Portfolio runoff means assets with a finite term are not replaced as they mature.
When the principal invested in a fixed-income security with a set maturity is repaid, the investor must decide whether to reinvest it. When the proceeds from matured bonds are not reinvested, a portfolio can be said to be in runoff.
Key Takeaways
- Portfolio runoff describes a decline in fixed-term investment assets.
- Portfolio runoff can occur when proceeds from maturing fixed-term securities are not reinvested.
- Investment returns decline over time in a portfolio runoff as the asset base generating returns shrinks.
- Portfolio runoff can allow central banks, like the Federal Reserve, to reduce their balance sheet without selling holdings.
Opportunities in Balance Sheet Runoff
For a bank or lender, portfolio runoff can occur if it can’t make new loans quickly enough to replace the repaid ones it made previously. Runoff can also occur when early prepayments are allowed or as defaults occur.
Banks can experience runoff when individuals and businesses withdraw capital to invest in other higher-paying investments, thereby reducing the bank’s total capital.
In an effort to reduce portfolio runoff, some loans specify prepayment penalties. These provide additional compensation for the lender if the borrower pays off a loan before the end of its term.
Harnessing Runoff in Investment Portfolios
Fixed-income investments like asset-backed securities (ABS) and mortgage-backed securities (MBS) usually have a fixed maturity date. For MBS, it would be based on the term of mortgages bundled to make up the security.
If cash flow from mortgage-backed securities is not reinvested, the income the portfolio generates will decline.
Strategic Moves by the Federal Reserve
The Federal Reserve bought Treasury debt and mortgage-backed securities in quantitative easing (QE) programs adopted following the 2008 financial crisis.
To start reducing its balance sheet, the Fed doesn’t need to sell those securities; it can merely choose not to reinvest some or all of the proceeds as the debt matures and is repaid.
Navigating Insurance Portfolio Runoff
Just as a fixed-income investor may choose not to reinvest coupon payments or principal repayments, a reinsurer may choose not to write new policies while waiting for those it previously wrote to expire. Its portfolio would then be in runoff.
Related Terms: fixed-income security, prepayment penalty, asset-backed securities, mortgage-backed securities, quantitative easing, reinsurer.
