Independent Banker - July 2024 - 31

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teams are often surprised how long
portfolio mark-to-market losses are
carried into the future. But there are
some common pitfalls to avoid in
approaching the conversation.
Portfolio mark-to-market
To explore this further, let's examine
a sample portfolio that is broadly
representative of industry averages
based on a variety of factors (yield,
gain/loss, duration and sector
composition). An overview of the
portfolio is shown in Figure 1 (left).
Your portfolio may look somewhat
diff erent from the sample, but a key
part of this discussion centers around
the general concept of duration rather
than the particular characteristics
of an individual portfolio. So, please
bear with me.
Where duration is useful
(and where it isn't)
Management teams frequently use
duration to estimate how portfolio
marks will move due to changes in
interest rates. Based on our sample
portfolio's eff ective duration of 4.58,
one can reasonably assume that
its price would decline by roughly
4.6 percentage points if interest rates
increased by 100 basis points. Though
there is some nuance to why actual
marks could diff er from projections,
this is an entirely appropriate
application of the concept-and, quite
simply, it is precisely what duration is
designed to do.
But management teams often
extrapolate that thought process
to estimate mark-to-market rolloff
in a similar fashion. It seems
intuitive to think one can divide our
sample portfolio's mark-to-market
loss of 11.6 percentage points by its
duration of 4.6, leading to expected
price improvement of roughly
2.5 percentage points per year (or just
over $15 million per year).
Figure 2: Horizon projections for sample portfolio
Assumes a static interest rate environment, holds Book Price constant and estimates horizon price using constant OAS
However, a closer look shows
that using duration to estimate
mark-to-market roll-off can create
misleading results. Figure 2 (above)
explores a horizon market value
analysis on our sample portfolio that
provides a more realistic depiction of
how mark-to-market will evolve in
future years.
Of particular note is that
$29.6 million of loss remains
outstanding after fi ve years,
representing nearly 43% of the
portfolio's beginning loss position.
Furthermore, the average annual
decline in mark-to-market is
$7.9 million over this period-roughly
half of the " expected " decline based
on portfolio duration. Naturally, this
can be quite jarring for managers who
expected mark-to-market to move
back to neutral within fi ve years!
Closing the gap between
perception and reality
The reasons for the variance between
actual versus " expected " movements
in gain/loss needs a more in-depth
dialogue than can be provided in this
issue's column, but it largely boils
down to the fact that market price
improves at a considerably slower
rate than the simple, duration-based
calculation would suggest. Though
percentage loss does improve each
year in this example, the slow pace of
improvement suggests that reductions
in the dollar value of mark-to-market
losses are primarily driven by
principal paydowns rather than
price appreciation.
The relative importance of longerthan-anticipated
mark-to-market
persistence will depend on many
factors specifi c to your institution-
risk tolerance, capital and liquidity
positions, profi tability outlook, and
interest rate risk profi le, to name a
few-as well as market factors that
are beyond your control. However, a
better understanding of the portfolio's
trajectory is a crucial fi rst step in
evaluating appropriate responses. And
with that burden lifted, you can spend
more time thinking about the next
family road trip.
Michael Benedict
(benedictm@stifel.com) is a
managing director, fixed income
strategies, at Stifel, ICBA Securities'
exclusively endorsed broker.
independentbanker.org // 31

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Independent Banker - July 2024

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