Income Or Safety? Choose Your Path

Credit unions must balance aggressiveness in their investment strategy against their appetite for risk.

 
 

At the 2013 Callahan & Associates' National Investment Forum, a statement was made: “You can have income or you can have preservation but you can’t have both. The market isn’t giving you income with safety. You have to choose.”

Statisticians describe two types of errors, Type I and Type II. Type I errors are when a negative event occurs and you did not prepare for it (e.g., interest rates rise and you did not shorten the portfolio’s duration). Type II errors, on the other hand, occur when you prepare for that negative event (“risk”) and it never occurs. An example is an institution that maintains a high cash balance fearing that rates will rise, yet they do not.

In portfolios, Type I errors manifest as higher unrealized losses resulting from the longer duration and rising interest rates. With a Type II error such as the high cash balance illustration, a credit union experiences lower interest income and earnings associated with the high cash balance and its low yield.

INVESTMENT PORTFOLIOS WITH HIGHER RETURNS HAVE LOWER CASH BALANCES
ALL U.S. CUs Ranked by Investment Performance Quartiles As Of Sept. 30, 2012
© Callahan & Associates | www.creditunions.com

investment-portfolios-high-returns

Generated by Callahan & Associates' Peer-to-Peer Software.

Since the end of November 2012, the yield of the 10-year Treasury has risen to 2% from 1.6%. For the 12 months ending January 2013, the U.S. economy has added on average 168,000 jobs per month.  Additionally, many credit unions are now seeing loan growth. These signs of “confidence” are not going unnoticed by ALCOs who are beginning to ask “so what should be sold when rates go up?”

The simple answer to ALCO’s question is that the securities with the longest duration in the portfolio should be sold as they will experience the greatest price decline as rates rise. 

For example, if a credit union had sold its $10 million position in 10-year Treasuries at the end of last November, it would have avoided a market value decline of $320,000 through the end of January. Stated another way, $10 million in 10-year Treasuries purchased at the end of November would now have an unrealized loss of $320,000 associated with the 40 basis point rise in rates. During this period, though, the yield of the 2-year Treasury rose just 1 basis point, which would have resulted in an unrealized loss of only $2,000.

A credit union that has decided to lengthen the duration of its portfolio going into 2013 in order to capture higher income has experienced a Type I error. It decided to take the interest rate risk associated with a longer duration in exchange for higher income. Specifically, a $10 million investment in the 10-year Treasury on November 30, yielding 1.6%, would have produced $160,000 in annual income compared to just $25,000 in the more conservative 2-year Treasury.

At its January meeting, the Federal Reserve recommitted to its bond purchase program and an objective of 6.5% unemployment. From the current 7.9% unemployment level, the economy will need to average 277,000 new jobs over the next 12 months in order to achieve the 6.5% target. Adding just 168,000 jobs per month over the next year will only cause the rate to decline to 7.4%.

The ALCO with a $10 million position in 10-year Treasuries now faces a dilemma. Should it accept the loss and sell the position in the belief that the economy is truly recovering and rates are headed higher from here? Or should it keep the position, realize the higher income and hold to the belief that, while the economy is stronger than a few years ago, it is not growing fast enough to bring the unemployment rate significantly lower over the next few years.

The credit union that accepts to realize the loss and sell the position is using the investment portfolio to manage risk and is willing to live with the results of a Type II error. In other words, they are willing to realize a small loss now in order to avoid the risk of a greater unrealized loss in the future but can accept that rates may not go higher.

On the other hand, the credit union that accepts to hold the position is using the investment portfolio as a “loan alternative” in order to supplement income.  They are willing to live with the results of a Type I error, including a greater unrealized loss in the future from their longer investment if rates continue to rise.

Which is the correct answer? Both, but it is up to the credit union to determine which one strategy is appropriate according to its own risk tolerance. In either case, the credit union must ask itself whether or not it can live with the results if it is wrong.  If it cannot, then, the alternative path is the appropriate one.

Jeff Greenert is Sr. Portfolio Manager for VyStar Credit Union. He can be reached at greenertJ@vystarcu.org.

 

 

 

Feb. 4, 2013


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