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5 Things Not To Do With Your Investment Strategy

May 12, 2016

1. Don’t manage investments in a silo.

Investments are an integral component of the business strategy. Investment strategy should be developed in light of a credit union’s unique financial structure and strategic objectives.

Understand how the whole financial structure works together. For example, if the lending portfolio includes a significant amount of long-term loans, investments can be purchased to offset interest rate risk while still contributing some yield. Conversely, a shorter or more variable rate loan portfolio might be complemented by some higher-yielding mortgage-backed securities (MBS) or fixed rate collateralized mortgage obligations (CMO).

Most importantly, ensure management and the board have a clear and holistic understanding of the investment strategy and how it fits with the financial structure and overall strategic objectives. Get agreement as a group on investment risk appetite, stick with it, and manage to it. Document the rationale for major decisions and review the strategy regularly.

Understanding the bigger picture can then make it easier for you to evaluate individual investment decisions. As you review investments with different structures and yields, the overall strategy objectives will provide clarity to the choices you make.

2. Don’t get yield envy.

Seeing credit unions with higher yields on investments can be frustrating and tempting. What if money is being left on the table? If your credit union could earn that same investment yield, how much would it boost the return on assets?

Buying those higher-yielding investments is a simple matter, as your broker will no doubt confirm. Remember, though, that with higher returns come higher risks. Do those investments fit your strategy?

It’s critical to understand the environments in which your investments are designed to help and those in which the investments can hurt. Every investment has a trade-off, and getting a clear picture of that trade-off is key. If you aren’t seeing a trade-off of risk somewhere, then something is missing.

Knowing your own investment strategy and how it supports the overall financial structure and Asset/Liability Management (A/LM) needs can guide you through such potential pitfalls.

3. Don’t assume a callable investment will be called.

We continue to see credit unions purchasing callable bonds with long final maturities. The yields can be attractive and, often, lead managers to believe the investment will be called “because the last 10 did.” Moreover, the unprecedented low interest rate environment of the last 8 years can seem to bolster that expectation.

But what happens if rates rise? Typically, people say they will sell the investment before rates become unfavorable and, therefore, they won’t be stuck with it. The only reliable way that this could happen is if the credit union could accurately forecast rates. A strategy assuming that you know what will happen in the market, before the market occurs, is fraught with danger and has burned many institutions.

Callables will NOT get called if rates rise. Make sure your credit union is evaluating the risk to final maturity if you consider investments with optionality like callables, or mortgage-related products. Buying long-maturity callables with the expectation that they will be called can be a risky strategy.

4. Don’t abdicate your investment decisions to any advisor.

Linking investment strategy to the credit union’s unique and changing financial structure is a role that credit union leaders are best equipped to play.

Working with trustworthy investment brokers can certainly help to identify effective investment alternatives. But, decision-makers should independently simulate the risk/return trade-offs to help ensure that the recommended investment strategy complements their entire financial structure and fits within their overall strategic objectives and future business needs.

Every investment strategy has risk/return trade-offs. If simulations show gain and no potential pain, it is highly likely that the strategy is too good to be true. Digging deeper as to why would be the essential next step.

5. Don’t ignore what your strategy might call for in the future.

Are loans growing significantly? Is the growth in autos or mortgages? What if economic conditions change? Is the credit union at risk to have deposits leave or migrate to higher- yielding options?

Consider the deposit growth shown for credit unions over $1 billion in assets. While the number of accounts has increased significantly since the last rate peak in 2007, the average balance per account has increased even more. What will those depositors do if rates begin to return toward those 2007 levels?

Business strategies and annual plans should inform the investment strategy. Liquidity should be considered. In addition, investment planning should incorporate effective A/LM to determine how the strategy could be expected to perform in a changing environment.

Investment decisions should contribute to and complement the credit union’s strategic objectives. Agree on how long you are willing to live with investment decisions if things don’t go as planned. What conditions would determine when it’s time to unwind investments before they result in unacceptable risk? It is up to decision-makers to understand how their investment strategy works not only today, but as the environment changes.

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