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Investment Strategy: Consider Income Volatility vs. Yield

Increase in loan-to-asset ratios along with the potential for higher market interest rates and tighter liquidity heighten the importance of the investment strategy and its role in supporting a credit union’s overall business strategy.

Understanding income volatility versus yield can be valuable in establishing investment strategy. Below we are illustrating the point using two investment strategies with similar yields while exploring volatility in various rate increases. This concept can also be applied to individual investments.

The illustration below complements concepts featured in the February 23rd blog, Don’t Just Focus on Interest Rate Risk – Yield Matters.

Again both investment strategies have essentially the same yield today. Additionally, they have very similar income volatility as a percent of yield in a +300 rate environment.

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At this point, when deciding between the two strategies the credit union would view the decision as a coin flip or slightly tilted to Investment Strategy #1.

But let’s not stop there. Every credit union has a unique appetite for risk and expectation for rates. Beyond evaluating risk in a +300, if a credit union is focused on a +100 bp increase in rates, then they would also want to evaluate the risk/return relationship in a +100 rate environment.

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Considering the risk/return trade-off is similar in a +300, but Investment Strategy #2 has less volatility if rates increase 100 basis points, the credit union would determine that Investment Strategy #2 is a better fit overall.

For many credit unions, looking beyond a +300 rate change is an important part of the risk management process, especially considering that a +400 rate environment today could be the +300 rate environment in the near future. Understanding risk and risk/return relationships beyond +300 is good practice.

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If the credit union is actively managing risk through +400, the risk/return relationship shows Investment Strategy #1 to be the best fit.

Creating a table that provides the risk/return relationships for a wide range of rate scenarios can provide better clarity in connecting the investment strategy with the credit union’s overall strategy and appetite for risk.

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Keep in mind there is no “right” answer. What is important is to help key stakeholders easily see the trade-offs.

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Interest Rate Risk Policy Limits: One Big Misconception

We initially published the blog below on January 28, 2016.  With interest rates having increased recently – and more increases seemingly on the horizon – we thought this a good topic to revisit as it has been coming up in model validations we complete.

We often see interest rate risk policy limits that rely too much on net interest income (NII) volatility and miss the absolute bottom-line exposure. Such reliance can cause boards and managements to unintentionally take on more risk than they intended.  Why?  Because these types of policy limits ignore strategy levers below the margin.

Establishing risk limits on only part of the financial structure is a common reason for why risks are not appropriately seen. Setting a risk limit focused on NII volatility does not consider the entire financial structure and can lead to unintended consequences.

For example, assume a credit union has a 12-month NII volatility risk limit of -30% in a +300 environment. The table below outlines their current situation and the margin and ROA they would be approving, as defined by policy, in a +300 bp rate shock.

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By definition, the credit union is still within policy from an NII perspective but because of the drop in NII, ROA has now decreased from a positive 0.50% to a negative 0.43%. This example helps demonstrate that stopping at the margin when defining risk limits can result in a false sense of security.

Not All 30% Declines are Created Equal

To punctuate the point, let’s apply the 30% volatility limit to credit unions over $1 billion in assets.

On average, if this group of credit unions experienced a 30% decline in NII in a +300 bp shock, the resulting ROA would be 3 bps.

But each credit union’s business model and strategy are unique. So instead of looking at the average for this group, let’s look at the potential range of outcomes.

 Based on NCUA data as of 3Q/2016, excluding one credit union that had an exceptionally negative ROA

It is important to note that 47% of all credit unions with assets over $1 billion would have a negative ROA within 12 months if this volatility were to occur.

This enormous range of ROA, and with so many credit unions at risk of negative earnings, helps demonstrate that an interest rate risk limit along these lines could result in material risk with the unintended consequence of institutions being potentially blinded to the exposure of losses.

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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.

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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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Too Much Loan Growth?

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Many credit unions have had the good problem of being so successful in lending that liquidity has become a challenge.  A blog we wrote in December 2016 identified 6 key questions that decision-makers should evaluate on the issue.  This post expands on that topic by looking at several possible liquidity solutions credit unions are considering as they deal with tightening liquidity, and what the A/LM implications of each scenario would be.

So how did we get here?  The average loan-to-share ratio for credit unions has increased by almost 12% over the last 4 years as loan growth has steadily outpaced deposit growth.  The average loan-to-share ratio now stands at almost 80%, while many individual credit unions have seen their loan-to-share ratio increase well above that level.

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As liquidity has tightened, some credit unions have turned to selling or participating out loans as a way to manage short-falls in funding.  However, many of those same credit unions are finding that selling or participating out loans at favorable terms has become increasingly difficult, and that trend could continue.  If the economy strengthens, financial institutions would likely see loan demand remain strong, which could further hamper an ability to sell loans.  Why would another credit union or bank buy loans from your institution, if they can originate loans on their own?

One solution could be to slow down loan growth by raising rates.  However, credit unions are initially reticent about this path if other viable alternatives are available due to fears about getting growth ramped up again, especially for institutions that do a lot of indirect or commercial loan business.

While there are important strategic and budgetary considerations that should be evaluated, the A/LM impact should not be forgotten.  Below are examples of liquidity funding scenarios that credit unions are testing with some frequency.  In each scenario, the credit union is adding $50M in auto loans, while evaluating 3 distinct funding strategies.  Additionally, in these scenarios the credit union has assumed it has the internal capacity to make these loans without the need for increased operating expenses.

Member CD Promo

For many credit unions, the first option to attract liquidity would be to get it from the credit unions’ members.  The first option (see Option 1) looks at the impact of solving the liquidity challenge through an aggressive CD promotion (1-year term at 1.4%).  A challenge with the member CD solution is the likelihood of cannibalizing lower cost deposits as members take advantage of the higher rate.  Additionally, funds acquired through CD promotions could be rate sensitive if opportunities develop for the member to obtain a higher yield.  Both of these risks were factored into the modeling.  The results show that adding autos and funding with short-term CDs (including transfers from lower-cost deposits) would negatively impact ROA today compared to the base case, as well as increase risks to earnings and net worth if rates rise.

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Intermediate-Term Borrowing

The credit union could also evaluate an intermediate-term borrowing strategy (Option 2).  While borrowing at a fixed rate for 3 years is more expensive than short-term borrowings, it can help reduce risks to earnings and net worth if rates rise.

If borrowings are utilized, there are other questions to consider.  For example:

  • What internal borrowing limits might your credit union have in place?
  • Are there any regulatory constraints on your planned borrowing strategy, and how much would you have remaining in available lines of credit in the event of a liquidity emergency?
  • Would your credit union plan to increase available lines of credit in the future? If so, the type of loans being added would matter.  For instance, consumer loans are not as readily collateralized as mortgages.          

Selling Investments

The final strategy (Option 3) looks at selling investments to fund the same $50M in loan growth and assumes the investments are sold at a 1% loss.  Setting aside the slight decrease in the net worth ratio, the results of this scenario look the most favorable with improvements in ROA and the risk measurements.  However, this solution could raise a different set of questions.  For example:

  • Are the investments that were sold being used as borrowing collateral?
  • If they were borrowing collateral, how would this impact future liquidity options and is it a sustainable strategy?
  • What kind of gain/loss would there actually be if investments were sold?

Whatever the solution, it is important to look beyond just the next couple of quarters.  If loan sales remain challenging or loan growth continues to outpace deposit growth, what is your credit union’s long-term liquidity management strategy?  Consider playing this out over the next 12 months, think through the tough strategic questions, consider the impact to your budget/forecast, and make sure you play out the results from an A/LM perspective.

Finally, if it is determined that there are limits to the amount of loans the credit union can book going forward, does the credit union have the tools that allow you to see the complete risk/return picture of your different asset categories to determine which have the most favorable risk/return trade-offs?  Armed with that information, your credit union could work to maximize the growth in the most favorable loan categories, while perhaps reducing emphasis on those categories that are less favorable.  Our clients have reporting that allows them to comprehensively evaluate the risk/return trade-offs of individual loan categories.  We wrote a c. notes on this topic in 2016.

 

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Derivatives – Another Option For Helping Mitigate Interest Rate Risk

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The Federal Reserve signaled their expectation to continue Fed Funds rate increases in 2017, but substantial uncertainty remains about when and where market rates will move.  Credit unions can find it challenging to achieve a desirable ROA today while maintaining an acceptable level of risk should market rates increase.  Decision-makers have a variety of options available for attacking interest rate risk challenges, and derivatives can be another useful arrow in the ALCO quiver.

Some of our clients are using or considering derivatives as a tool for mitigating interest rate risk.  While c. myers does not sell derivatives, we regularly model their impact on our clients’ financial structures to show the risk and reward trade-offs.

Derivatives can be thought of as purchasing insurance.  As an example, consider your purchase of an auto insurance policy.  You pay a premium to provide protection for your car from accidents, theft, etc.  The premium may be paid over the course of years.  If the car is never damaged or stolen, the insurance protection is never used or realized.  Overall of course, you’re probably happy that the insurance wasn’t needed.  Was the insurance valuable?  Was it worthwhile?

Derivatives operate similarly to protect against interest rate risk.  There are a variety of derivatives available to credit unions.  To illustrate some of the key attributes, let’s consider caps and swaps.

A cap is insurance purchased for a fixed price up front and provides protection for a specific time frame (the term) for market rates that go above a specific level (the strike rate).  Credit unions establish a notional balance, say $100 million, which never exchanges hands but is used like a principal balance for determining the interest payments.  If market rates increase to a point where they exceed the strike rate, the difference between the market rate and the strike rate is applied against the notional balance and paid to the credit union.  The cost of this insurance is largely determined based on the strike rate and term desired by the credit union, but again it is known and fixed up front.

Unlike a cap, an interest rate swap is not purchased for a fixed price.  In fact, there is no up-front cost for the swap.  Rather, two parties agree to pay each other different interest rates on a given notional amount for the term of the swap.  One party will pay a fixed rate, while the other will pay a variable rate based on an index such as LIBOR.  The idea is that as market rates increase, the variable rate could at some point exceed the fixed rate payment and offer protection to the fixed rate payer.  Consider the following interest rate swap example with a notional amount of $100 million, where the credit union pays a fixed 2.25% rate and receives
1-month LIBOR.

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In this example, for simplification, an instantaneous rate change was assumed.  However, the timing and direction of market rate changes will ultimately determine the resulting cost or benefit of the swap over its term.

Derivatives can be a valuable tool for credit unions to consider within their interest rate risk management strategy.  When deciding whether to use derivatives, it is important to understand both the expected interest rate risk protection, as well as the potential costs within a range of rate environments.  It also makes sense to ask how the protection may change over time and whether there are circumstances that might make the protection not as valuable.  For more detailed information about derivatives and understanding key considerations, please see our c. notes paper, Considering Derivatives?