This article is provided by ALM First Financial Advisors, LLC, the investment advisor for Trust for Credit Unions.
With the fixed-income market pricing for multiple rate cuts in 2019, some of the credit union investors we speak with each day express a need for specific investments or strategies that perform well in a falling rate environment. While this question may make sense on the surface, your credit union’s overall investment process is what’s most critical in this — or any — interest rate environment.
Focus on the Process
In our experience working directly with several hundred financial institution clients and managing the Trust for Credit Unions portfolios, investment managers are better served managing interest rate risk at the balance sheet level rather than through individual investment decisions. If, for example, model results show falling rates having a more detrimental impact on an institution’s value than desired, increasing overall asset duration and/or purchasing instruments such as interest rate floors are two ways to mitigate the interest rate risk associated with said scenario. Doing so would more effectively align the duration mismatch between assets and liabilities if so desired.
Although the outlook may change regarding the direction of rates, ALM First’s investment process remains constant. A well-thought-out investment philosophy and disciplined investment strategy can assist your credit union in creating a thorough portfolio. By creating a sound strategy and framework, investment decisions become independent of interest rate levels. That’s why we advise all of our credit union clients to focus on process, rather than simply considering individual investment options in the context of our outlook for rates.
The investment portfolio serves an important role within a credit union’s overall balance sheet management process. Regardless of the portfolio’s specific objective (liquidity, income, etc.), the ultimate goal should be to maximize return per unit of risk taken.
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Investment managers may make hundreds of fairly routine decisions over the years. That’s why it is so important for a credit union to have a well-defined investment process and decision-making framework to help ensure the portfolio generates reasonable risk-adjusted returns. Institutional fixed-income portfolio management is best thought of as a “rinse and repeat” process, in which portfolio riskiness is increased when compensation for risk is high and vice versa.
For example, if yield spreads and expected returns on corporate bonds or mortgage-backed securities (MBS) are low, portfolio weights and exposure to these assets would also be low. As spreads widen relative to U.S. Treasuries or interest-rate swap rates, exposure is increased.
A successful fixed-income manager should be armed with both sound trading-level analytical models and a data- and research-oriented framework to address portfolio management in a controlled manner. Individual security selection can be thought of as the raw materials for portfolio returns. As a best practice, managers should also consider relative value analysis using robust trading-level analysis in an option and credit-adjusted framework.
If you don’t have the resources internally to analyze specific trades, you may want to consider an advisory partner or utilize credit union specific investment options like the Trust for Credit Unions.
Exhibit 1 displays a portfolio management process that begins with an assessment of the overall balance-sheet risk profile. In particular, the securities portfolio should be managed within an asset liability management framework, which accounts for the balance sheet’s existing relationship between the asset and liability risk profiles. Arguably most important is interest rate risk; managing the duration of the portfolio such that the duration of equity is either mitigated or targeted appropriately is very important. However, other considerations, such as liquidity risk, credit risk, and earnings needs, also come into play. Credit union investors don’t manage their investment portfolios in a vacuum, and the portfolio duration target should be developed in such a framework. Once portfolio objectives are established, it’s important to ensure the guidelines/policy allow for successful implementation of the strategy. If they aren’t aligned, the depository’s portfolio manager is limited in his/her ability to deliver long-term performance goals.
From here, top-down market themes lead the way through the investment process. Top-down themes communicate the current assessment of various market metrics and risk factors, which drive sector allocation decisions. Security selection, risk budgeting, and risk measurement bring us to the finish, with ex-post performance evaluation.
Actively managed fixed-income portfolios are at some stage of this feedback loop at all times. For example, we might see monthly top-down themes, combined with daily security selection, weekly risk analysis, and monthly performance reporting. Duration targeting and interest rate risk management take the guesswork off the table.
NOTE: There’s no discussion here on the direction of rates or when the Fed is going to move. Interest-rate forecasts, rate bets, and trades that are explicitly positioned for a specific interest-rate change have no place in this process and often can cause portfolio managers to rue the day. Instead, portfolio performance comes from good, old-fashioned risk measurement and management, as well as sector and security selection.
Know Your Outsourcing Options
A growing number of credit unions are turning to experienced external advisors, both for expert guidance and to outsource specialized functions like investment and balance sheet advisory. An institutional asset manager can provide the tools and resources (both systems and human capital) needed to build and maintain high-performing bond portfolios at a fraction of what it may cost to attain those resources internally.
Credit union specific investment options, such as the Trust for Credit Unions, may also be worth your consideration. The TCU Ultra-Short Duration and Short Duration Portfolios were designed for and by credit unions and offer target durations ranging from three months to two years to help match your institution’s liquidity and cash flow needs. Below is recent performance data for both funds as of July 15, 2019.
TCU Ultra-Short Duration Portfolio
TCU Short Duration Portfolio
* The yields reflect the 30-day effective yield (net of fees and expenses) as of July 15, 2019.
For questions please call the TCU Group at 1-800-237-5678 or email firstname.lastname@example.org.
When seeking outside counsel on investing, credit unions must understand how that advisor is compensated (e.g., fee-based or commission), and performance must be measured relative to the stated portfolio objectives. That said, a thoughtful and disciplined investment process should lead to more consistent and predictable earnings from the fixed-income portfolio.
Read more from ALM First about the latest economic data releases and overall market trends at Trustcu.com.