Even with a recent spike in interest rates, the low-rate environment that has prevailed for the last several years is pushing credit unions to seek out ways to generate revenue. Not surprisingly, this setting has emboldened investment firms that offer "new" and "innovative" ways to glean profits from an investment portfolio, while eschewing more measured investment tactics that take an institution's entire balance sheet into consideration.
Whether they recommend repositioning to longer duration assets or taking on additional risk in a reach for yield, these investment strategies all have several things in common-while they may produce results in the short-term, they are generally one-dimensional, inflexible and largely dependent on a fluid economic forecast. Back in the day we referred to these strategies as being part of a "bond of the day" or "one bond fits all" approach.
Be Wary Of The Weary
Investors should be weary of these strategies today, just as they should have been then. They can be dangerous because they are generally a means for inventory distribution and ignore an institution's balance sheet. Longer more esoteric assets that would not normally be considered are suddenly being seen as acceptable because the math is compelling enough to help the bottom line. Although added yield will help generate earnings and eventually start to grow net worth, CUs need to consider if it is enough to offset a possible explosion in risk-based asset growth and credit risk. The higher yield is there for a reason, but is it enough to compensate for the overall risk being taken on? A well-informed and calculated investor would usually say no.
The investment portfolio for credit unions is only a piece of the puzzle, albeit a growing one. It is not necessarily there to become a surrogate to CU's core business. It is paramount to understand the impact a particular investment decision will have on the balance sheet. Every decision can have implications on other aspects of a CU's business model, and those implications can be different in various interest rate environments.
Tough Balancing Act
In today's market we are presented with a tremendous balancing act. Don't go out on the curve because rates may go up, versus staying short only to experience a continued drag on earnings.
To respond to such a dilemma, it is important to minimize holding cash for liquidity and emphasize the development of cash flow management strategies that will produce a reasonably predictable stream of liquidity that can be re-invested in the future or used to help fund loan origination and/or expenses. These incremental earnings can give an institution the advantage of flexibility in pricing their loans and deposits, and ultimately help it be more competitive in the market. The most viable approach in this regard involves re-focusing on the old fashioned ladder and/or the selective use of amortizing products with stable profiles.
The laddered approach is also beneficial because it takes market timing out of the equation. Waiting for rates to bottom out for an acceptable yield threshold to present itself can be an expensive plan of action, and ultimately it never works. Don't be afraid to selectively extend in duration with some portion of the portfolio-even in a low-rate environment. Duration risk is a very real risk, but it is just one of the many types of risk that can be managed.
Reaping The Benefits
Diversifying these risks and keeping them at acceptable levels is a key element of portfolio management. Adding exposure to quality, well-structured "bullet like" securities may not look as attractive as some alternatives, but they will reap the benefit of the yield pick-up available in longer maturities, and over time these bonds will "roll in" on the curve and make the shape of this very positive yield curve work for them.
Rolling down the yield curve simply means that an investor purchases a bond whose bullet maturity is near or at the top of the yield curve and holds that bond until it reaches a lower-yielding portion of a traditionally shaped yield curve. In doing so, the investor enjoys the relatively high yield of that bond versus the lower yields at the shorter end of the curve. Further, if done with short- to intermediate-term bonds, yield curve roll may provide protection against the risk of price decline should interests rates move higher. This is just one of the many strategies that could be used to infuse an investment portfolio with dynamics that work for an institution.
Successful portfolios are not necessarily the ones that generate the highest yield but are the ones that have the most impact on an overall business model.
Simply put, there is no "one plan fits all" approach that will work. Education can empower institutions to make appropriate decisions, step by step, without locking into any exclusivity of approach or relationship.
Michael Faughnan is managing director of fixed-income strategies at First Empire Securities. For info: 631-979-0097 or email@example.com.