By John Kirby, Investment Officer
Many credit unions that had previously only purchased certificates of deposit (CDs) for their investment portfolio made the move to bonds the last 18 months for yield and supply advantages. Investors have been clamoring for trade ideas to get out of their low-paying cash positions and maintain earnings. With new investments comes more optionality and, by proxy, more sophisticated investment strategies.
You may already be familiar with the purchase process for a bond, but what about afterwards? What tips and tricks will maintain your portfolio’s performance over time?
Start by borrowing some retail investing terms you may recognize from financial advisors: diversification, reinvestment, evaluation of risk, asset allocation and monitoring the portfolio. Want an easy-to-remember acronym? Try “DREAM.”
Diversification serves two purposes. First, it reduces risk by not putting all your eggs in one basket. Second, it can improve performance through exposure to higher yielding sectors.
Hypothetically, if a credit union’s investment portfolio is allocated with 25 percent CDs, 25 percent agency bonds, 25 percent mortgage-backed security (MBS) pools and 25 percent collateralized mortgage obligations (CMOs), you’ll receive the yield and monthly cash flow advantages of amortizing bonds, while maintaining the cash flow stability and structure of CDs and agency bonds, with reduced optionality. Conversely, if you build a portfolio entirely out of CDs or agency bonds, you’ll miss out on the strong yield opportunities, but your portfolio will likely be very predictable in terms of cash flows.
Reinvestment boils down to minimizing your cash position. We all know cash positions haven’t paid much the last 18 months and it’s reflecting in reduced credit union earnings in many cases. Every dollar that stays in cash unnecessarily is a dollar that’s not maximizing earning potential.
If you haven’t already, consider tracking your cash position closely for a couple months. If you find your average daily balance leaves extra room to work, consider what type of liquidity position you’d like to maintain, and reinvest the rest!
Evaluating risk probably falls within most credit union job descriptions, but there are quite a few risks to manage in your investment portfolio. With amortizing bonds, you must make sure you’re not taking on too much prepayment or extension risk. In a low-rate environment such as this, reinvestment risk is a concern. When rates are rising, you have to consider interest rate risk. On the other hand, for credit union investors, credit risk may not apply, so identify the risks you’re taking on with a particular investment choice and how they could eventually reflect on the balance sheet.
For retail investors, asset allocation means the mix of stocks and bonds in their portfolio. For credit unions, it relates more to the balance sheet overall.
Here’s a simple illustration of the concept: If your credit union has 100 percent of its loan portfolio in auto loans, with an average life of two to three years, does it make sense to keep your investment portfolio within that same timeframe? Depending on your liquidity needs, it might. More likely, you have a significant portion of your assets rolling over every two to three years. From an interest rate risk perspective, you’ve probably got some wiggle room in your investment portfolio to add some duration and yield.
The counterexample would be a credit union that only makes 30-year fixed rate mortgages. Here, it would make much more sense to maintain a short-term ladder, since the average lives on those mortgage notes will probably be north of five years. Take this same concept and try applying it to perceived weak points on your balance sheet.
Monitoring the portfolio on a quarterly basis, at least, can help alert you to concentration issues, which might point you to diversification or asset allocation. You might also uncover maturities or paydowns you previously missed, in which case reinvestment would make sense. And lastly, you might notice heavy prepayments in your MBS holdings, indicating increased risk, that warrant making changes to future purchases.
Catalyst Corporate’s Brokerage Team offers a wealth of knowledge and experience to help your credit union effectively manage its investment portfolio through a host of varying economic environments. To find out how they can help you plan for today, and tomorrow, contact us for more information.
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.