services.
On the product side, the IPS may typically allow the following: commercial paper, high grade and high yield corporate bonds, equities, preferred stocks, structured products, government agency bonds and mortgage-backed securities, institutional money market mutual funds, municipal securities, US treasury securities, brokered certificates of deposit (CD) and placement programmes. In general, captives will have funds in safe investments in order to pay claims. Safety, liquidity, and yield, in that order, are typically the most important objectives.
Plan into practice
Once an IPS is in place, the captive and financial consultant can implement the specific investment strategy.
A useful strategy in this current low interest rate environment is a bond ladder. Building a bond ladder is an excellent tool that can help reduce (although not eliminate) interest rate risk and re-investment risk, while maintaining steady cash flows.
So, as interest rates begin to rise, as one bond matures the funds can be reinvested to the end of the ladder into longer higher-yielding bonds. For example, a three-year brokered CD laddered portfolio could have investments that mature every six months. When the first CD comes due in six months, the captive will have the opportunity to buy the current three-year CD rate.
By using this strategy, the portfolio is building liquidity every six months, essentially playing defence against an increase interest rates. Building a laddered bond portfolio is just one way that a financial consultant can service a captive’s investment needs.
The financial consultant can also use portfolio analytical tools to simulate how a portfolio may behave under certain market conditions by shocking the portfolio. This portfolio analysis allows the captive to shock the market with a change in interest rates or a market crash to see the resulting impact on the portfolio. For example, using a parallel shift in the interest rate curve allows the captive to bump the interest rate curve by a constant spread (+ or -), which corresponds to upward or downward shifts of the interest rate curve, respectively.
Once completed, the captive will be able to revalue the portfolio under each scenario, and calculate the difference between the original and scenario fair value.
Once a shock test is performed, the financial consultant can discuss the possibility of adjusting the duration of the portfolio and take action. One action is to do a bond swap. An investor might consider swapping longer-term bond holdings for shorter-term bonds in order to lower the potential impact on their overall bond portfolio value.
Another strategy is to implement a swap to increase the portfolio yield. Instead of a buy and hold investment strategy, investors will often swap a shorter-term bond for a longer-term, since longer-term bonds typically offer a higher yield.
And for a captive that may have surplus funds over and above what is needed for collateral, or a more mature captive with a larger net worth, a more aggressive approach can be considered. For example, an investor might consider accepting lower credit quality in order to gain a greater return. Bonds with lower credit ratings typically compensate investors for the greater risk with higher yields.
Other analytical tools available from the financial consultant to the captive include credit quality, sector and maturity analyses. With that said, a captive and financial consultant should review the portfolio on a timely basis.
In the same fashion as when we go see the doctor to make sure our health is in good working order, regular consultations with a financial consultant ensures that a portfolio is properly aligned to the captive’s needs and goals.
Have any of the corporate bonds in the portfolio experienced a downgrade? Or, are any on negative watch? Do the captive’s investments match the tail on their loss reserve liabilities?
These are all questions the financial consultant can review with a captive in order to maintain a good bill of financial health.
In this day and age, the financial marketplace continues to see a growing number of financial portals. The portal is marketed as a self-service trading tool to buy and sell securities. As mentioned above, today’s financial marketplace is a complex environment.
For example, a simple bond search—via a portal—for a government agency bond can produce hundreds of bond offerings to choose from. Each one of those bonds is likely to be structured differently based on certain call provisions or coupon structure.
With that said, having a financial consultant is a valuable resource to take the helm and navigate through this ocean of bonds.
A dedicated investment professional can help select a bond and most importantly discuss the investment and all the terms and conditions, as opposed to just hitting the ‘search’ button.
Bond du jour
At the end of the day, whether involved in the beginning stages of forming a captive, or in a mature captive, a financial consultant is a valuable resource to have available.
A financial consultant can help to design and implement a proactive investment approach rather than letting the market take charge.
Prospective captive clients should hear about all of the different products and services discussed above, but there is one quality that is truly the most important piece to a client investment relationship: integrity.
A financial consultant has all tools and skills necessary to help manage a portfolio, but if they do not have integrity, then their client’s financial goals will fall prey to the ‘bond du jour’. Rather than settling for the bond du jour, find a financial consultant who has this quality, and leverage all that it has to offer.
This is not a complete analysis of every material fact regarding any company, industry or security. The information and materials herein have been obtained from sources we consider to be reliable but Comerica Securities, Inc. does not warrant, or guarantee, its completeness or accuracy. Materials prepared by Comerica Securities, Inc. personnel are based on public information. The views expressed are those of the author at the time of writing and are subject to change without notice. We do not assume any liability for losses that may result from the reliance by any person upon any such information or opinions. This material is for general educational/informational purposes only, and should not be considered as investment advice. Past performance is not indicative of future results. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Securities and other non-deposit investment products offered through Comerica Securities, Inc. are not insured by the FDIC; are not deposits or other obligations of, or guaranteed by, Comerica Bank or any of its affiliates; and are subject to investment risks, including possible loss of the principal invested. Comerica Securities, Inc. is a broker/dealer, member FINRA/SIPC and a subsidiary of Comerica Bank. Comerica Securities, Inc. is a federally registered investment advisor. Registrations do not imply a certain level of skill or training.
