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.
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.