C. Myblog

Callables and Low Rate Environments

August 3, 2012

Trying to get any kind of yield on investments is tough when rates are this low. Some credit unions are reaching for yield by purchasing longer-term callables with the justification that “we don’t have to worry much about the risk because they are going to get called.” But consider this, if rates move up even a little bit, most callable bonds will not get called, and the credit union could be stuck with material losses. The example table below demonstrates this potential risk.

The example assumes that a $1M 1/5 callable (callable in 1 year, final maturity in 5 years) is purchased today at 80bp. It shows that, compared to Overnights earning 25bp, this investment would yield an additional $6K in revenue over the course of 1 year, at which point it would be called. However, when you layer on industry-average cost of funds, operating expense and fee income, it reveals that from an ROA perspective this investment loses $19K in year 1. If rates go up at all, the bond will stick around for the full 5 years, and in a +300bp rate environment the bond would lose about $147K over its lifetime when the credit union cost of funds, operating expense and fee income are factored in. If rates returned to levels seen in 2007 (5%), this bond would lose $190K over its lifetime.

Note that for simplicity sake it is assumed that rates move immediately.

Some credit unions can afford to take this risk, some cannot. In any case, the decision to buy longer-term callables should NOT be based solely on the expectation that they will be called; the consequences of being wrong could have a very negative impact on a credit union’s risk profile and future earnings.

Comments
  • Gregg Stockdale

    True, if it was fixed rate. However, most that purchase callables, purchase the step-up type. Those usually have a 150BP to 200BP (until recently) start rate above the market. And, these can be had at a discount. So, call my bond, or don’t call my bond… it makes no difference to me. If it’s called, I reinvest above market… if it’s not called, my rate rises over time. I’ve seen end-rates above 10%…. It’s pretty hard to envision those bonds going to maturity. In fact, almost none do. They are not without some risk if the step-up slope resembles a handicap ramp, but overall they vastly outperform the rest of the market. You also run the danger of having all your bonds called until the market bottoms out and then having to work forward from the very lowest rate. A balanced portfolio with some fixed rate non-callable will help offset this risk (as long as your starting point for that strategy isn’t right now. This may not be the bottom, but you can see it from here!) —- I have some nice 5% for 5-year CD’s that will be on my books for more than one more year. My step-up’s at that rate have all been long called. The only danger that most miss with step-up’s is that they must be risk-rated to maturity. If you get that fact wrong, you’ll be in PCA in a heart-beat. NCUA has no wiggle room here, even though they admit the decision to risk-rate to maturity was a capricious and arbitrary one. I was told “We had to draw the line somewhere, and we set step-up’s as maturity.” No REAL reason given. Would you expect anything else from those that watched WesCorp implode in front of their very eyes while they did nothing? Sorry, that’s off the subject, but it’s consistent with the treatment given this investment instrument. Gregg

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