I’ll say it, because it needs to be said: bond yields have fallen to near historic lows, again. Until last summer, investors had seen steady rate increases from the Federal Open Market Committee (FOMC) that began at the end of 2016. That meant higher investment yields for credit union investors after eight years with near-zero rates following the 2008 Financial Crisis.
Fast forward to May 2020, and we find ourselves in the same near-zero rate environment. It wasn’t long ago that markets were moving in every direction at breakneck speed, setting unprecedented levels of volatility in the wake of the COVID-19 shutdown. Now, bond markets have stabilized, with most sectors trading within a reasonable, albeit near-zero, range for the last 30 days.
With businesses slowly reopening across the country, the hope is that ongoing economic consequences will be less severe. The FOMC has said they won’t consider raising rates again until the economic fallout from the pandemic is under control. Barring any further aberrant market events, the current rate environment will stand for the foreseeable future.
What does this mean for credit union investors?
Balance sheet strategy
The inverted yield curve of 2019 has passed, and yields are on a normal, upward-sloping curve again. With a normal yield curve, stick to whatever strategy best suits your credit union’s balance sheet. For more yield, ladder investors might consider supplementing their certificate of deposit (CD) and agency holdings with well-calculated credit risk purchases or with four to five-year mortgage-backed security (MBS) purchases for additional yield and monthly cash flow. Credit union MBS buyers typically work with 10-year or 15-year collateral, so you may want to consider expanding your maturity horizons to accommodate 20-year collateral for increased yield. On the short end of the curve, some well-seasoned collateralized mortgage obligations (CMOs) can offer attractive short-term yield and cash flow opportunities.
Mortgage-backed securities and collateralized mortgage obligations
Due to historically low rates, mortgage refinances are pushing, or exceeding, all-time highs. If you’re an MBS or CMO buyer, that means premium – or prepayment, risk – is also at a record high. Discounted prices are all but gone, so clean, safe mortgage collateral is an investor’s best bet for a secure return. Attributes like big loan counts, small loan sizes and bank servicing are ideal ways credit unions can reduce prepayment risk. However, those features are more expensive now, because prepayment risk is higher than ever. Better yielding options are available but paying a large premium for a higher yield with jumbo collateral and non-bank servicing could work against you in the long run, if current prepayment trends continue. As a result, credit union investors may consider picking up any bonds with clean collateral and +80 spreads to benchmarks, if available.
Risk spreads on public finance bonds have widened drastically over the last 60 days. The COVID-19 shutdowns are wreaking havoc on municipalities, which is creating a lot of uncertainty around the ability of debt issuers to pay their bills. In addition to recent political commentary surrounding the refusal to bail out “poorly run” states, Standard and Poor’s released a report on April 1 entitled, “All Public Finance Sector Outlooks Are Now Negative.” Credit unions may want to consider waiting on these types of purchases until more thorough data is available.
According to Brad Thomas, CFA, a credit analysis specialist with CU Investment Solutions LLC, “It is particularly difficult to evaluate credit stress on issuers. For those participating, we prefer bank notes [over taxable municipal bonds], as bank note issuers have liquidity support from the Fed, regulatory oversight and the ability to raise additional capital. Many municipal issuers do not benefit from these support factors, and for those under stress from pension obligations prior to the pandemic, that situation has only worsened.”
Agency bullet opportunities remain limited, so you may want to consider adding as many top-tier CD rates as possible. Agency bonds with call features have been a popular credit union buy lately, with Fed MBS purchases reducing value in that sector. Low rates have these agency bonds being called in the hundreds of billions on a monthly basis. As with MBS pools, focusing solely on the highest yield available could end up working against you if that yield comes with a short lockout and you’re reinvesting at a lower rate if it’s called.
Navigating this new market will undoubtedly present a multitude of unique challenges and uncertainties in the months to come. However, tactics such as evaluating your investment portfolio strategy beyond the yield curve and arming your organization with actionable insights are just a couple of ways credit unions can make informed decisions about the road ahead.
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All securities are offered through CU Investment Solutions, LLC. The home office is located at 8500 W 110th St, Suite 650, Overland Park, KS 66210. CU Investment Solutions, LLC registered with the Securities and Exchange Commission (SEC) as a broker-dealer under the Securities Exchange Act of 1934. CU Investment Solutions, LLC is registered in the state of Kansas as an investment advisor. Member of FINRA and SIPC. All investments carry risk; please speak with your representative to gain a full understanding of said risks. Securities offered are not insured by the FDIC or NCUSIF and may lose value. All opinions, prices and yields are subject to change without notice.