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Credit union investments have taken quite a ride over the past two years, and credit unions need to react, but how? First, a word about how we arrived at our current situation. Deflationary fears sent Treasury yields to 45-year lows during the summer of 2003.The bond rally came amid comments by Federal Open Market Committee (FOMC) officials that the committee may use “unconventional” measures to stave off the threat of deflation. The market interpreted these statements to mean that the Fed might implement monetary policy by purchasing longer-term bonds (e.g., 10-year notes) in addition to targeting overnight rates (Fed Funds). At the time, the remark precipitated a flurry of buying activity across the yield curve, and on June 25, 2003, a decision to cut the Fed Funds rate from 1.25% to 1.00% was announced. The accompanying policy statement indicated that economic risks were “balanced” and that risk to general price levels tilted toward deflation. Yields are on the rise for a variety of reasons. For one, the market perceives that the Fed will continue to raise the Fed Funds rate in 25 bps increments for the next several meetings. The consensus view is that Fed Funds will be in the 3.00% to 3.50% area by the end of 2005. Meanwhile, economic data continues to portend a strong economy. Gross Domestic Product (GDP) grew by 4.0% in the third quarter of 2004, and payrolls continue to increase in six-figure increments. Market dynamics are also contributing to the sell-off in bonds and the steady increases in interest rates. As the duration on mortgage-backed securities extends, market participants are forced to hedge their positions by selling Treasury securities. As rates steadily increase off the June 2003 lows, credit unions that invested heavily in callable assets are going to face significant extension risk on their mortgages and callable bonds. Mortgages will prepay at slower rates and callable bonds will not be called as interest rates rise. Credit unions that have, on average, invested in shorter-term investments for the last few years will be able to reinvest the proceeds at higher rates now. Callable assets contain certain characteristics that differentiate these instruments from bullet bonds of the same issuer. Credit unions should consider a bullet bond and callable bond issued by the same Government Sponsored Enterprise (Agency), an example is shown below: Agency Bullet

Agency Callable Bond

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