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Examining Investment Decisions Based on the Yield Curve

November 30, 2020

By Casey Peterson, Catalyst Strategic Solutions, Senior Advisor 


The year 2020 has been like no other, and the financial services industry – like most – has felt its share of turmoil during the COVID-19 pandemic. Credit unions have endured a nationwide lockdown, modified branch activity and accelerated timelines for digital solutions and online banking. Member spending behavior has even changed significantly under pandemic restrictions. Over the last eight months, two major economic byproducts have also emerged: 1) deposit/share growth and 2) record low interest rates.

Throughout the second quarter, industry share growth was at an annualized rate of 25 percent, while loan growth was at five percent. The largest deposit increase was in cash and investments – which combined – represented a 70 percent annualized growth rate. Since the end of 2019, investment portfolio yields have dropped due to lower interest rates, making it challenging for credit unions to deploy their excess cash in the low rate environment.

As depicted in the investment alternatives chart below, the U.S. Treasury yield curve is hovering near all-time lows, yet there is still opportunity to find slope within the curve through select investment sectors. Mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs) offer from 35-60 basis points of additional yield above the Treasury curve. The added slope provides not only a mechanism to enhance return, but also additional value and protection against moderate rate increases.
Investment alternatives chart
Although interest rates have dropped, a few strategies can help you analyze your credit union’s investment options. Calculating your portfolio’s break-even point and assessing how much each security will “roll down” the yield curve are both simple, but valuable, exercises to better understand the value each security may offer.

For example, if we compare a five-year MBS with a yield of 1.05 percent to overnight cash earning 0.08 percent, the earnings potential of the MBS is 13 times greater in the first year. Staying in cash for one year versus purchasing a five-year average life MBS, the investor would give up 121 basis points, which would have to be recovered over the remaining investment horizon to break even.

The following table, known as a break-even analysis, further expands on this concept and compares three investment options over a five-year horizon. Comparing the five-year MBS with a yield of 1.05 percent to a three-year MBS yielding 0.65 percent, the curve suggests that the three-year MBS would need to yield 1.65 percent by year four – an increase of 100 basis points over the initial rate.
Break-even analysis chart
Historically, as employment and inflation rates started trending toward certain triggers, the Federal Reserve proactively adjusted rates higher or lower as needed. However, the FOMC recently released new guidance to provide further rate clarity in the current economic environment. The new guidelines allow the triggers to move significantly beyond their original values until a longer-term average is achieved.

What does this mean for credit unions? We can expect the overnight rate to remain low for an extended period – perhaps even years. The information gathered from a roll down analysis, along with this new guidance, should increase confidence in term and asset class analysis. 

From strategic planning to portfolio analysis, Catalyst Strategic Solutions’ team of experienced Advisors offers a wealth of knowledge to assist with your investment needs. For more information, contact us today.