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Mar 20 2018

Investment Portfolio Considerations in a Rising Interest Rate Environment

Article

Written by webmaster

4 min read

By Jason Williams-Portfolio Manager and President of Moreton Asset Management

After the longest period in U.S. economic history of short-term interest rates remaining below 1 percent, the U.S. Federal Reserve initiated a rate tightening cycle that began in December of 2015 (raising the overnight lending rate to 0.75%) and continued until today (1.75% overnight lending rate with more expected to come this year).¹

Credit union managers and decision makers have been hearing for several years now to beware of rising interest rates. Over two years ago, NCUA Chief Economist Ralph Monaco urged credit unions to model rising interest rates in their loan and investment portfolios.² In 2017 and 2018, short-term interest rates are now rising, and some of the consternation about the dangers and pitfalls surrounding credit unions can finally just be dealt with. In a recent conversation with a credit union CEO, she commented to me, “It’s nice to finally enter into the rising rate cycle. We have been talking about it for so long it was starting to psyche us out… like pulling off the band-aid.”

For the credit union investment portfolio, the prolonged period of falling and then historically low interest rates saw bond prices elevate and stay elevated. This meant that for many credit unions, the value of the investments they purchased elevated as well. During this period, it was common for a credit union to be able to buy a security and then months or a year later, see the value of the same security be more than what they paid. Unrealized gains were also common in credit union investment portfolios. Also during that time, callable bonds were likely to be called. This had a shortening effect for many credit union portfolios, and some became comfortable with having excess liquidity. If your credit union has employees who have not worked in the industry prior to 2008, they may have started to believe that the only thing interest rates do is go down and the only thing fixed-income securities do is appreciate in value.

After 1.25% of rate hikes since 2016, those dynamics for the credit union portfolio may have changed. Many credit union investment portfolios are likely now posting unrealized losses, and the rate at which callable bonds are being called has slowed or stopped completely.

Here are some helpful items to consider as you now navigate your investment portfolio in a rising rate environment.

Buy and Hold to Maturity This is an investment principle that is helpful to remember when the value of your portfolio has slid as interest rates have risen. Just as during times when interest rates are falling and there are unrealized gains in your portfolio, the same truth exists when interest rates are rising. In order to turn an unrealized gain or loss into a realized gain or loss, the investor must first sell the security. In individual fixed income securities, if you hold the security to maturity, you receive both your principal and interest back and both unrealized gains and losses remain just that… unrealized.³
Check the Price Twice After a prolonged investment environment like we have just experienced, it is easy to become complacent on the pricing of the securities that you buy. Here is a good example: For years (roughly 2012-2017), brokered certificates of deposit generally offered interest rates that were higher than U.S. Treasuries and agencies for the same term to maturity. In recent months, however, this is not true! U.S. Treasuries have been offering higher rates than certificates of deposit (particularly in maturities of 24 months or less).⁴ It is good investment practice to check fixed income security pricing before you buy with more than one broker, and keep in mind that the commission for various securities varies as well.
Yield Curve Flattening When short-term interest rates rise, and long-term interest rates don’t rise as much, the yield difference that an investor can earn by purchasing longer-term securities shrinks. Be aware of subtle differences between securities yield and maturity length. You can do this by being careful to consider a broad spectrum of maturity ranges for fixed-income securities. An example: Your credit union has a maximum of 36 months maturity in your investment policy. Many credit union portfolio managers become complacent and begin to just look at securities in a specific maturity range. It helps your understanding of the changes in interest rates to know what the investment yields are for 60 months securities (even if you can’t invest in them). Take a broad view. Know what yields are for varying maturities along the whole curve. It will help you to make more informed investment decisions.

In sum, when interest rates or other market conditions change, it can be a time to heighten your awareness of the pricing, timing, and attributes of various fixed-income securities. Consult with your investment advisor or broker and remember to ask lots of questions (even if you have known your investment advisor or broker for a long time… they are human and can become complacent too). Understand fully how your investment advisor or broker is paid. Compare and contrast various security types to stay informed. Review your investment policy often.

The information contained herein is not intended to be a source of advice or investment analysis with respect to the material presented, and the information and/or documents contained in this article do not constitute investment advice. Please consult with your investment advisor for questions related to your specific situation.

¹https://www.thebalance.com/fed-funds-rate-history-highs-lows-3306135
²https://www.cutimes.com/sbm-cut/2015/12/23/ncua-economist-urges-credit-unions-to-model-rising/?slreturn=20180202135447
³It is possible for the issuer of fixed-income securities to default. Receiving interest and principle at maturity depends on the issuer paying back the debt.
⁴Pricing for individual fixed-income securities varies with market conditions, commissions, fees, and individual brokers and issuers. Please consult with your investment advisor or broker for actual pricing comparisons and suitability for your portfolio.

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Jan 14 2021

Five Top Credit Union Topics For 2021

As we move into 2021, the following topics might be worth discussing and considering with your management team.

Earnings

During the first half of 2020, net interest margins came under substantial pressure as market interest rates were shocked dramatically downward. Net interest margins are expected to remain under downward pressure throughout 2021 as investment portfolios continue to reprice lower and share growth continues.

One of the easiest and quickest responses to declining interest income is to address the cost of funds. Many credit unions still have room to decrease their cost of funds, as shown in the September 2020 ending period graph below.

Source: NCUA

Delinquency

Based on the September 2020 call report data, loan delinquencies and net charge-offs remained low and were below September 2019 delinquencies. Loan forbearance and other assistance programs in place through the entirety of 2020 may have helped delinquencies. Also, certain sectors of the economy are not as impacted as others. The unemployment rate is expected to continue drifting lower in 2021. However, as the assistance programs are lifted, delinquencies and charge-offs are expected to increase as unemployment remains substantially above the years leading up to the pandemic.

Source: MHSI Online Peer Analysis Module through September 2020

Credit Union Philosophy

Serving the underserved has always been a hallmark of credit unions, and now more than ever, there is an opportunity to do this for many credit union members. As these times have been challenging, credit unions can continue to evaluate and prioritize how to best serve members in the coming year, especially those under financial stress. Exploring how to provide service to those that are underbanked might be an opportunity. One option may include evaluating risk-based lending policies and programs, especially given the robust liquidity on most credit union balance sheets. New and alternative avenues to bolster income should continue to be explored.

Digital and Technology

As the pandemic shifts and prolongs, credit unions should evaluate if their electronic delivery channels meet members and potential members’ needs. Moving to or improving digital delivery channels should be accelerated and prioritized. Digital delivery should include evaluating loan origination and servicing channels to maximize new loan volumes. Online and remote financial services will continue to grow and may be the preferred way members access and manage their financial activities.

Balance Sheet Growth

Before the pandemic, many experts anticipated credit union loan growth to taper off but remain positive. After the first quarter of 2021, loan production became unpredictable, however, by the end of the third quarter, annualized loan growth was 6.34%. Real estate lending, driven by the abruptly lower interest rate environment, helped with the growth. Experts anticipate loan growth to be around 6.0% to 6.5% over the next 12 months as the economy recovers.

The first few months of 2021 may see strong share growth as the second round of government assistance and stimulus takes hold, and households remain reluctant to spend until signs of COVID easing and warmer weather occur. Share growth last year increased at an annualized rate of over 18% and is expected to be approximately 8.0% to 10.0% in the coming year. If double-digit growth continues, earnings sufficient enough to sustain capital will be critical. If economic conditions improve and overall consumer activity increases, loan growth and increasing long-term interest rates could counter some of the anticipated income pressures. Fortunately, the credit union industry is very well capitalized and able to ride out the adverse conditions and absorb some more growth, even if earnings are reduced.

Nov 04 2020

The Bottom of the Frog Market

Several years back, I went to Mexico for a vacation. While there, I found a ceramic hand-painted frog-shaped planter that I wanted. My husband loves the hunt, and his quest began. Every time we saw a frog-planter, he would start negotiating with the vendor to get the lowest possible price. We searched for several days and would stop in different towns and check the markets while enjoying our vacation and exploring. When we found a frog, he would inquire about the price and negotiate for further discounts. After a few days and no success at getting the cost of the frog below a certain point, my husband declared, “we have hit the bottom of the frog market.”

…

The Bottom of the Frog MarketRead More »

Sep 30 2020

Economic Uncertainties and Interest Rate Certainties – Asset Allocation Assessments and Considerations

Future GDP Projections

In September, the Federal Reserve Chairman spoke publicly on several occasions and reiterated that the central bank is committed to helping the economy “for as long as it takes.” He noted continued improvements in the economy, but also acknowledged a highly uncertain path ahead. The September FOMC (Federal Open Market Committee) projections are now projecting a full-year GDP decline of 3.7%. This is substantially better than their previous expectation of a 6.5% decline. However, they lowered their 2021 outlook from 5.0% to 4.0% and their 2022 outlook from 3.5% to 3.0%. Their 2023 outlook is at 2.50%.

Interest Rates and Economic Uncertainties

The FOMC also indicated that they would allow inflation to run above 2.0% on a sustained basis before any federal funds rate increases. As such, most individual members of the Committee indicated that the federal funds rate could remain close to zero through 2023. Some economists and analysts even think that we may not see an increase in the federal funds rate until 2024 or 2025. They believe that it will take up to five years for the global economy to fully recover to pre-pandemic levels.

The risks to the FOMC economic growth projections are high. Even the Chairman of the FOMC acknowledged the economic uncertainty of the path ahead. Following the sharp rebound in many economic data measures and drop in the unemployment rate, some recent measures have disappointed compared to expectations and some are indicating a recovery that is stalling. At the current time of this article, the nature of further fiscal stimulus continues to be negotiated in congress and some are not expecting a resolution until after the presidential election. Of course this only adds to the current economic uncertainty.

What is highly certain over the short to medium term timeframe is that interest rates will not likely be increasing more than just relatively minor fluctuations in the medium to long end of the U.S. Treasury yield curve. It is more likely that potential risks on the horizon could drive medium and longer-term U.S. Treasury yields even lower.

Reassessing Balance Sheet Strategy

Given the above outlook, it would certainly seem that some credit union balance sheet strategies of recent years should be reevaluated for the foreseeable future. Reassessing asset allocation strategies is possibly more relevant at the current time than at any time in the past several years. For example, the credit union may want to ask itself how much should we be redeploying assets into two to three year investment CDs given current interest rates on those maturities. If the answer is less than previous years, then what are the alternatives we can explore.

Priorities Going Forward

In exploring alternatives, the first priority for credit unions is of course serving members. Assessments and considerations could include expanding the types of loans offered, reevaluating risk based lending allocations, increasing real estate concentrations, debt consolidation programs, and loan payment support alternatives to name just a few. Secondary to the first priority are considerations such as allocations to loan participations and alternative investments. For example, should the credit union assess CUSO or similar investment possibilities. What are all of the possibilities for these type of investments that may be available to the credit union? After all, an alternative of earning five basis points at the corporate credit union with too much of assets is not likely to accomplish any priorities or goals for the credit union.

The present time and foreseeable future is a great time for credit unions to really show how they can serve and support members during these challenging times. Being there for your members is for sure the highest purpose for the credit union and always assessing ways to provide service and assistance to them will always be the credit union’s first priority. In addition and secondarily, now more than any time in recent years it may make sense to really take a deep dive into the above asset allocation assessments, considerations, and possibilities. Ideally, the best answers going forward would combine the first priority with the second to optimize balance sheet performance while best serving members.