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The Fed raised rates again: Five investment strategies to consider

By: Bob Post, CIO

It was of little surprise that the Federal Open Market Committee (FOMC) raised the target overnight rate at their meeting this month. Market expectations revealed a solid 100% probability of this hike in the weeks leading up to it.

Read part one of this series in this month’s edition:

Reviewing the past, anticipating the future: An economic rundown

So what’s next?

First, let’s remember that the Fed’s action of 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.” As the economy approaches full employment and progress is made on inflation, reaching the Fed’s medium-term target of 2.0%, this will allow the Fed to continue gradual moves in the target rate. Managing your balance sheet during these times involves utilizing some best practices and considering various investment strategies.

Going forward, keep these following best practices in mind:

  • Manage interest-rate risk through a comprehensive ALM policy so as to effectively manage your net economic value in various interest-rate scenarios.
  • 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 your credit union’s 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?

Five strategies to consider based on the Fed’s decision

1. Stick with your current 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 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.

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, 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.

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. 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

We wish to continue to be a trusted source for all of your liquidity and investment needs, including cash management. As usual, our senior investment services representatives 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 2017!