Why Purchasing Premium Bonds Can Make Sense in a Rising Rate Environment

Interest rates on investments have risen substantially since the beginning of the year, particularly on maturities of five years or less. The two-year Treasury yield is up more than 70 basis points, and the five-year Treasury is up more than 50 basis points from year-end 2021 levels. Yields are increasing in response to high levels of inflation and expectations for multiple rate hikes from the Federal Open Market Committee in 2022.

The market has priced in six FOMC rate hikes of 25 basis points by the end of the year, with almost four projected by midyear. Although volatility is likely, expectations are for a continued increase in interest rates. Most credit unions will benefit from rising interest rates, but investing in a rising rate environment has its challenges.

What does this mean for your investment portfolio?

Bond values move inversely to interest rates. So as interest rates increase, bond values decrease. The existing holdings in your portfolio are likely to show unrealized losses. Keep in mind that these losses will remain unrealized unless you sell these investments. Another impact of rising interest rates on investment portfolios is the likely extension of average life on amortizing mortgage-backed investments, because fewer mortgages are being refinanced and prepayment speeds are slowing down.

One strategic choice credit unions can make to minimize the future impact of rising interest rates is to favor higher coupons and premium bonds when purchasing non-callable and non-amortizing investments.

A bond that trades above its par value is called a premium bond. A bond that trades below its par value is called a discount bond. If two bonds have the same maturity and the same credit risk, the bond with the higher coupon rate will trade at a higher price. If a bond is trading at a premium, it means the coupon rate of the bond is above current market interest rates. The fixed income market is efficient and will adjust the trading prices of two different bonds with two different coupon rates such that the return will be roughly the same when the bond matures.

If the return is the same at maturity, why would a credit union benefit from favoring premium bonds in a rising rate environment? Two reasons:

1. The higher coupon rate will carry a lower duration. This means the market value of premium bonds will be less sensitive to rising interest rates than discount bonds. Premium bonds are more defensive and will decline in value less than bonds with lower coupons.

   Lower Coupon Bonds     =     Higher Interest Rate Risk

   Higher Coupon Bonds       =     Lower Interest Rate Risk    

2. In a rising interest rate environment, higher coupons generate more cash flow over the life of the bond. A bond with a 4% coupon will pay more interest than a bond with a 2% coupon, even if the total return is roughly equal at maturity. If interest rates continue to rise, those higher streams of cash flow can be reinvested at higher rates and will generate greater compounded returns.

The strategy of buying premium bonds when interest rates are rising works well with agency bullets (noncallable bonds) and U.S. Treasury notes. A credit union should be more cautious when buying callable bonds and amortizing mortgage-backed securities (MBS) at significant premiums.

If a bond is called before maturity, the investor will have less time to earn interest to offset the premium price and the yield will be lower than if the investment went to maturity. Always look at the yield-to-worst case scenario when purchasing a callable bond. For MBS investments, prepayment speeds are generally slower when interest rates rise, but a credit union should still consider multiple scenarios when purchasing amortizing investments. Review both faster and slower prepayment speed scenarios before purchasing an MBS investment at significant premiums.

Credit union earnings margins should benefit from rising interest rates in 2022, but higher rates can create challenges in investment portfolios. Favoring higher coupons and premium noncallable bonds can help lower interest rate risk in the investment portfolio and will provide greater future cash flows to be reinvested as interest rates rise.

Catalyst Corporate’s Brokerage Team offers a wealth of knowledge and experience to help your credit union effectively manage its investment portfolio. For more information, contact us today.

As Manager of Brokerage Services, and a registered representative of CU Investment Solutions, LLC, Jonathan Jackson is responsible for leading the activities of Catalyst Corporate’s Brokerage Services division.

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.