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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.
December 6, 2004
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