A Primer in Credit Union Investment Risk
Credit union presidents and CFOs are typically expert at analyzing loans because most of them grew up on that side of the business. But what about your credit union’s investment portfolio? And do your credit union’s board members know the basics about managing risk in the investment portfolio?
Parking significant amounts of your investment portfolio in low-yielding overnight investments or CDs may miss out on the opportunity to benefit from higher yields with only a relatively moderate increase in risk. Understanding and managing the do’s and don’ts of risk in your credit union’s investment portfolio can boost its return, thereby increasing your credit union’s net worth and dividends for members.
The applicable federal law in this area can be found in the Code of Federal Regulations or “CFR” at 12 CFR Part 703. Section 703.3 governs credit union investment policies and, among other things, states that such policies must address how each credit union will manage four kinds of risk in its investment portfolio: interest rate risk, liquidity risk, credit risk and concentration risk.
Alas, the law does not define these terms. But fear not; plain English explanations are here to the rescue.
Interest rate risk. This refers to the potential loss that a credit union may have to take in selling a fixed income security before maturity at a price lower than the credit union paid for it. How can this happen? Well, the answer lies in thinking of a fixed income security as a see-saw with price on one end and market interest rates on the other; as interest rates in the market for newly issued securities increase, the price of a previously issued fixed income security typically falls.
Why? Because potential buyers of the bond you own that pays, let’s say 2%, can now buy other bonds for the same price, but the new bonds pay 2.5%. As a result, your bond is not worth as much as you paid for it, so if your credit union has to sell it for some reason (loan demand, deposit withdrawals, operations, etc.), you’ll likely take a haircut. Hence the term “interest rate risk.”
Liquidity risk. The risk that a credit union will not have the funds it needs to meet demands for cash. Liquidity is the ease with which a security can be sold at or near its value. If a credit union can sell securities at or near their purchase price and use the proceeds to satisfy loan demand, withdrawals, etc., its liquidity risk is low.
If, however, the credit union cannot sell the securities at or near their value to meet cash demands, its liquidity risk is high. The difference between the bid price and offered price as quoted by a broker is a measure of liquidity. But, if a credit union plans to hold a bond to maturity and has the financial wherewithal to do so (i.e., it can meet cash demands without having to sell the securities), liquidity risk is not a significant concern.
Read more: Credit and concentration ...
Credit risk. A bond is really an IOU in which the issuer promises to pay the buyer certain periodic interest payments until the bond matures and then pay back the entire purchase amount (principal) at a certain point in the future (maturity). Also known as “default risk,” credit risk simply refers to the possibility that the entity who issued the security (and who promised the buyer payments of interest and principal) will not make those payments on time or at all.
In other words, the credit union doesn’t get what it bargained for because the issuer doesn’t pay. It used to be that credit unions were one of the few institutional investors that were required to look beyond rating agencies like S&P and Moody’s when evaluating the creditworthiness of securities, but in the wake of the financial crisis, Dodd-Frank now requires banks to do the same.
Concentration risk. This is the degree to which the credit union has diversified its investment portfolio. A credit union that has invested a large percentage of its portfolio in a single kind of security from a single issuer, for example, is said to have high concentration risk because if the issuer or issuers default, a relatively high percentage of the investment portfolio will suffer.
By contrast, a credit union that has spread its investment portfolio dollars around a variety of security issuers and types has low concentration risk because the adverse effect will not be all the severe if a single issuer defaults as a result of the diversification of the portfolio.
Understanding, respecting and appreciating these risks is key to effectively managing your credit union’s investment portfolio because as Warren Buffet wrote, “Risk comes from not knowing what you're doing.”