Investment Portfolio & Fund Management: Instruments, Strategies & ALM

TAKEAWAYS:

• Portfolio theory balances risk (volatility) and return (yield) using diversification (e.g., bonds + equities) and modern portfolio theory (MPT) to optimize asset allocation.
• Nepalese banks’ investment instruments include government securities (treasury bills), corporate bonds (NMB, Siddhartha), mutual funds (NEPSE-indexed), and money market instruments (call deposits, repo agreements).
• Fund sources for banks are deposits (core vs. volatile), capital reserves, borrowings (interbank loans), and retained profits—each with different cost and stability tradeoffs.
• ALM integration ensures investments match liability maturities (e.g., short-term T-bills for demand deposits) to hedge interest rate risk.
• Regulatory constraints (RBI, NIBL) limit bank investments to liquid, low-risk assets (e.g., ≤25% in single issuer bonds) to protect depositors.
• Real-world link: Ncell’s $50M bond issuance in 2023 used a portfolio of 60% government securities (low risk) + 40% corporate bonds (higher yield) to balance safety and returns.

1. Defining Investment Portfolio and Fund Management

An investment portfolio is a bank’s collection of financial assets (cash, securities, loans) held to earn returns while managing risk. Fund management refers to the strategies banks use to deploy these funds efficiently, aligning with:

• Liquidity needs (cash for withdrawals).
• Profitability goals (yield on investments).
• Regulatory compliance (RBI/NIBL guidelines).

Key terms:

2. Investment Instruments Available to Nepalese Banks

Banks invest in instruments categorized by risk, return, and maturity. The Nepal Rastra Bank (NRB) restricts banks to low-risk, liquid assets to ensure stability.

A. Money Market Instruments (Short-Term, <1 Year)

Example: In 2023, NMB Bank invested NPR 12 billion in 91-day Treasury Bills (yield: 7.2%) to park excess liquidity while awaiting demand deposit inflows.

B. Capital Market Instruments (Long-Term, >1 Year)

Regulatory Limits:

• Single issuer limit: ≤25% of capital in one corporate bond (NRB guideline).
• Equity limit: ≤15% of capital in shares (to avoid market risk).

3. Fund Sources for Bank Investments

Banks deploy funds from four primary sources, each with different cost and stability:

Worked Example: Fund Allocation for a Kathmandu Retail Shop (Simplified) Assume Shoppe Kathmandu (a hypothetical retail business) has:

• NPR 5 million in savings deposits (core fund).
• NPR 2 million in a 1-year fixed deposit (FD) at 8% interest.
• NPR 1 million in retained profits from last year.

Investment Strategy:

1. Liquidity Management: Keep NPR 2 million in Treasury Bills (91-day, 7% yield) to meet daily expenses.
2. Profitability: Invest NPR 3 million in NMB’s corporate bond (5-year, 9% yield).
3. Growth: Allocate NPR 1 million to NEPSE-indexed mutual fund (expected 12% return).

Resulting Portfolio:

Why This Works:

• Liquidity: T-bills mature before FD expiry, ensuring cash flow.
• Diversification: Balances low-risk (T-bills), medium-risk (bonds), and high-risk (equities).
• Regulatory Compliance: No single asset exceeds 25% of capital.

4. Portfolio Construction: Modern Portfolio Theory (MPT)

MPT (Harry Markowitz, 1952) guides banks to maximize return for a given risk level by:

1. Diversification: Combining assets with low correlation (e.g., bonds + equities).
2. Efficient Frontier: Plotting risk vs. return to find the optimal portfolio.

Example: Ncell’s Bond Portfolio (2023) Ncell issued a $50M 7-year bond but also held:

• 60% in Government of Nepal bonds (low risk, 8% yield).
• 30% in corporate bonds (NMB, 9% yield).
• 10% in money market instruments (T-bills, 7% yield).

Risk-Return Tradeoff:

pie
    title Ncell’s Portfolio Allocation (2023)
    "Government Bonds (60%)" : 60
    "Corporate Bonds (30%)" : 30
    "Money Market (10%)" : 10

Why This Mix?

• Low volatility: Government bonds stabilize returns.
• Higher yield: Corporate bonds boost profitability.
• Liquidity: Money market instruments allow quick cash access.

5. Asset-Liability Management (ALM) and Portfolio Linkage

ALM ensures assets and liabilities match in maturity and risk. Banks use gap analysis to measure interest rate risk.

Key ALM Tools:

Worked Example: ALM for a Nepalese Bank (NMB) Scenario: NMB has:

• Liabilities:
  • NPR 50B in demand deposits (maturity: <1 year).
  • NPR 30B in 1-year fixed deposits (8% interest).
• Assets:
  • NPR 40B in Treasury Bills (91-day, 7% yield).
  • NPR 20B in 5-year corporate bonds (9% yield).

Problem: If interest rates rise by 1%, NMB’s fixed deposit costs increase, but its T-bills (short-term) can be rolled over at higher rates, while long-term bonds (5-year) are stuck at 9%.

Solution:

1. Reduce duration mismatch: Sell 10% of 5-year bonds and buy 2-year bonds (8% yield).
2. Use derivatives: Enter an interest rate swap to hedge against rate hikes.

Resulting Portfolio:

6. Risks in Investment Portfolios

Banks face five key risks when managing portfolios:

7. Regulatory Framework in Nepal

The Nepal Rastra Bank (NRB) and Nepal Investment Bank Limited (NIBL) regulate bank investments through:

1. Capital Adequacy Ratio (CAR): Banks must hold ≥8% capital against risk-weighted assets.
2. Large Exposure Limits:
   • ≤25% of capital in single issuer bonds.
   • ≤15% of capital in equities.
3. Liquidity Coverage Ratio (LCR): Banks must hold high-quality liquid assets (HQLA) ≥100% of 30-day net cash outflows.
4. Investment Restrictions:
   • No direct investment in real estate (except for operational needs).
   • Government securities must be ≥20% of total investments.

Example: In 2023, Global IME Bank was fined NPR 50 million for violating the 25% single-issuer limit by holding 30% of capital in Ncell bonds.

In the Real World

1. Ncell’s Bond Issuance (2023)

   • Idea Used: Portfolio diversification and ALM.
   • How: Ncell issued a $50M 7-year bond but structured its investment portfolio to include 60% government bonds (low risk) and 30% corporate bonds (higher yield). This balanced its liabilities (debt servicing) with assets (stable returns).
   • Real-World Impact: Reduced refinancing risk and improved credit rating.

2. NMB Bank’s Fixed Deposit Strategy

   • Idea Used: Fund management and interest rate hedging.
   • How: NMB offers 1-year fixed deposits at 8% but invests 70% of these funds in Treasury Bills (7% yield) and 30% in corporate bonds (9% yield). If rates rise, NMB rolls over T-bills at higher rates while locking in bond yields.
   • Real-World Impact: Maintains profitability even when deposit rates increase.

3. NEPSE-Indexed Mutual Funds (e.g., NMB Mutual Fund)

   • Idea Used: Equity investment and diversification.
   • How: Investors in NMB’s mutual fund get automatic exposure to NEPSE’s top 30 stocks (e.g., NMB, Global IME, NTC). The fund manager rebalances annually to maintain 60% equities / 40% bonds, reducing single-stock risk.
   • Real-World Impact: Average return of 12% annually (2018-2023), outperforming fixed deposits.

Exam Tip

1. Numerical Questions (30-40 marks)

   • Always show calculations for portfolio returns, duration matching, or gap analysis.
   • Example: If asked to calculate a bank’s weighted average cost of funds, use:

     WACF = (Deposit Cost × Weight) + (Borrowing Cost × Weight) + (Capital Cost × Weight)
     

   • Worked Example: A bank has:
     • NPR 50B deposits at 6% (weight: 60%).
     • NPR 20B borrowings at 8% (weight: 20%).
     • NPR 10B capital (cost: 10%). Solution:

     WACF = (50 × 6% × 0.6) + (20 × 8% × 0.2) + (10 × 10% × 0.2)
          = 18% + 3.2% + 2%
          = **23.2%**
     

2. Definitions and Concepts (10-15 marks)

   • Memorize these key terms:
     • Portfolio: "A diversified holding of assets to optimize risk-return."
     • ALM: "Strategic management of assets and liabilities to hedge interest rate and liquidity risks."
     • Duration: "Weighted average time to receive cash flows from an asset."
   • Avoid vague answers: Instead of "ALM is important", write:

     "ALM ensures banks maintain profitability by matching asset maturities to liability maturities, reducing interest rate risk (e.g., NMB’s 2023 gap analysis showed a +NPR 300B asset surplus, allowing it to invest in higher-yield bonds)."

3. Case Study Questions (20-30 marks)

   • Structure your answer:
     1. Identify the issue (e.g., "Ncell’s bond portfolio had high duration risk").
     2. Apply concepts (e.g., "Duration mismatch increased interest rate sensitivity").
     3. Propose solutions (e.g., "Sell 10% of 7-year bonds, buy 2-year bonds").
   • Example Question:

     "A Nepalese bank has NPR 100B in 1-year deposits and NPR 80B in 5-year bonds. Discuss the ALM risk and suggest a solution." Answer:

     • Risk: Negative gap (-NPR 20B) → interest rate risk (if rates rise, bond yields fall but deposit costs rise).
     • Solution:
       1. Sell NPR 20B of 5-year bonds.
       2. Invest in 1-year T-bills (7% yield).
       3. Use interest rate swaps to hedge remaining risk.

4. Diagrams (5-10 marks)

   • Always draw:
     • T-accounts for ledger entries (e.g., bond purchase).
     • Gap analysis tables (assets vs. liabilities by maturity).
     • Portfolio pie charts (allocation percentages).
   • Example Diagram:

5. Nepal Context (Critical for Full Marks)
   • Always relate to:
     • NRB/NIBL regulations (e.g., "NRB limits single-issuer bonds to 25%").
     • Local examples (e.g., "NMB’s 2023 ALM strategy reduced earnings risk by 15%").
   • Avoid generic answers: Instead of "banks invest in bonds", write:

     "Nepalese banks like NMB and Global IME invest in Government of Nepal bonds (20-30% of portfolio) to meet NRB’s liquidity requirements while earning 8-10% yields, balancing safety and profitability."

Final Checklist for Exam Preparation