Posts

/by

5 Things Not To Do With Your Investment Strategy

, ,

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.

/by

Making “No” Decisions

One of the key characteristics of a high-functioning credit union is the ability to make “no” decisions in order to stay focused on the credit union’s strategic direction. As this year starts and the project list grows, it will be important to keep a laser-like focus on the projects that the management team has determined are the most important for achieving the credit union’s strategic objectives.

With 100% certainty, there will be many “shiny new objects” throughout the year that will be highly tempting or considered “must haves.” Before committing to those “shiny new objects,” it will be critical to take the time to filter them through the credit union’s strategic direction and objectives to see if or how they fit.

If they truly fit, then deliberately consider the timing of taking on more. Are these “shiny new objects” really top priorities or would the credit union be better served by delaying the start date so as not to distract from current strategic objectives?

Mastering the skill of strategically allocating resources is exceedingly important because technology innovations are happening at lightning speed. In the meantime, distractions will need to be put in the “no” or “not right now” column.

/by

Weighing Credit Union Investment Strategies

,

Given the flight to safety combined with sustained low loan demand, threats to non-interest income and NCUSIF assessments, many credit unions are reevaluating their investment strategy.

The problem is not enough credit unions are evaluating their investment strategy in light of their entire financial structure and strategic objectives.  They are evaluating one investment at a time. In other words, this investment seems to be a good deal today. But how long will it be a good deal?  And, if/when the decision needs to be unwound, what will be the viable options?  How does it fit with the credit union’s strategic objectives and financial structure?

Let’s take an example using callable bonds.  We are seeing credit unions purchase callable bonds with final maturities of 10 and 15 years.  The reasoning too often is, we need to do something, and they are going to be called anyway, so we may as well get the extra yield today.

Typically, people say they will sell it before rates become unfavorable, 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.

Some say that if rates go up they won’t need to sell low-yielding investments because loan demand will be so good, the yields on new loans will offset the risk of the lower-yielding investments.  This could happen.  However, it is important to keep in mind that rates can go up without economic recovery.

Stating the obvious, there is a tremendous amount of uncertainty—there always has been.  Yet decisions have to be made.  Just make sure your decision framework is sound.  Stick with the basics:

  • Make decisions in light of your entire financial structure.
  • Agree on how long you are willing to live with your decision if things don’t go as planned.  In the above example, answer:  are we willing to live with this decision for the next 10 or 15 years?  If not, how are we going to know it is time to unwind before it results in unacceptable risk for our credit union? This thought process should be followed when making any decision with potential long-term consequences.
  • Don’t assume that the future will be brighter or more forgiving than the present.  Isn’t that part of the mindset that got us here in the first place?
  • Document the rationale for major decisions.  Memories are short, so it’s important that key players remember why the decision was made in the first place.  Especially if the changes in the environment result in unfavorable financial performance.
  • Test drive your investment strategy before you implement it by using your A/LM model.  Don’t just look up +300 basis points either.  Remember, rates were 500 basis points higher just three years ago.  By rehearsing tomorrow today, you can understand the potential risk of what you are buying and can decide if that risk is worth today’s reward.
  • Agree on your appetite for risk for your entire enterprise, stick with it and manage to it.

This writing is not intended to say that callable bonds are bad, we are using them for example purposes only.  Our philosophy is that every decision has a trade-off; it is critical to understand the trade-off before implementing decisions.  It is up to decision makers to understand how each investment they purchase works not only today, but as the environment changes.  Decision makers must also understand how investments complement or compound issues in their entire financial structure and risk profile.