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
Bond Issued:
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July 2003
Issued: July 2003 Coupon:
1.50%
Coupon: 1.75% Maturity:
July 2006
Maturity: July 2006 Call:
October 2003, Quarterly Both bonds exhibit similar credit and liquidity risks. In addition to these risks, the callable bond contains an embedded call option. The embedded call feature presents a significant risk to the bond holder as the bond's maturity can be as little as three months, or as long as two years. The bullet bond, on the other hand, carries a fixed maturity and exhibits a predictable cash flow schedule. As you can see, the call feature is valuable because the issuing entity can call the security in favor of cheaper financing levels if interest rates fall. Conversely, if interest rates rise, the issuer can extend the bond to its final maturity date. The value of this option is represented in the additional 25 bps in coupon paid to the holder of the callable agency versus the agency bullet bond. This additional coupon is called the call premium. Callable bonds by themselves do have a place in a credit union's portfolio, provided that the credit union understands the risks involved. In a rising rate environment, some credit unions are surprised to see some of their callable assets extended to the next call date. Credit unions should recognize that callable assets shorten up when interest rates fall (call risk), and lengthen when interest rates rise (extension risk). Mortgage-backed securities exhibit similar characteristics to the callable bonds. Due to falling interest rates, many mortgages issued over the past three years were refinanced at least once, and many were refinanced multiple times. Heavy refinancing activity caused many bonds backed by mortgages to pay off early (call risk). Mortgage-backed securities exhibit significantly more call and extension risk than callable bonds, as homeowners can prepay in part or in whole whenever they want. This can cause mortgage-backed securities to fluctuate between expected durations of less than one year, to more than seven years. Investments that have a floating rate coupon can be an attractive alternative to fixed rate callable bonds or mortgages during periods of rising rates. With the market expecting a significant jump in short-term rates, and the FOMC giving every indication that it will provide the impetus for rising rates, floaters are very attractive right now. While the initial rate is higher on a fixed rate agency, it is not expected to keep up with a floating rate investment that tracks Fed Funds.
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