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Investment Strategies: Transitioning your portfolio in a low interest-rate environment

By Jeff Duesler, Senior Investment Services Representative

As the pandemic situation continues to disrupt the economy and interest rates remain low, credit unions continue to face unprecedented challenges regarding cash management and investments. Prior to the pandemic, and even during the long period of recovery after the financial crisis, investors were able (most of the time) to find better-than-market rates on custodial and brokered CDs. While this market is still available, the depth and availability of new issuers has deteriorated, making it very challenging to find competitive rates in the marketplace, especially in issues that aren’t widely held.

While this CD situation is good for institutions looking for liquidity, it is a challenge for those looking to place new funds or rollover maturities. Because of all the stimulus money on the table and the length of time it might take the economy to fully recover from the pandemic, we are likely looking at this low interest-rate environment for quite some time. Along with this is the likelihood that the demand for deposits, especially wholesale deposits, will also be tepid. Therefore, it might be necessary to make some changes in what instruments your credit union employs in the investment portfolio. Our investment department has recently seen credit unions pivot from primarily using CDs to choosing other assets, as well.

Today, I would like to focus on a few different security types* that might be right to make the transition in your portfolio during this low interest-rate environment.

Bullet Agency Securities

Bullet agency securities are U.S. government agency securities (issued by FNMA, FHLMC, FFCB, FAMCA, and FHLB) that have a fixed rate coupon and a stated maturity date. Because these securities are not callable, they fit perfectly into a laddered investment strategy. If it’s a five-year ladder and you add a five-year security, you don’t have to worry about replacing prior to maturity at a lower rate.

U.S. Treasury Securities

These securities are going to operate like bullet securities; only their yields are (usually) going to be lower based on being full faith and credit of the U.S. government and slightly more liquid. U.S. Treasury securities have unlimited market participants and very tight bid/offer spreads. One of the many benefits of investing in U.S. Treasury securities is the fact that there are many issues available (e.g. multiple maturity dates in multiple months to fit a ladder).

Callable Agency Securities

Like Bullet Agency Securities, Callable Agency Securities are U.S. government agency securities (issued by FNMA, FHLMC, FFCB, FAMCA, and FHLB) that have a fixed-rate coupon and a stated maturity date; they also can be called prior to maturity according to a set schedule. The period of time between the issuance date (original settle date) and the first call date is known as the lockout period. The set call schedule comes in three forms:

  • American: Callable any time after the lockout period (also referred to as “continuous call”)
  • Bermuda: Callable on specific dates following the lockout period (monthly, quarterly, semi-annually or annually). Also referred to by the nature of the call (e.g. quarterly)
  • European: Callable one time only on the stated date. (Also referred to as “1x call”)

Generally, the shorter the lockout period, the more the investor is compensated for taking on call risk. Along these lines, the investor is also compensated (in terms of yield) for giving the issuer more chances to call the bond. For example, one should expect a higher yield on American callable bonds vs European callable bonds.

Under “normal” market conditions, we’ve suggested callable agencies as a way to pick up yield in a rising rate environment, but under current conditions there might be room in your portfolio in this type of security if you understand and accept the risk that it could be called early and there is reinvestment risk. Remember, one of the goals of every credit union portfolio is to pick up additional yield over cash on excess liquidity and current conditions allow for investors to earn additional yield in callable securities.

Strategic advantages of these securities

Availability. We’ve found that some of our investors have been “log jammed” because of the downtick in available issuers in the CD market. Each of these security types have active market participants, and there are plenty of maturity dates and structures available that would fit into your investment strategy. New issue agency securities, especially callable issues, are underwritten almost daily by firms like Multi-Bank securities, which means there are plenty of choices.

Compatible with a laddered investment strategy. Because of the availability mentioned above, you can’t go wrong with a laddered strategy. U.S. Treasury securities and Bullet Agency securities work very well to employ this strategy, as well as fill in gaps in your current ladder structure.

Liquidity. While there is limited liquidity available in CDs because of the amount of market participants, including broker dealers in the marketplace, these security types offer liquidity to investors (meaning you likely will be able to find a “bid” in the marketplace for your security if selling prior to maturity). Bids are based on market conditions at the time. Out of the instruments discussed, U.S. Treasuries are the most liquid, followed by bullets and then callable securities.

Pledgeability. Most liquidity providers allow these securities to be pledged as collateral for lines of credit. Because they are zero-percent risk-weighted, U.S. Treasury securities would likely have a “low to no haircut,” while the other security types might differ, depending on the provider.

Not subject to FDIC insurance regulations on size of purchase. When you decide to purchase any of these securities, you’ve understood and accepted the risk within the security chosen. You are only limited in purchase size by what you are comfortable with, what your investment policy allows for, regulatory risk (usually addressed within the investment policy), and availability of the issue; you aren’t limited to purchase under the $250,000 threshold, which means less line items in the portfolio.

Disadvantages to consider

Call risk. While bullet agencies and U.S. Treasuries are not callable prior to maturity, callable bonds can be called prior to maturity. It is likely that the bond will be called if the economics make sense to the issuer. (Meaning, if the entity can issue a similar bond at a lower yield, they will do so.) This is akin to refinancing a mortgage or car loan for a consumer with an obvious lower cost to an issuer.

Loss of value. While these securities are all liquid, if rates go up during the holding period and you would need to liquidate, you could take a loss on the security. These securities are also given market prices on a regular basis that could fluctuate over time. Most credit unions are both buy and hold and are prepared to explain the fluctuations in these values (as they could very well increase in price over time, too).

Opportunity cost. All investments have an opportunity cost. Sitting in cash also represents a high degree of opportunity cost. The laddered strategy helps mitigate the risk involved in opportunity cost, especially as it relates to cash. Opportunity cost involves choosing an investment and giving up the opportunity to invest in something else that might be better in the future.

The following chart is for informational purposes and shows current market rates (not a firm set of offerings). The callable bonds have different structures/lockouts but represent a cross section of what is available in the marketplace. It is worth looking at these rates through the lens of what you are receiving in cash and or CDs. The 5-year below is 20 basis points over the bullets and 38 over treasuries, making taking on the call risk calculated.


Term

Callable

Bullet

Treasury

2.0 year

0.23%

0.20%

0.13%

2.5 year

0.31%

0.20%

0.15%

3.0 year

0.375%

0.28%

0.15%

3.5 year

0.40%

0.28%

0.18%

4.0 year

0.45%

0.31%

0.21%

5.0 year

0.65%

0.45%

0.27%


Next steps

All of the senior investment services representatives at Corporate One are willing to set up a virtual meeting to discuss your credit union’s current portfolio and strategy. We are also available for consultations/discussions and have educational materials available to assist you and your investment staff on the information in this article, as well as other investment options like CMOs and Mortgage-backed securities. If you would like to receive daily notifications of investment rates, securities rates, special structured offerings, SimpliCD certificates and more, I encourage you to visit this page to sign up. We look forward to helping you add value to your organization and, in turn, your membership, as you continue to be an essential part of the financial system.




*Note: All of these security types are currently permissible investments under the regulatory framework for most credit unions. As always, please consult your investment policy for your own situation. U.S. Treasuries are full faith and credit of the U.S. government. Government agencies have the implied guarantee of the federal government. FNMA and FHLMC have been conserved by the federal government since shortly after the housing crisis began.