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5 investment strategies to consider based on the Fed’s decision

By Jeff Duesler, Senior Investment Services Representative

January 14, 2016 -- It was of little surprise that the Federal Open Market Committee (FOMC) raised the target overnight rate at their meeting this month. Individuals have been speculating on when the Fed might make a move since November 2014. There has been so much anticipation leading up to this point, it almost felt like Y2K all over again. Okay, so maybe not that much anticipation and preparedness, but everyone needed something to talk and opine about.

So now that the long-anticipated Fed move has finally happened, what’s next? Let’s start by discussing what we have seen so far and how the markets have reacted.

Examining the before and the after

The chart below shows the closing yields of the most commonly traded U.S. Treasury issues along the yield curve (also called the “on the run issues”) from Thursday, December 17 (the day after the change), Wednesday, December 16 (the day of the FOMC meeting), and Thursday, December 10 (one week prior to the rate change).

Maturity Yield 12-17 Yield 12-16 Yield 12-10
3 Month 0.218 0.248 0.238
6 Month 0.463 0.483 0.523
1 Year 0.658 0.673 0.678
2 Year 0.986 1.00 0.945
3 Year 1.32 1.34 1.26
5 Year 1.70 1.75 1.68
7 Year 2.03 2.11 2.02
10 Year 2.22 2.30 2.23
30 Year 2.93 3.00 2.97

As you can see, U.S. Treasury rates changed little after the FOMC rate hike. Most of the move was anticipated and “baked into the cake,” as far as the market is concerned. In fact, rates are slightly lower than they were prior to the meeting.

Anticipating 2016

Everyone likes a good game of predictions. So what about 2016? Let’s take a quick look at the following Bloomberg LIBOR futures screenshot from December 18.

Historically, 3-Month LIBOR Futures tend to be a good predictor of the overnight Fed Funds rate. Typically, the spread between the target Fed Funds overnight rate and 3-month LIBOR is 15 basis points. Line 13 above implies a rate of 1.17% for a 3-month LIBOR. Using this as a predictor based on past results, this futures market is predicting a 1% Fed Funds rate for this time next year.

If this is true, it will be either one, 50 basis-point move by the FOMC next year, or, more likely, two 25 basis-point moves.

Understanding what the Fed’s move means for your credit union

First, let’s remember that the Fed going from an “easy” to a neutral or tightening monetary policy means that overall the U.S. economy has improved and is showing signs of continuous development. The FOMC uses economic indicators such as employment numbers, inflation data, and growth expectations to measure the overall velocity of the improvements.

Right now the Fed is moving from a considerably long period of low interest rates to a period of neutralizing or “normalizing interest rates.” This language is important to note because it will allow the FOMC to take a “wait and see” approach. In other words, the FOMC will make changes to policy as needed. Interest rates have been so low for so long that no one wants a shock that might ripple negatively through the economy.

For example, the last time the Fed tightened rates was 2004-2006. During this period, the Fed used the term “measured pace.” According to an online Wall Street Journal article by John Hilsenrath on December 9, 2015, many officials believe that using this terminology forced the Fed down the path to regular, quarter point increases, something they want to avoid during this cycle.

Going forward, credit unions should consider a few things (although most credit unions follow these best practices regardless of interest rates).

  • Manage interest-rate risk through a thorough ALM policy, which includes aligning the investment policy and investment actions with the loan portfolio.
  • Consider your liquidity policy. Best practices include testing liquidity sources annually (at the very least) and testing issuing through SimpliCD (if taking in non-member deposits is part of the policy). If the expectation is that rates will be higher at this time next year, credit unions might want to consider locking in term financing now by taking advantage of Corporate One’s term- loan specials or issuing through SimpliCD at current rates rather than future, higher rates.

So what about the investment portfolio? How can your credit union benefit from changes in rates? Consider the following five things if you haven’t already.

5 investment strategies to consider based on the FOMC’s decision

1. Stay the course.

Sometimes interest-rate changes cause investment professionals to deviate from their original strategy to instead “chase rates.” 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, the net effect of higher or lower rates is cushioned by these reinvestment strategies.)

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 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 of 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.

In the past few years, we have seen some opportunities where treasury rates were better than what an investor could earn in a CD with the same term. We also saw several examples of treasury rates that were higher than U.S. Government Agency Bullet Securities. Speaking of term, the U.S. Treasury issues on a regular basis, therefore, when filling needs within an investment ladder, it is likely that a few different issues will be available for the month you are looking for, even if it is an odd term. For risk-based capital requirements, U.S. Treasury securities are zero-risk weighted and are good items to pledge when collateralizing a line of credit.

3. Select securities that benefit from rate changes.

Securities that benefit from rate changes are floating-rate securities that 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. Last month, yours truly put together a white paper all about this topic. Access it here.

4. Consider securities with call features, including step-ups.

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.

In order to have this option, the security purchaser is able to demand a higher rate. In an environment where interest rates are moving lower, call risk is magnified because bonds have a higher probability to be called. When rates move lower, investors are still paid for the optionality, but bonds are less likely to be called.

Step-up bonds have more optionality than fixed-rate, callable bonds because they have a call component and a rate component, meaning if the issuer decides not to pay the investor a higher rate (step the bond up), the issuer calls the bond, usually refinancing at a more economical rate.

Step-up bonds are good options if you expect rates to continue to rise, and you realize the rate you receive at the beginning of the bond’s term isn’t as high as a fixed-rate bond. Example: a five-year, fixed-rate callable bond with a 2.50% coupon rate versus a five-year step-up bond that has an initial coupon rate of 1.25% and steps up semi-annually to have a yield to maturity of 4.00%. In this example, the investor picks up the yield throughout the life of the bond (a yield to maturity 1.50% higher) but giving up 1.25% (the difference of the 2.50% and 1.25%) at the beginning of the bond’s full term.

The step-up bond is going to keep pace with higher rates and offer a good investment option in this environment.

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, the fact that these securities return principal regularly (amortize monthly), 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.

Helping out with your investment options

I know from the conversations those in our department have had with many of you that most credit unions have been preparing for this day for a long time, and this rate hike has come as no surprise. We wish to continue to be a trusted source for all of your liquidity and investment needs, including cash management. As usual, I and my colleagues are available to discuss the suggestions mentioned in this article, which have been condensed and are certainly not your only options.

On behalf of Corporate One’s investment department, have a wonderful start to 2016!