Using the Investment Portfolio to Balance Risk

With short-term interest rates on the rise, credit unions should examine their current investment strategies. Read about what issues to address and alternatives to consider when revising strategic investment plans.




Short-term interest rates are clearly on the rise. Now is a good time to step back and take a look at your current investment strategy. For most credit unions, the investment portfolio plays a critical role in managing interest rate risk as well as putting excess funds to work. Very few credit unions, or banks and thrifts for that matter, can afford to manage their portfolio in isolation from the rest of the balance sheet. For some credit unions, the investment portfolio is also a very significant source of revenue.

With today's steep yield curve, we get paid handsomely to extend maturities. With increasing pressure on net interest margins there may be a temptation to take on too much interest-rate risk. The investment strategy and resulting portfolio structure should take into account the future prospects for member loan and share business and also provide a "safety valve" for relieving potential interest rate risk and liquidity pressures. In all cases the portfolio strategy needs to balance current income requirements against future performance. It is particularly easy today to enhance current revenues at the expense of future margins.

Investments As Part of the Balance Sheet Management Cycle
Figure 1 below shows that the investment strategy fits in with the overall balance sheet management process. The investment strategy follows the planning and analysis of the core businesses. Before we can develop the optimal investment strategy we also need to set targets and boundaries for both income and risk. Since everything starts with the strategic plan and most credit unions are just starting to formulate the business plan for 2005, now is the time to act.

Review Liquidity Requirements
The first thing to do is to review current and projected liquidity requirements to see what funds are needed to support projected loan growth and what will be excess to those needs. A multiple of historical outflows might provide a good benchmark. Peer group data might also help you identify what similar credit unions are doing in this area.

Cash balances have grown sharply in recent years in response to the rapid inflow of funds into regular share and money market accounts. Many credit unions have been particularly cautious about reinvesting these funds in the term market.

There are a number of alternative liquid investments to leaving excess balances in overnight accounts. Term floating rate certificates, that many corporates offer, might provide a reasonable pick-up in yield without taking on undue liquidity or interest rate risk. A pool of term floating-rate investments that could either be liquidated or pledged against temporary borrowings.

Both share and loan growth projections should be reviewed regularly so that any changes are factored into investment ongoing decisions. Credit unions should have some type of liquidity measurement system in place with some mechanism to surface any liquidity problems at an early stage. Credit unions should also have developed a contingency funding plan that will act as a roadmap for actions in the event of unforeseen liquidity problem.

Developing Goals and Objectives for the Portfolio
With the liquidity requirements clearly defined, we can turn our attention to the deployment of term funds. There is a finite amount of interest rate risk that an individual credit union will be comfortable with. That amount will be different for each credit union and will depend on the:

  • mix and volume of core member business
  • level of reserves
  • amount of credit risk in the loan portfolio
  • level of risk management expertise
  • unique culture of the board and staff

The first issue to address is to set boundaries and targets for risk in the investment portfolio. These will either be incorporated with overall balance sheet limits and goals or be laid out separately. Even if they are laid out separately, they must be complementary. Without clearly defined objectives, the portfolio strategy will lack direction and purpose, frustrating both staff and officials.

With those objectives clearly define, we can start developing the strategy that will optimize income and operate within acceptable risk parameters. Whatever, investment strategy you pursue, it is important that the portfolio has some core structure and stability. Figure 2 shows the core components of the portfolio:

Investing in a Rising Rate Environment
In today's environment, some thought needs to be given to stabilizing future earnings and the market value of the portfolio. With today's steep yield curve, we get paid handsomely today to extend maturities.

As rates rise and funding costs increase, future margins will be lower. An investment that carries a coupon which increases over time can help stabilize future earnings in a rising rate environment. Term floaters can provide protection against the effects of rising interest rate but will reduce current earnings.

Embedded period caps could provide higher yields in exchange for more volatility in market value. Step-up's have coupons that increase once or several times during their life. While these typically have embedded call features, it is possible to have your corporate structure a non-callable certificate that has a coupon rate that increase over time. This could help stabilize future earnings. Puttable investments are also available.

Putting the Plan into Action
There are a myriad of investment options open to us today. However, the investment process starts with balance sheet planning, goal setting and the development of a core strategy. Selecting individual investments is the last link in the chain and will only be successful if a proper foundation has been established.

When selecting individual investments, the most important consideration is to build a stable structure with diversified and predictable cashflows. There is no one investment that will perform optimally in all interest rate environments. Consequently, a mix of different structures will probably be required. Fixed term non-callable investments, term floaters, callables, step-ups, and amortizing investments might all find a home in your portfolio. We must balance our need for income against liquidity needs and interest rate risk within the framework of the entire balance sheet.

Given the wide range of investment alternatives available to credit unions, some expertise is required, along with a clear understanding of the potential risks under a wide range of interest-rate scenarios. WesCorp offers many educational resources for credit unions to become better-informed investors, including InsideRISK magazine, regular webcasts, numerous seminars and town hall meetings. In addition, the Credit Union Outlook 2005 conference will be held in Las Vegas Sept. 20- 22.

WesCorp also provides a wide range of consulting and hedging services, including the Financial Solutions Group, which focuses on asset/liability management. WesCorp offers a full suite of investment products ranging from overnight investments to long-term certificates that can be fixed or floating, callable, and/or amortizing. For those credit unions looking to invest in securities, WesCorp's wholly owned broker/dealer subsidiary, WesCorp Investment Services LLC, can help. WesCorp Investment Services LLC is the only credit union-owned underwriter of Agency securities.

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




Sept. 6, 2004



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