November 11, 2010
Credit Union Management’s Web-only “CFO Focus” column runs the second Thursday of each month.
The speed of the global recovery has been referred to as lethargic, or like watching paint dry, so a little relief would be welcomed in today’s economic malaise. Wall Street continues its random walk through news of the mortgage fiasco. Oddly enough, last year we were forecasting economic growth which would spark loan demand and higher interest rates. Instead we continue staring at the light at the end of the tunnel, and it doesn’t seem to be getting any closer.
Loan growth has trickled in – except payoffs and defaults outnumber new originations. Today it’s arguably worse than any other time. We have been hit with a one-two punch of anemic loan growth and historically low interest rates. Not to mention special assessments that continue to weigh on the credit union movement.
What’s a credit union to do? Increasing fees seems to be an easy choice but not a popular one, and the thought of staff reductions is gut wrenching. Therefore, squeezing more out of the investment portfolio remains the sensible choice. Decisions in the investment portfolio will come down to two issues: duration risk and credit risk. For most of you, your charter does not permit you to take credit risk, so duration is the only variable to consider. But the dilemma of moving out the yield curve while interest rates are at historic lows to capture incremental yield is a tough pill to swallow. So again, what is a credit union to do?
A way to manage duration risk and take advantage of expected rising interest rates is by investing in variable coupon investments. Agency structured notes are widely available and popular for their incremental yield and maturity options. Structured notes are similar to callable agencies with the exception that structured notes have a coupon that will adjust, or “step up,” on a predetermined schedule. Just like the callable bonds, the notes will have a call schedule that needs to be analyzed.
Coupon steps can vary from issue to issue, with some offering gradual coupon steps higher of 25 basis points every six months, while others could be 100 basis points annually. These notes will bode well for investors concerned about adding duration at current market rates. Possibly, depending on the steps, the notes could be called while interest rates rise. Such a scenario would exist under large steps in the coupon at reset, and/or if the market has moved by a lesser amount. If the security is called, it is not a bad thing no matter what the steps are, since you will outperform cash and can reinvest the proceeds at higher yields. So, you will not need to compromise your need for income with the displeasure of adding duration.
If you have the time and analytic ability, floating rate agency collateralized mortgage obligations, or CMOs, can be an additional way to pick up yield without adding duration. With sound analysis you can add floating rate CMOs to your portfolio in the area of one-month LIBOR (London Interbank Offered Rate) plus 35 basis points. Agency CMO floaters offer coupons that reset monthly or quarterly and can also hedge you in a rising interest rate environment. Even though they are floaters and can have short average lives, these securities have interest rate caps that can limit your interest payments. A down side of investing in these floaters is if LIBOR remains low for an extended period of time. Again, these investments are much more complex and require thorough analysis.
Depending on your charter, another investment alternative is to take credit risk via corporate credit floating rate notes, which reset monthly or quarterly. Some of these notes are issued by such well-known corporations as GE and IBM.
Lastly, the NCUA has been offering guaranteed notes, which reset monthly and have the backing of the NCUA for an AAA rating by Fitch S&P and Moodys. All of these investments will need to be analyzed under the same scrutiny as is done for all securities. However, these variable coupon investments may offer value when carefully and correctly analyzed.
Investing today is not without concerns, but there are strategies to generate income during this low interest rate environment while preparing for the eventuality of higher rate levels. I have a fundamental belief in keeping your portfolio balanced and while the economic environment may be changing, we must keep our eye on the long-term horizon and in alignment with our investment policy statements, ALM view and due diligence protocol.
While interest rates may remain at current low levels over the shorter term, I view looking forward that the future rate environment is skewed toward higher rates. Under this outlook, increasing your exposure to floating rate notes and variable coupon instruments is recommended.
The downside of this strategy is limited, as shorter rates are already ultra-low and the lowest they can go is zero. However, when interest rates begin to rise, it is likely to be significant, especially at the shorter end of the yield curve. This is something we would all welcome, and you will too, once you layer on a rising rate strategy. So let’s keep our eye on the horizon and add more weighting to floating rate and variable coupon investments that will perform better in a rising rate environment.
Edward Meier is senior portfolio manager, fixed income, with MEMBERS Capital Advisors, the registered investment advisor for CUNA Mutual Group, a CUES Supplier member based in Madison, Wis.
