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Don’t Just Focus On Interest Rate Risk – Yield Matters

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While interest rates have been fluctuating over the last few months, some feel rates will consistently begin to move up based on indications from the Fed. But what if they don’t? As you discuss your earnings and interest rate risk, it is important to not just look at the risk. Credit unions should pull it all together and look at the overall risk/return trade-offs, because yield does matter.

Take, for example, the two assets shown below.  Mortgages are considered to carry a relatively high potential for interest rate risk, and for good reason.  Mortgages can increase a credit union’s interest rate risk. The column labeled “% NI impact vs Assets” displays the relative risk of each asset to the average risk of the institution.

The baseline in this report is 100%.  If an asset class shows more than 100%, it carries more interest rate risk than the average risk of the institution.  If an asset class shows less than 100%, it carries less interest rate risk than the average risk of the institution.

In this example, the 1st Mortgages have risk equal to about 160% of the credit union’s average risk, while the Callable Step Up has risk equal to about 120% of the credit union’s average risk.  For this credit union, then, 1st Mortgages have more relative interest rate risk than the Callable Step Up.

But understanding the risk is only a piece of the picture.  Yield relative to risk certainly does matter.

The last column – “Volatility % of Yield” – relates the risk of the asset to its yield:  the risk/return trade-off.  It is this last analysis that lets the credit union see that all risk is not created equal.

The interest rate risk of the Callable Step Up is about 197% of its yield, whereas 1st Mortgages have risk of about 77% of its yield.  The interpretation of this is that while the Callable Step Up carries relatively less risk for this credit union’s structure, the 1st Mortgages represent the better risk/return trade-off.

17-02-buz-blog-irr-yield-matters

The objective of this example is not to say that mortgages are always a better risk/return trade-off than Callable Step Ups or to suggest that credit unions should load up on mortgages.  The objective is that in areas where you feel your credit union may be able to take on more risk, why not understand where you are able to get the best risk/return trade-offs?  We wrote a c. notes on this topic in 2016.

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Investment Value

In previous posts we have discussed the increase in long-term rates and the potential impact to loan generation as rates rise. Due to long-term rates continuing to climb this week, we thought it would be beneficial to discuss one of the impacts to investments.

From Bloomberg the morning of 7/9:

One thing that has occurred in this low rate environment is that many institutions are reaching out longer with their investment portfolio to pick up more yield. Note that a 1-year investment yields less than many overnights. The longer investments bring more return, but also more risk. This trade-off is magnified as the upside of such a low-yielding long investment is minimal and it does not take a large increase to wipe out the return.

For example, a month ago an institution could have purchased a
5-year bullet with a yield expectation of 1.09%. A month later, as rates increased 39 basis points, the value of that same bond dropped almost 2%. In fact, a 5-year bullet yielding 1.09% can have a 1.09% loss in value after only a 23 basis point increase in rates.

While the intent of the investment purchases may not be to sell the investments in the future, understanding the potential change in value is beneficial, as the value can impact the flexibility an institution has to alter its structure. The recent increase in rates is a reminder of this, but is a small sample compared to some of the larger changes that history has shown us.

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Investment Decisions: Prepayment Assumptions Can Drive the Results

Yield tables provide a wealth of information to evaluate prospective investment purchases.  Take the example below.  The screen shows the coupon and the prices as well as possible prepayment speed, yield and average life depending on the rate environment.

Not unlike the IRR process, decision-makers should asses the reasonableness of the assumptions being presented in the table. The key assumption is the prepayment speed which affects the potential yield and average life of the investment.  Referring to the example, the assumed prepayment in the current rate environment is 460 PSA which causes the potential yield to be 0.825%.  You can observe that the prepayment speed over the life of this investment has been 610 PSA and has been increasing over the last 12 months (see historical prepayments box on the example).

Keep in mind the importance of the prepayment assumption when there are large premiums (as indicated by the 108-13 Price).  The calculated yield would be materially lower if any of the historic prepayment speeds were used.  For example, looking at the -100bp rate environment, the prepayment speed is 712 PSA which matches the 6-month experience of this investment.  The yield with the higher prepayment speed is now almost breakeven at 0.071% compared to the 0.825% with the 460 PSA.   The difference in yield is drastic and likely changes the decision a credit union would make.

The question is, why is a lower prepayment speed being used?  It could be an expectation that prepayments will slow in the future or it could be that the higher resulting yield makes the investment look more attractive.  Historical prepayment behavior may not be an accurate predictor of future prepayment behavior, so the prepayments could slow down.  However, using history is a reasonable starting point for understanding what the possible yield is.  From there, decision-makers should test a range of prepayment speeds in order to understand the yield impact and make sure they are comfortable with the possibilities.

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Investment Decisions

It is important for decision-makers to understand the impact assumptions can have on the risk-return trade-offs presented in investment proposals.  One of the key assumptions that can have a material impact on the decision information being presented is prepayment speeds.

Our focus in this blog is on investments with high yields and high premiums.

If the credit union pays more than the current face value for the investment, the additional payment is treated as an expense recognized over the life of the investment.  Of course, the life of the investment is not only influenced by contractual maturities but also by prepayments.

The upside of the type of investment is if prepayments are slow, the higher coupon can help generate additional revenue.  On the other hand, if prepayment speeds are faster than assumed, the investment will pay down faster than assumed—decreasing the investment yield by shortening the time the credit union has to recognize that premium.

In some instances, this may even create a situation in which the credit union has a negative yield, which is the result of earning less interest income over the life of the investment than what the credit union paid in premium.

When evaluating investments with high yields and high premiums, be sure to ask your investment advisor to explain the rationale of the prepayment assumptions being used and always insist on a stress test of the prepayment speeds, especially in the current rate environment.  Prepayment assumptions used for the current rate environment typically include average CPRs over the last 1-, 3- or 12-months which can be a fair starting point, but the analysis should not stop there.

It is also prudent to gain a better understanding of the underlying collateral.  For example, is the underlying collateral a pool of interest-only loans that are on the cusp of converting to principal and interest?  How might borrower behavior change when principal and interest payments are due?  Is it a pool of newly issued mortgages?  As these mortgages become more seasoned, how might prepayments change?  These are just a couple of examples of how prepayments in the future may be materially different than history.

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Callables and Low Rate Environments

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.