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Are Your Investment Policy Limits Working Against You?

January 11, 2021

By John Kirby, Investment Officer

Most financial managers understand that bond prices have an inverse relationship with interest rates. It’s the basic premise of interest rate risk, which credit unions generally prefer to avoid on their balance sheets. The record low-rate environment of the COVID-19 pandemic has shifted the focus of some portfolio managers, while others remain tied to pre-pandemic policy parameters. Unfortunately, those parameters may be working against your credit union’s long-term interests.

Are your investment policy limits working against you?Every credit union is different, but the easiest way to illustrate the point is by looking at a credit union’s policy limit on a mortgage security’s price sensitivity. A low price sensitivity (+/- 300 basis point scenarios) inherently advocates for the purchase of high-coupon securities, which are objectively the best way to avoid interest rate risk. Higher coupons, of course, have lower price volatility.

If your credit union’s loan demand is at or above pre-pandemic levels, there may be little cause for concern. However, if loan demand has tapered off, portfolio managers may face two near-term quandaries in the current rate environment.

The first quandary relates to supply. Fannie Mae and Freddie Mac are no longer printing coupons three percent and above on 10- and 15-year mortgage-backed securities (MBS) pools. The three percent coupon would typically show a + 300 basis point price sensitivity around -10 percent, but with that collateral no longer available on new production pools, your current and future available supply will be limited. Even 2.5 percent coupon MBS pools are hard to find, as borrowers who qualify for agency pools will typically have strong enough credit to warrant a lower rate. MBS supply is already limited due to the Federal Open Market Committee’s asset purchase program. The need to target higher coupons to comply with policy only exacerbates the issue.

The second quandary relates to prepayment speeds. If you bought mortgage securities or had mortgage loans on your balance sheet in 2020, you are already aware of the much faster prepayment speeds experienced during the year. The aforementioned limited supply in higher-coupon securities implies the future purchase of more seasoned, i.e., pre-pandemic, securities. With refinance levels near all-time monthly highs, those seasoned high coupons are likely to pay down much quicker, front-loading your P&I cash flows dramatically and inherently creating more reinvestment risk. Again, if your loan demand is at or above your pre-pandemic levels, you probably won’t mind. If not, you will have to reinvest those funds at current rates, which will exacerbate the reduction in interest earnings you’re probably already experiencing.

Conversely, a long-term trade-off quandary is interest rate risk. Hypothetically, if you were to adjust your policy limits to accommodate current market conditions – allowing for a wider selection of lower-coupon investment vehicles – you would only create future interest rate risk for your portfolio.

MBS coupons on 10- and 15-year collateral have started printing as low as one percent. That’s right. There are homeowners out there with 1.75 percent mortgage rates on a 10-year term. Unfortunately, the lower the coupon, the higher the price sensitivity in a + 300 basis point scenario.

The question becomes: Will a policy change to an existing price sensitivity target or maturity limit reduce your present prepayment risk in exchange for future interest rate risk? Investing is admittedly difficult enough right now with low rates and limited supply. Reviewing the long-term implications of a policy change may be worth considering, however, only if it will aid your interest earnings over time.

Catalyst Corporate’s team of seasoned investment professionals can help you review these considerations and develop an investment strategy that will benefit your credit union over the long run. For more information, contact us today.

All securities are offered through CU Investment Solutions, LLC. The home office is located at 8500 W 110th St, Suite 650, Overland Park, KS 66210. CU Investment Solutions, LLC registered with the Securities and Exchange Commission (SEC) as a broker-dealer under the Securities Exchange Act of 1934.  CU Investment Solutions, LLC is registered in the state of Kansas as an investment advisor. Member of FINRA and SIPC. All investments carry risk; please speak with your representative to gain a full understanding of said risks. Securities offered are not insured by the FDIC or NCUSIF and may lose value. All opinions, prices and yields are subject to change without notice.