Owning fixed-rate bonds in a rising interest rate environment can be a hard
pill to swallow for a credit union’s ALM Committee. In a rapidly rising rate
environment the market value on fixed rate securities can depreciate pretty
quickly, and the bond markets are not a forgiving place for investors who find
themselves “long and wrong.” If these securities need to be sold prior to maturity
then from a total return standpoint the credit union will have to recognize
a loss in their financial statements.
Can variable rate securities provide any relief? Before that question can be
addressed the following rules governing prudent investment decisions must be
- Define and understand the attributes of the investment
- List the pros and cons, or risk and return
- Evaluate within the context of the existing portfolio and balance sheet
Each one of the rules requires different analytical techniques, and as the
complexity of the instruments expands so does the analysis required to assess
the instruments. For example, in variable rate securities you come across a
whole host of terms germane to this sector, like cap, floor and collar risk.
Not only is the terminology different from fixed-rate securities, from a valuation
standpoint these instruments are as assumption driven as any fixed-income product.
Since coupon cash flows are not fixed you have to make assumptions regarding
the level of interest rates in the future, and whether the coupon rate will
be competitive compared to current market yields.
Even within the variable rate sector there are different instruments that provide
varying degrees of performance. For instance a true floater has a coupon that
can change every day, based on an underlying index. A typical variable security
will change based on a predetermined schedule, and assume a new rate based on
an underlying index and some margin with limits placed on the adjustment (caps
and floors). While these may seem like subtle differences, in fact these two
instruments can react very differently to interest rate volatility.
To develop a better understanding of the market, you need the knowledge and
tools to analyze these instruments. Please join us for the upcoming
webinar April 14 at 2:00pm EST, Adjustable Rate Securities: Evaluating
Risk, Return and the Market. The speakers include Robert Rowe, Director,
Senior Portfolio Manager, Evergreen Investment Management Co., LLC, Emily Hollis,
CFA, President of ALM First Financial Advisors, LLC, and John Nilles, CFA, CFO
Retail Employees Credit Union. Click
here for more information