Variable Rate Securities:

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.

 
 

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 adhered to:

  • 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

 

 

 

April 12, 2004


Comments

 
 
 
  • Very interesting topic, but article is too short and superficial. Didn't offer a more detailed explanation by e-mail, but should have.
    Anonymous
     
     
     
  • this is a test
    Anonymous