Floating Rate Investment Strategies Worth Considering

Are you correctly positioned for rising short-term interest rates? One positioning strategy is to divert some investments into term floating rate investments.

 

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The Federal Reserve Open Market Committee (FOMC) has raised the Target Fed Funds rate by 25 basis points at each of its last four meetings and the next meeting will soon be coming up on December 14. In less than six months, the Funds Rate has doubled to 2 percent and we are looking for continued tightening throughout 2005. Until recently, inflation had seemed to be well in check and not an immediate issue for the FOMC. However, the dramatic increase in oil prices combined with continuing strength in the consumer sector does pose some questions about the FOMC’s ability to maintain its “measured” course towards higher short-term rates. In his testimony to Congress last week, Chairman Greenspan responded to a question about the potential impact of rising rates by stating, “Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money.” While WesCorp’s own forecast still has short-term interest rates rising only100-125 basis points by year-end 2005, the risk is clearly that short-term rates might rise faster and reach higher levels than expected. This uncertainty raises some interesting balance sheet management issues.

So are you correctly positioned for rising short-term interest rates? The yield curve has been very steep for some time, anticipating tighter monetary policy ahead, and it was widely thought that intermediate and long-term interest rates would not have to increase too much above current levels. That may not be the case if short-term rates rise further than expected. Is the right strategy to keep booking long-term fixed-rate assets, or is it better to wait to see if intermediate and long-term rates spike up as expectations change? Typically, this type of move happens very quickly. Back in March of this year, the 5-year rate increased by over 90 basis points in less than 30-days as market sentiment suddenly turned around. While we may not have much control over member preferences and demand for fixed-rate loan products, we do have full control over our investment strategy. One strategy we could adopt would be to divert some of our investments into term floating rate investments (“Floaters”).

Floaters are term investments with maturities typically ranging from as short as 12-months out to five or ten years. Because the interest rate is not fixed and moves with changes in the level of market rates, the fair market value of Floaters typically exhibits less volatility than that of a similar term fixed-rate investment. While still subject to some market value volatility, the cost of liquidating these investments may be less onerous than liquidating fixed-rate investments. In addition, their collateral value for securing funding is also likely to be more stable than fixed-rate investments should rates continue to rise. The rate earned on these investments is the sum of a market index plus a spread, which is usually fixed for the life of the investment. Investors in Floaters earn an enhanced spread over that available on short-term investments in the form of a liquidity premium. Consequently, spreads tend to increase with the original term of the investment. Common market indexes include the Daily Federal Funds Effective Rate, 1-month, 3-month (the most popular) and 6-month LIBOR rates, 90-day Treasury Bill auction yields, Federal Reserve Bank Constant Maturity Treasury (CMT) indexes from their H15 report and the 11th District FHLB Cost of Funds Index. The relationship of one index to another changes over time and the differential will also vary for different maturities.

The four key issues to look at when investing in Floaters are:
1) the underlying benchmark index
2) when the index resets
3) the lookback or date(s) at which the index is captured
4) the term or maturity of the investment

Resets, indices and lookbacks can be set up in any combination to meet almost any need or desired risk profile. For example, we could set up a Floater that reset on the first day of each month based on the daily average Fed Funds Effective Rate for the prior month. This Floater would match up very well against WesCorp’s “Market Daily” share account and adjust very quickly. If we chose a Floater that reset quarterly and was indexed to 90-day Treasury Bills then the coupon would adjust much more slowly and lag short-term interest rate hikes. While the second Floater would be less attractive as rates rise it might be preferred in a period of declining interest rates. Normally, short-term resets are based on short-term indices. If we set up a one-month reset on the ten-year CMT Index we would introduce a high degree of rate sensitivity to the shape of the yield curve. This type of Floater might look very attractive when the yield curve is steep but would dramatically under perform as the yield curve flattened. So far this year, short-term rates have risen by 100 – 125 basis points while 10-year rates have risen only 7 basis points. So be very careful about using long-term indices based on intermediate and long-term interest rates. Maturities can be set up as bullet maturities, scheduled to amortize on a pre-determined schedule, amortize according to changes in a pre-defined index, or include call provisions. Once again, almost any cash flow profile can be set up.

As with all investments, there are pros and cons to investing in Floaters. First of all, you will most probably give up yield initially as you move back down the yield curve. If you are looking at a straight trade-off between a Floater and a fixed-rate investment then you should run a number of different scenarios to see which investment provides the best combination of interest income and price stability. Term-floaters adjust with the market, so if interest rates start to fall, the yield will decline. This may not be a bad thing if the cost of funding these assets is also sensitive to changes in market rates. However, if the yield curve is correct or underestimates future rate levels, the Floater will benefit over a fixed-rate investment over the life of the transaction. Overall, term-floaters may provide a sensible solution for credit unions looking to participate in a higher-earning investment as rates move up, generally with very limited market-value issues. In addition, moving part of your excess funds out of overnight accounts into Floaters might be a simple way to enhance investment returns. However, some analysis of potential short-term liquidity needs should be done before making this move. Floaters can also be structured to provide hedges against interest rate-sensitive assets. WesCorp offers a range of standardized Floaters and can customize a Floater to meet your exact needs.

If you would like to learn more about WesCorp’s investment products and services, please call (800) 442-4366, ext. 6307, or visit www.wescorp.org.

 

Dec. 6, 2004


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