Optimize Investment Portfolio to Support Balance Sheet

cu360 - Bob Lindner, CUNA Mutual Group
July 31, 2006

The rising rate environment and shrinking interest margins should prompt credit unions to understand how these trends are affecting the overall risk profile of their balance sheets. Now is a good time to revisit your ALM modeling assumptions and consider current and future rate environments.

This analysis may prompt changes in your investment portfolio to support interest rate risk mitigation on your balance sheet. Rising rates have had a significant impact on the market value of loans, investments, prepayments, and other embedded options.

Credit unions should review their current investment strategies and allocations to ensure they make sense in the context of their balance sheet risk profile. Structure your investment portfolio to optimize investment income, considering various risk factors of your balance sheet.

Ask and answer these questions:

• What is our exposure to mortgage loans or mortgage-backed securities?
• Are we in a position to take on additional credit risk to improve investment performance?
• What investment sectors should be under- or over-weighted based on relative value analysis?

ALM Considerations

ALM models provide much of the data and information needed to complete the analysis. Reviewing net income simulations (what happens to net income under multiple interest rate environments) and net economic value analysis (volatility of assets, liabilities, and capital) is important. The focus here will be on how net economic value and duration analysis (price sensitivity) provide information you need to optimize your investment portfolio.

Optimization considers maximizing investment yields given constraints (risks, investment allocations, and policy limits). Collect data that provides insight into investment security prepayment speeds, sector analysis, spread differentials, relative value, and detailed security analyses. Ideal sources for this type of information include corporate credit unions and registered investment advisers.

Let's assume the underlying assumptions for the ALM output in Figure I are sound. The net economic value ( NEV) (post-shock capital ratio) declines from 12.35% in the flat rate environment to 9.32% in the +300 basis point (bp) environment--well above the credit union's policy limit of 7%. Focusing on a rate shock of +300bp, the duration of investments extends modestly to 0.64 from 0.55 in the flat environment.

An analysis of the effective duration of both loans and shares (in combination with the knowledge of each portfolio's mix) indicates that this credit union could extend the duration of its investment portfolio while staying within the policy limits established by the board. At this point, the credit union could consider moving out on the curve (this may not make sense in today's flat yield curve environment with a spread of 12bp between a two-year treasury note and a 10-year treasury bond) to pick up additional spread offered by the increase in interest rate risk.

The investment strategies should be modeled to fully understand the impact on the overall risk profile of your balance sheet. Relative value analysis would support decisions around which sectors to overweight or underweight. Detailed security analyses would indicate which securities are ideal for the portfolio, given the simulation. Rigorous pre- and post-trade analysis will ensure effective decisions are made and that the portfolio is being optimized.

Investment Strategies

Credit unions can consider several approaches to optimize their portfolios. Liquidity and cash flow needs should be key considerations in the overall strategy. Targeting specific durations for the investment portfolio in the context of your balance sheet can mitigate risk. Targeting durations with benchmarks for both quality and yield considerations is prudent. When managing durations to your credit union's target levels, consider optionality, such as that found in callable securities and changing prepayments on mortgage-backed securities. Optionality can shorten or lengthen portfolio durations substantially.

Bond swaps offer another opportunity to shorten or extend duration targets on the asset side (assuming this is your desired goal). Bond swapping is defined as swapping out of a longer-term duration investment into a shorter duration investment or vice versa. Be sure to consider the gain/loss of the security to be sold. Is taking a loss an acceptable consequence for achieving your target duration? Model the scenario and see the overall impact.

Informed Decisions

A diligent review of your ALM assumptions and output will help you make investment-portfolio decisions that make sense given your balance-sheet risk. NEV reports will indicate where your optimal target duration might exist. And investment portfolio analytics will support decisions on best security selection to optimize the portfolio. If you need access to tools or expertise, consider working with investment professionals at a corporate credit union or a registered investment adviser to perform the analysis and structure your portfolio.

Bob Lindner is the director of CU Financial Products for CUNA Mutual Group. Contact him at robert.lindner@cunamutual.com or 800-356-2644 ext. 8158. This article was published online by CU360 at http://cu360.cuna.org. Reprinted with permission.