Finding Relative Value Among Agency Step-Up Investments
By Charlie Watts
Sales and Marketing Manager
Credit unions essentially have four practical choices for investing their excess liquidity, other than loans. These include 1) cash, 2) corporate credit union certificates, 3) insured CDs issued by financial institutions, and 4) federal agency notes. In tough times like these, credit union managers are struggling to earn net interest income because cash rates are so low and depositing members are very rate sensitive. This situation has led many credit unions to explore investing in callable and step-up agency securities in order to get that extra boost in yield for their portfolios. As simple as callable and step-up investments appear on the surface, finding the best value among all of the choices can be difficult without using the right tools.
Embedded Options
There are many features within callable and step-up bonds called embedded options, which credit union managers must consider when making investment decisions. These include settlement period, lockout period, call frequency, step frequency, and coupon steps, among others. The difficulty that credit unions face is determining the value of these embedded options to ensure that you are paying the right price. Thankfully, there are some valuation techniques that are excellent tools for quantifying this relative value. These tools include Option Adjusted Spread (OAS) and Total Return Analysis (TRA).
Option Adjusted Spread
Option Adjusted Spread (OAS) analysis defines the average spread over a benchmark curve that is adjusted to reflect the effect of the embedded options in the bond. In other words, OAS tells you how much additional yield spread over a comparable bullet security that you are getting for the bond’s call and step-up features. OAS analysis is done by using Monte Carlo simulation which models repeated random samples to determine the most likely path of future interest rates. The statistically probable path is then used to determine the OAS.
However, this method also uncovers the biggest weakness of OAS: the statistically probable path may not be the one that is realized, and therefore the OAS would be inaccurate. Investors must also consider the term structure of OAS. Generally speaking, this means that the longer the term to maturity of the investment, the higher the OAS should be. OAS has proven to be a great tool in determining relative value among callable and step-up securities. The rule of thumb is, all else being equal, the higher the OAS, the better the price you are paying for that bond.
Total Return Analysis
Another excellent tool available to credit union investors for determining relative value among callable and step-up bonds is Total Return Analysis (TRA). TRA is very similar to the analysis that is used in determining Net Economic Value (NEV) for Asset Liability Management (ALM) reporting. TRA calculates the total return of an investment for a given period by discounting the cash flows received from future interest payments as well as the change in price from changes in interest rates. Just like in your ALM reporting, TRA can be run using +/- 300 basis point rate shock scenarios. TRA also compares the investment’s returns to a benchmark security, like a US Treasury, and considers interest rate volatility in the calculations. Credit unions can use TRA to not only compare different investments, but also estimate the effect of those new investments on their future ALM reports.
Agency callable and step-up bonds can be great additions to a credit union’s core cash and ladder portfolio. However, credit union managers must be careful when investing to make sure they are getting the right price for these investments. With all of the features and embedded options in agency callable and step-up bonds, investors need to use a better tool to determine value than just a comparison of coupons, yields, and Internal Rates of Return (IRRs). Using OAS and TRA can help you compare different agency bonds and make the best investment decisions for your credit union.
For more information, please access the recording of our webinar held on January 12 titled "Finding Relative Value among Agency Callables and Step-Ups". You can access this recorded session online from the Recorded Sessions section of our Online Learning Center.
Charlie Watts (CRD# 3125484)
a Registered Representative with
CU-Investment Solutions, Inc. (ISI)
All securities are offered through CU Investment Solutions, Inc. (ISI). The home office of ISI is located at 9701 Renner Blvd., Suite 350, Lenexa, KS 66219. ISI is registered with the Securities and Exchange Commission (SEC) as a broker-dealer under the Securities Exchange Act of 1934. ISI also is registered in the state of Kansas as an investment advisor. Member of FINRA and SIPC. All investments carry risk; please speak with your representative to gain a full understanding of said risks. Securities offered by ISI are not insured by the FDIC or NCUSIF and may lose value. All opinions, prices and yields are subject to change without notice.
