What is portfolio runoff?
Portfolio runoff is a concept of financial portfolio management whereby assets decrease. This can happen in a variety of situations and scenarios. Portfolio runoff can be a balance sheet consideration or it can occur in different types of investment portfolios.
Key points to remember
- Portfolio runoff is synonymous with decrease.
- Portfolio runoff can occur when portfolios include payments and fixed income products.
- Typically, runoff is something that a manager seeks to mitigate because it results in reduced assets and reduced returns. However, runoff management can also be used strategically if one is looking to intentionally remove assets.
Understanding portfolio runoff
Portfolio runoff can be important to manage in any financial portfolio dependent on fixed income products. This usually includes banks, lenders and asset-backed portfolios. Banks and lenders will analyze the runoff of their balance sheets. Other areas such as investment portfolios can be more complex.
Dripping the balance sheet
For a bank or lender, portfolio runoff can occur when payments are made on fixed-term loans without generating additional loan volume. Payments on loans increase the balance of assets over liabilities with a specified target interest rate until the established maturity date. At maturity, the principal of a loan has been fully repaid with interest which then exceeds the initial liabilities at the target rate. If the bank no longer issues loans, it suffers from runoff. If interest rates fall and a bank has to make loans at lower rates, it will also experience runoff defined as the difference between what it did with higher-rate loans and what it does with newly issued loans. Runoff can also occur when prepayments are authorized or defaults occur, as these reduce expected receivables and returns.
Runoff can also occur when a bank experiences withdrawals that reduce its total capital. Individuals and businesses can reduce their capital in banks to invest in other better-paying investments or vehicles.
Balance sheet risk management
Overall, banks need to closely manage all of their balance sheet assets over a long period of time to ensure they are properly capitalized. Banks also seek to ensure that they continuously generate income through the approval of interest claims. To do this, banks must anticipate runoff and ensure that they generate a volume of loan issuance that keeps their debt portfolio stable at the expected target levels.
In an attempt to reduce portfolio runoff or to offset the impact of unexpected losses, some lenders have implemented tactics such as prepayment penalties. These allow the lender to impose and collect penalties if the borrower repays all or part of his loan at the start. Loans in arrears or which have been subject to default or foreclosure will also contribute to the flow of the portfolio because the total amount of the loan is not collected and the loan does not reach its target rate of return. Banks generally charge late fees to help mitigate losses due to defaults.
Alternative portfolio assets
Asset-backed portfolios or asset holdings can be another area where managers can experience runoff. Asset-backed securities like mortgage-backed securities generally have a fixed maturity date. The mortgages that are grouped together to constitute the security generally all have similar maturity dates which lead to the final maturity date.
For managers who specifically hold mortgage-backed securities, they can project a specific maturity date depending on the maturity of the security for which the interest payment claims will cease and they will receive their entire capital . If payments on mortgage-backed securities are not reinvested, the income from them will cease on a specified date. This means that there will likely be a difference in the return on the portfolio which can be viewed as runoff. Payments from asset-backed securities are accumulated in cash, which generally has a lower rate of return than investments in mortgage-backed securities.
In general, when alternative portfolio assets are involved, runoff is generally associated with the difference in return between cash holdings and reinvestment. For asset-backed portfolios, runoff can also be affected by early prepayments or defaults, two factors that can reduce returns and increase runoff.
Reinvestment can play an important role in runoff. Due to declining market returns, portfolio managers using reinvestments may be required to reinvest at lower rates, which creates runoff from spreads. Overall, portfolio managers can also induce runoff to intentionally decrease the assets of the portfolio. To reduce assets and create runoff, managers can stop reinvestment or choose to reinvest in low-yield investments like treasury bills.
Federal Reserve Actions
The Federal Reserve used mortgage-backed securities in its monetary policy actions after the 2008 financial crisis. Purchasing mortgage-backed securities inflated assets on the Fed’s balance sheet and reinvested in securities. Mortgage-backed mortgage loans continued to increase assets due to higher returns than cash or treasury bills.
The Fed can use reinvestments in mortgage-backed securities to manage portfolio runoff and reduce its balance sheet for normalization. In accordance with the management of runoff, the total cessation of reinvestment or the reinvestment of payments of mortgage-backed securities in Treasury securities creates a runoff which reduces the assets on the balance sheet.