What Is Portfolio Runoff?
Portfolio runoff is a general concept in portfolio management that describes situations where assets decrease. Runoff can occur for a variety of reasons including the maturation or expiration of securities, liquidation of certain assets, or any other situation where assets decrease or are withdrawn from a portfolio.
Runoff is of particular concern with fixed-income securities when these assets mature but are not replaced. Portfolio runoff can be a balance sheet consideration for firms or a wealth management concern for investment portfolios.
- Portfolio runoff is synonymous with a decrease in the amount of assets held.
- Portfolio runoff can occur when portfolios involve fixed-income payments and products that mature or expire and so cease to exist.
- Generally, runoff is something a manager seeks to mitigate because it leads to a reduction in assets and return.
- However, runoff can be managed strategically if someone wants to intentionally draw down assets.
Understanding Portfolio Runoff
Portfolio runoff is important to be aware of in the management of any financial portfolio that is dependent on fixed-income products or which contains derivatives contracts. The issue is that these types of securities come with finite timespans, and will eventually expire or mature. At that point, the assets are no longer held in the portfolio and cannot generate further returns.
This concern pertains mostly to banks, lenders, and asset-backed portfolios. Banks and lenders will analyze runoff from their balance sheets and decide which assets should be replaced or rolled over as their maturity nears. Investment portfolios can be subject to more complex considerations like risk, duration, convexity, and so on.
Balance Sheet Runoff
For a bank or lender, portfolio runoff can occur when payments are made on fixed-term loans without further loan volume generation. Payments made on loans increase the asset balance matched against the liability with a specified target rate of interest collection until the established maturity date. At maturity, a loan’s principal has been fully repaid with interest which then exceeds the initial liability at the targeted rate. If the bank does not issue more loans, it experiences runoff. If interest rates fall and a bank must issue loans at lower rates it will also experience runoff defined as the difference between what it made from higher rate loans vs. what it makes from the newly issued loans. Runoff can also occur when early prepayments are allowed or defaults occur as these events lower the expected receivables and returns.
Banks can experience runoff when individuals and businesses withdraw capital to invest in other higher-paying investments, thereby reducing the bank's total capital.
Balance Sheet Risk Management
Overall, banks must closely manage all of the assets on their balance sheet over a long time horizon to ensure they are adequately capitalized. Banks also seek to ensure they are continuously generating revenue through the approval of interest receivables. To do this, banks must anticipate runoff and make sure they are generating loan issuance volume that keeps their receivables portfolio steady at expected target levels.
In an effort to reduce portfolio runoff or 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 pays off all or much of their loan early. Loans that are delinquent or that have been the subject of a default or foreclosure will also contribute to portfolio runoff because the full amount of the loan is not collected and the loan does not achieve its targeted rate of return. Banks usually charge late payment fees to help mitigate losses from delinquencies.
Runoff in Investment Portfolios
Asset-backed portfolios or asset holdings can be another area where managers can experience runoff. Asset-backed securities (ABS), like mortgage-backed securities (MBS), usually have a fixed maturity date. The mortgages that are bundled to make up the security usually all have similar maturity dates which lead to the final maturity date.
For managers who hold mortgage-backed securities specifically, they can project a specific maturity date based on the security maturity for which interest payment receivables will stop and they will receive their full principal. If payments from mortgage-backed securities are not reinvested, the income from them will stop at a specified date. This means there will likely be a difference in the return of the portfolio which can be considered the runoff. Payments from asset-backed holdings are accumulated as cash which typically has a lower rate of return than the mortgage-backed security investments.
In general, where alternative portfolio assets are involved, runoff is typically associated with the difference in return from cash holdings vs. reinvestment. For asset-backed portfolios, runoff can also be affected by early prepayments or defaults which are two factors that can reduce return and increase runoff.
Reinvestment risk can play a big part in runoff considerations. Due to decreasing market returns, portfolio managers using reinvestments may be required to reinvest at lower rates, which creates runoff from the rate differentials. Comprehensively, portfolio managers may also induce runoff to decrease portfolio assets intentionally. To decrease assets and create runoff, managers may stop reinvestment or they may choose to reinvest in lower-return investments like Treasuries.
Federal Reserve Actions
The Federal Reserve used mortgage-backed securities in its monetary policy actions following the 2008 financial crisis. Buying mortgage-backed securities inflated the Fed’s balance sheet assets and reinvesting in mortgage-backed securities helped to continue increasing assets due to their higher returns compared with cash or Treasuries.
The Fed can use mortgage-backed security reinvestments to manage portfolio runoff and shrink its balance sheet for normalization. Consistent with managing runoff, stopping reinvestment altogether or reinvesting mortgage-backed security payments in Treasury securities creates runoff, which reduces balance sheet assets.