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Focusing on Investment Process, Regardless of Interest Rates

BY ROBERT PERRY AND JASON HALEY

The current interest-rate environment presents challenges for credit unions. The Fed has continued to raise rates and while industry-wide financial performance has improved, net interest margins remain thin. Appropriately pricing deposits and loans while effectively managing the investment portfolio can be difficult, especially as many credit union CFOs wear multiple hats.

However, if your credit union has a well-thought-out investment philosophy along with a disciplined strategy and framework for making investment decisions, it becomes fairly independent of interest rate levels. This is why ALM First advises credit unions to focus on process, rather than simply considering various bonds and securities to add to their portfolios.

The Investment Process – Creating a Framework for Sound Portfolio Decision-Making

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A credit union’s investment portfolio serves an important role within the overall balance sheet management process and regardless of the portfolio’s objective (liquidity, income, etc.), the ultimate goal should be to maximize return per unit of risk taken. Generating reasonable risk-adjusted returns requires discipline and focus amid an ever-changing market, economic, and regulatory landscape. To that end, a credit union should have a well-defined investment process that involves much more than just looking at bonds.

 

A credit union’s investment portfolio serves an important role within the overall balance sheet management process and regardless of the portfolio’s objective (liquidity, income, etc.), the ultimate goal should be to maximize return per unit of risk taken. Generating reasonable risk-adjusted returns requires discipline and focus amid an ever-changing market, economic, and regulatory landscape. To that end, a credit union should have a well-defined investment process that involves much more than just looking at bonds.

Imagine managing a two- or three-year duration portfolio for 50 years – you’re making hundreds and hundreds of fairly routine decisions. This is what makes the decision-making framework or investment process much more important than any individual decision and that is the crux of this article. Institutional fixed-income portfolio management is best thought of as a “rinse and repeat” process, in which portfolio riskiness is increased when compensation for risk is high and vice-versa. For example, if yield spreads and expected returns on corporate bonds or mortgage-backed securities (MBS) are low, portfolio weights and exposure to these assets would also be low.

As spreads widen relative to U.S. Treasuries or interest-rate swap rates, exposure is increased. A data- and research-oriented framework, combined with sound trading-level analytical models, arm today’s successful fixed-income managers to address portfolio management in a very controlled manner. Individual security selection can be thought of as the raw materials for portfolio returns. And, as a best practice, consider relative value analysis using robust trading-level analysis in an option and credit-adjusted framework.

 

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