BY MARK WICKARD
The Problem: : Most CU’s do not differentiate between variable rate alternatives – specifically floating rate and adjustable rate – which leads to: 1) Lower / lagging investment income; and 2) Declining market value / increased devaluation in a rising rate environment.
In our last two articles, we focused on the negative effects of rising rates on both net interest margin (NIM) and the mistakes most CU’s make in investment portfolio strategy, thereby causing unintentional harm to their institution.
In this article, we will focus on solutions to those problems. Specifically, from the standpoint of how adding floating rate investments are not only preferable to fixed rate bonds, but also adjustable rate bonds.
Why Differentiate Between Floating Rate and Adjustable Rate Bonds?
For purposes of clarity and comprehension for this discussion, we distinguish variable rate investments into two distinct categories. The importance of this distinction and differentiation will not be lost on the reader when taking into context how the FED (FOMC) has steadily raised the FED Funds Rate 7 times (175 Basis Points) since December 2015.
Here are the 2 distinct categories of variable rate investments we make for purposes of educational clarity and portfolio strategy opportunity:
- Floating Rate Bonds: Floating Rate bonds have a frequent resetting coupon under one year. Thus, a frequently resetting coupon will react quickly and positively to rising rates from an income / earnings perspective. As will be explained, floating rate bonds which reset every 1-3 months are strategically beneficial.
- Adjustable Rate Bonds: Adjustable Rate Bonds have an infrequent or irregular resetting coupon. These coupons reset one year or greater. Thus, they are slow / late to react to a rising rate environment. Although “adjustable in name”, they fail to adequately respond to a CU’s need for rapidly increasing income to offset the squeeze on their NIM.