The Benefits of Bank Notes

Posted: May 27, 2020 | Author: Mr. Zane Wilson

With Treasury yields at historical lows and fewer attractive investment alternatives, many credit unions may have high levels of cash on their balance sheet. And while investments with an embedded call option offer a higher yield, credit unions may also want to consider adding non-callable investments to their portfolio to help reduce call risk when market rates are low. An extended low interest rate environment can wreak havoc on portfolio returns and credit union return on assets (ROA). Weighing credit risk vs. yield with Bank Notes

Credit unions primarily use non-callable certificates of deposits (CDs) and government agency securities to add structure to their investment portfolio and reduce reinvestment risk or call risk. The term “structure” is used because these investments will not disappear or pay down faster when rates decline.

One underutilized investment option for credit unions looking to achieve that structure is bank notes. Bank notes offer a higher yield than CDs and non-callable government agency securities.

Greater risk, greater yield spread

Credit union-eligible bank notes are senior, unsecured obligations of U.S.-chartered state and national banks. Unlike most CDs, bank notes are not covered by federal deposit insurance, which means investors are exposed to the credit risk of the issuing bank. To compensate for assuming this credit risk, bank note investors are paid an incremental yield spread. As the perceived credit risk of the issuer increases, the yield spread grows.

Credit union bank note regulations

In March 2016, the National Credit Union Administration (NCUA) approved a rule change giving credit unions access to a larger pool of permissible bank note investments. As outlined under NCUA Regulation 703.14(f)(5), permissible bank notes must meet the following criteria: 1) The issuer must be a national or state bank, the accounts of which are insured by the FDIC; 2) The remaining maturity must not exceed five years, though the original maturity can be longer than five years; and 3) The bank note must be a senior obligation of the issuing bank and may not be a subordinate note.

Calculated risk assessment

Although bank notes include credit risk, investing for a term less than five years may help reduce some of that risk. Credit union CEOs and CFOs, familiar with financial institution balance sheets, can perform due diligence on a bank and look at a short holding period of less than five years to make a risk determination. CU Investment Solutions’ partnership with corporate bond research firm Gimme Credit offers exclusive third-party analytics on corporate debt. Credit unions can use these insights, along with other key credit metrics, to simplify the due diligence process prior to investing.

Ultimately, with bank notes, credit unions can earn a notably higher spread over Treasury yields versus CDs and non-callable agency securities. Currently, a two-year non-callable bank note issued by Truist Bank, and rated A by S&P, yields 73 basis points higher than the two-year Treasury, giving it a yield of 0.87 percent. A two-year non-callable government agency yields 0.26 percent. The bank note offers a significant pickup in yield for a two-year term. For more information on bank notes, and how they may fit into your investment strategy, contact Catalyst Corporate Brokerage Services at 800.405.7067.


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