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Six investment strategies to consider right now with rates expected to rise

By: Jeff Duesler, Senior Investment Services Representative

As the FOMC continues to normalize interest rates and the global economy picks up steam, overall interest rates are expected to keep rising. It is likely your credit union, your board, and your asset and liability management group have all prepared for this. This is the first in a series of articles that will speak to investments and investing when interest rates are trending upward. Let’s focus on some general suggestions to consider this month:

1. Stick with your current investment strategy.

Sometimes interest-rate changes cause investment professionals to deviate from their original strategy and “chase rates” instead. An example of this would be abandoning the laddered strategy originally designed to protect the portfolio from fluctuations in interest rates. (With a ladder, you are always reinvesting matured, principal amounts at current rates; therefore, these investment strategies cushion the net effect of higher or lower rates.)

Please note that this isn’t a recommendation to shorten or lengthen the average maturity of the investment ladder. That decision would be made based on how much interest rate risk your credit union can handle, and this article’s discussion is based on taking a holistic view of the balance sheet and using the investment portfolio to supplement the lending portfolio.

2. Look toward actively traded markets like the U.S. Treasury market.

During the period of historically low rates, bank and credit union CDs have offered tremendous value versus U.S. Treasuries and Government Agencies with similar risk profiles. These CDs are still available, and, depending on portfolio size and make up, they may still offer the most value. However, for portfolios flush with the top-tier names or taxed with too many line items, another place to look at filling buckets in your ladder would be the U.S. Treasury market.

The U.S. Treasury market is the most liquid of all the sectors of the fixed-income markets. When we say this market is liquid, it means that treasuries trade constantly throughout the day with plenty of market participants. The price differences between where the securities are bought (bid) and sold (offered) are very close; you might have heard this referred to as a tight bid-offer spread. This simply means when you purchase a treasury, you are investing at current market rates at the time of purchase. Because of this, while the Fed’s overnight target rate sets short-term rates, treasuries will set all other rates available in the marketplace.

3. Select securities that benefit from rate changes.

Securities that benefit from rate changes are floating-rate securities and include SBA securities, hybrid adjustable rate mortgage pools (ARMs), floating-rate CMOs, and floating-rate agency debt. All of these securities are tied to an index that will change when interest rates change. This usually allows the security’s rate to move higher when overall interest rates move higher, which means the security benefits from these rate changes.

4. Consider securities with call features in both the primary and secondary markets.

Callable securities should trade with higher rates than securities without calls (bullet securities) because the issuing entity is able to call the security back, according to a set schedule prior to maturity. Issuers will call a security when it is economically profitable to do so. Did you know that in addition to a robust new issue market, there are plenty of bonds available in the secondary market that might fit your cash flow needs. Please do not ignore these securities just because they have a discount or a premium.

5. Consider securities that amortize (pay principal and interest back monthly).

Mortgage-backed securities issued by GNMA, FNMA, and FHLMC are securities that amortize. During periods of rising interest rates, prepayments on mortgage collateral will slow down due to the lack of economic benefit for the borrower(s) to refinance at lower rates. The mortgage-backed securities market, especially the mortgage pass-through market, is transparent in pricing and is a very liquid market, especially when investing in large pools.

In addition, that these securities return principal regularly (amortize monthly), which means the investor can reinvest this principal at current rates, including term investments and rates earned in overnight money market funds. Keep in mind that it is important to consider and be comfortable with the extension risk associated with each offering.

6. Find securities that mimic bullet structures, but have higher yields and/or amortize.

I previously wrote a detailed description of deep-discounted callable securities, but for now, allow me to summarize. These securities are callable, but since their coupon rates are below prevailing market rates they sell at a discount and are unlikely to be called. Because the call still exists, the yield to maturity on these bonds is higher than that of bullet securities with similar maturities. Commercial mortgage backed securities that are guaranteed by the agencies like FNMA, DUS bonds, and Freddie Mac K securities, mimic bullet securities by the nature of their structures. In many cases, they will pay out both principal and interest monthly.

Want to learn more about your investment options?

Check out our Credit Union Investments on-demand webinar library. Each webinar reviews the benefits and risks of investing in specific securities. Or just give me or one of our other senior investments services representatives a call at 800/366-2677. We’ll be happy to answer any questions you may have.