A ratio that helps credit unions measure and manageprofitability is net interest margin. For more than a decade, NIMfor credit unions has been under significant pressure. NIM isimpacted by a credit union's lending and investing strategies.While credit unions deserve an A+ for how well they have managedlending activities, industry data suggest there is room forimprovement in regard to investment management.

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Inside the Numbers

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U.S. credit unions hold assets worth $1.3 trillion, $386 billionof which is cash and investments. Nearly 80% of credit unioninvestments are allocated to either agencies or savings andloans/banks. The average yield on investments is 1.3%.

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With a significant concentration to but a few sectors of thefixed-income market and a pedestrian 1.3% average yield oninvestments, credit unions could strengthen NIM by improvinginvestment results. This can be accomplished in two ways: Byutilizing a broader range of securities in their investmentportfolios and actively managing those portfolios. The problem,however, is that as lending institutions, the majority of U.S.credit unions lack the necessary resources to fully engage andcommit to actively managing a diversified investment portfolio. Asa result, investment returns suffer.

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At worst, investment management is non-existent as many creditunions hold only cash and/or CDs as investments. Other times,investment management is one of several items listed on anexecutive's to-do list.

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If investment returns were improved by just 20 basis points,roughly $775 million of additional income would be produced for theindustry.

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While many factors drive investment returns, optimalrisk-adjusted returns can only be achieved through diversificationand skilled, active portfolio management.

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Diversification

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A primary means to achieving diversification in a fixed-incomeportfolio is through the purchase of different bond types. This isbecause different sectors of the fixed-income market behavedifferently with respect to interest rate changes and other marketforces. With roughly 80% of credit union investments allocated toagencies and banks, credit unions are not utilizing many of thePart 703 permissible investments that are available to them.

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U.S. Treasuries and Municipal Bonds

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Consider U.S. Treasuries, for example. Viewed as the least sexyof all investments, the primary advantage of U.S. Treasuries issafety. No other investment carries as strong a guarantee thatinterest and principal will be paid on time.

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U.S. Treasuries play vital roles in diversified portfolios. Theincome stream from U.S. Treasuries is predictable and dependable.The benefit of predictability is enhanced by the fact thatTreasuries do not have call provisions and carry a multitude ofmaturity schedules that can put the investor anywhere along theyield curve.

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U.S. Treasuries have performed well for several years on a totalreturn basis. Even so, Treasuries are hardly utilized by creditunions as only 6% of total credit union investments are allocatedto Treasuries.

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Another underutilized segment of the fixed-income market aremunicipal bonds. Municipal bonds are the debt obligations ofstates, their political subdivisions, and certain agencies andauthorities. At $3.7 trillion, the municipal bond market is twicethe size of the agency market and one of our nation's mostremarkable financial institutions.

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Like Treasuries, munis have performed well (year to date, ourclients have achieved total returns of 15% from investment grademunicipal bonds). Municipal bonds typically carry positiveconvexity which can help reduce interest rate risk (bonds withpositive convexity will have larger price increases due to adecline in interest rates than price declines due to an increase ininterest rates). Municipal bonds represent a compellingfixed-income option for credit unions, offering high quality andattractive yields, yet very few credit unions own them.

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Treasuries and municipal bonds are but two examples ofpermissible securities that are missing from most credit unionportfolios. Excluding these securities from investment portfoliosinhibits total return potential while limiting risk reductiontechniques.

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Skilled, Active Investment Management

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There are many reasons why U.S. Treasuries, municipal bonds andother Part 703 permissible investments are underutilized: Buying anagency is “easy,” brokers aren't typically calling with the “hot”new Treasury of the week, municipal bonds require thorough andextensive credit analysis, and actively managing a diversifiedportfolio of fixed-income investments is difficult and requirestremendous resources.

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How then, can credit unions better diversify investmentportfolios and reap the benefits associated with skilled activemanagement? For smaller to mid-sized credit unions the answer isclear. Consider outsourcing investment management duties to anexternal asset manager.

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Roughly 85% of U.S. corporations that invest in individualsecurities utilize external investment managers to manage theirportfolios to specific mandates and benchmarks, according to a 2014U.S. Corporate Benchmark Survey. Should credit unions be anydifferent? External asset managers play a crucial role in helpingorganizations execute specific investment mandates, achieve higheryields and gain more nuanced liquidity control. Credit unionsshould consider this approach as they are not only likely tocapture extra basis points by way of investment returns, but thehours saved each month by finance personnel would be priceless.

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investment managementMatthew Butler is founderand managing principal of Elite Capital Manageement Group, LLC. Hecan be reached at 203-699-9662 or [email protected].

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