Published by Bank Business

Excess liquidity, net interest margin compression and a low-rate environmenthave made the search for investment yield top of mind for many financial institutions and their investment managers. However, it is critical to remember that simple measures of “yield” can have the unintended effect of keeping investors misinformedas to a portfolio’s true risk/return profile.

As you can see in the chart below, topline yield may be misleading as assets with similar – or even the exact same – yield on the surface may have very different risks, which can impact their actual returns over time. Risk-adjusted spread analysis levels the playing field in the investment universe and allows institutional investors to examine investment selections on a relative value basis.

Expected Performance vs. Realized Performance

Even after you deconstruct a yield into risk/return components and establish a foundation for relative value analysis, it is important to note that much of spread analysis is a model-driven, forward-looking exercise. Therefore, an informed investor should always remember that expected performance may not result in realized performance, or as we used to say “your mileage may vary,” particularly when observed events differ from original inputs and assumptions.

A recent example of this can be seen in very new production mortgage-backed security (MBS) pools trading at high dollar prices as investors struggle to evaluate pre-payments. As uncertainty increases with more complex assets, short-term yields can be drastically different than what models project as the yield to maturity (YTM). While more modeling and better analytics are necessary for more complex assets, diversifying the risk profile of the assets that comprise your investment portfolio is often the best solution as individual securities may vary month-to-month. A diversified portfolio is often able to produce a more consistent rate of return in various environments.

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