A little history - The Federal Reserve last tightened monetary policy in June 2006. The fed funds rate was moved to 5.25% in the June 2006 FOMC meeting and there it remained until September 2007 when the storm clouds surrounding the housing crunch began to swirl. As various financial institutions imploded over the next couple of years, the Fed eventually lowered the fed funds rate to 0.00% to 0.25% in the December 2010 meeting. There it has remained to this day. Credit unions have been struggling with this low rate environment for going on 4 years now.
Recent developments - Recent talk of the Fed tapering off the most recent round of quantitative easing has stirred the market from its complacent slumber. Just the hint of less aggressive monetary support has already triggered a pop in interest rates along the yield curve. Since the release of the non-farm payroll news in early May, the subsequent debate among various Fed Presidents and Governors about not whether to taper off QE but when, and finally the comments from Chairman Bernanke at this Congressional testimony on May 22 at which he acknowledged that the Fed could start tapering off QE purchases as early as late summer 2013. Most analysts had been expecting QE purchases to continue at least into 2014.
The 2-year note yield has risen from 0.20% on May 2 to the 0.33% area today (an increase of +12 basis points). Over that same period the 5-year has jumped from 0.65% to the level of 1.14% (+50 basis points) and the 10-year has moved from 1.62% to 2.22% (+60 basis points). This abrupt yield adjustment is happening with only the discussion of tapering off! The Fed has not decided to actually do it.
Credit unions got a taste of what higher yields might do to their portfolios when the portfolio evaluations for Mayís results were recently analyzed. Rates have not moved sufficiently to wipe out all unrealized gains, but they have certainly made a dent in them. NEV extension risk is growing as MBS prepay assumptions slow and the likelihood of a particular callable agency actually getting called declines. True, interest rates have bounced a time or two these last 4 years but there was always the idea that they would ultimately go lower. That possibility is becoming less and less likely.
How might rates increase? - There are two ways rates can go up.
- The FOMC leads the charge by preemptively tightening to contain inflationary threats. This happened in 1994. The Fed raised the federal funds rate by +300 basis points in 12 months. The entire yield curve shifted in a parallel fashion.
- The Fed drags its feet on tightening and the bond market gets nervous. This was the pattern in 2003-2004. The Fed talked about slowing down their easing activity in June 2003. In fact that was the last fed funds cut, but the Fed didnít start tightening until June 2004. Bond yields didnít wait for the Fed to move and pushed higher even though the Fed did not actually move the fed funds until June 2004. Iím afraid that the future is going to look more like the 2003-2004 experience. Rates along the curve increase, but the rates at the front end of the curve donít move. As noted above, this is already underway.
Investing in a rising rate world - Letís dust off the notes on investing in a rising-rate environment. With a more positively-sloped yield curve, credit unions tend to do well. Deposits rates tend to lag as market rates increase but you are able to re-price loans and certainly can pick up yield on portfolio investments as rates increase in the longer end of the curve. Margins should increase. However, current investments suffer as higher yields push bond prices lower on what we have already purchased.
The investment decision can be summarized in the following way:
Analyze Operating Cash - As market rates rise before the fed funds rate rises, the cost of keeping too much cash in overnights becomes significant. Consider moving into the 6-month to 1-year part of the curve for yield pickup with limited duration risk. Corporate certificates can be a very useful tool in this step.
Manage Interest Rate Risk Ė Shorten portfolio duration, as you will be getting more interesting yields without having to chase longer-dated assets. Consider floaters rather than fixed coupon assets. Here the issue is that most floating rate assets have a coupon tied to a short rate, usually fed funds or LIBOR. If the Fed is slow to move rates, these coupons will lag the market and might not keep up with your need to increase your deposit rates. However, floaters will eventually adjust and this will cushion the price decline of the asset. Floaters are available in agency debenture form, floating-rate CMOs or Adjustable Mortgage Backed securities (ARMs). Floating rate agency debentures tend to be offered with short maturities and they have coupons that adjust off the very short rates, fed funds or LIBOR. If the Fed is slow to raise rates, the shorter maturity floaters might actually mature before you get the full value of the upwardly-floating coupon. CMO floaters adjust frequently but also carry extension risk as well as cap risk. If rates rise substantially, there is the risk that you hit the cap and no longer participate in further rate increases. Since CMO floaters are structured from regular 15 and 30-year mortgage collateral, you can also experience extension risk on your holdings as prepayments slow. ARMs also adjust but their periodic adjustments donít begin until after some fixed period of time and then are often limited to annual rate adjustments. There has not been a lot of recent production of ARMs because homeowners have been able to get extremely attractive fixed rate mortgages and donít want to take on a loan that may adjust upward from these record low rates. As rates rise and the curve steepens, we expect the production of ARMs to also grow.
Pay attention to extension risk in your MBS and CMO holdings. With rates having remained low over an extended period, credit unions have not been that worried about extension risk. The NCUA has certainly been focused on this in recent audits, but the threat of extension never seemed that imminent. I think we should be more worried about this now.
Dollar Cost Averaging Ė The temptation is to be frozen into inactivity as rates increase and bond losses grow. It is prudent to remember that nothing moves in a straight line. If you bought a 2-year bullet agency yesterday at 0.40% and today that same deal is offered at 0.50%, just keep on wading into the investment. Be grateful that each additional purchase only enhances your overall portfolio yield.
Derivative Hedging Ė The NCUA has recently approved the use of swaps to hedge portfolio extension risk. This really is about the only way to effectively hedge the movement in longer-term rates. However, the impediments to actually getting approval to begin hedging are many. You need a trusted advisor to assist you in this initiative.
TIPS Ė Treasury Inflation Protected Securities (TIPS) are bonds offered by the U.S. Treasury that have fixed maturities with coupons that rise (or fall) with the CPI. The actual yield you receive is a nominal coupon plus whatever the CPI happens to be at the reset period. Since the government issues the CPI data, there might be a temptation for the bean counters to show a lagging CPI in the future. Your coupon would underperform in that situation. Plus, you donít actually receive the inflation-adjusted coupon in dollars but rather in an increased par value of the bonds you own. This lack of cash flow might be an impediment to a credit union owning these bonds. Unless you are really bearish on inflation in the future, you might give these a miss even though they are a floating rate asset.
Summary - Credit unions have experienced an unprecedented period of low and stable interest rates these last three plus years. That environment is about to change; in fact, the change is probably already underway. Credit unions can do very well in this new era of rising rates, but they will have to re-think recent buy and hold strategies. SunCorp representatives are standing by to assist you in this process.
Director of Investment Sales
Jeff's comments and insights, based on his professional expertise and the knowledge he has acquired observing the U.S. economy and global markets, are offered as his own personal observations and opinions, and not necessarily reflective of those held by SunCorp, our board or member credit unions.