What Is Portfolio Runoff?
Portfolio runoff is a concept in financial portfolio management whereby assets decrease. It can occur in a variety of situations and scenarios. Portfolio runoff can be a balance sheet consideration or it may occur in different types of investment portfolios.
- Portfolio runoff is synonymous with a decrease.
- Portfolio runoff can occur when portfolios involve fixed income payments and products.
- Generally, a runoff is something a manager seeks to mitigate because it leads to a reduction in assets and return. However, the management of runoff can also be used strategically if looking to intentionally draw down assets.
Understanding Portfolio Runoff
Portfolio runoff can be important to manage in any financial portfolio that is dependent on fixed income products. This generally encompasses banks, lenders, and asset-backed portfolios. Banks and lenders will analyze runoff from their balance sheets. Other areas like investment portfolios can be more complex.
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 things lower the expected receivables and returns.
Runoff can also occur when a bank experiences withdrawals which reduce its total capital. Individuals and businesses may reduce their capital at banks to invest in other higher-paying investments or vehicles.
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 try and reduce portfolio runoff or offset the impact of unexpected losses, some lenders have implemented tactics such as offering 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.
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 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 can play a big part in runoff. 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 has 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 the higher returns than 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.