WASHINGTON – Credit unions trying to manage interest rate risk by limiting their investment portfolio exclusively to fixed rate securities could be following a "flawed strategy." According to Rick Wieczorek, executive vice president of Trust for Credit Unions, in a rising rate environment, the market value on fixed rate securities can depreciate quickly and the bond markets are not a forgiving place for investors who find themselves "long and wrong." Variable rate securities may offer some relief but only if a few rules are followed, Wieczorek said. "Understand the role the security will play in the context of the entire balance sheet," he said. "Identify the key attributes of the adjustable rate security (and identify) what market conditions typically exist when these securities offer the best value." Wieczorek emphasized that adjustable rate securities can also react to a rising rate environment similar to that of a fixed rate bond. "It is in the investor's best interest to perform simulations, or shock tests on them before adding them to your portfolio," he said. Callahan & Associates, Inc. and WesCorp hosted a Nov. 30 Webinar on using floating-rate investments to enhance and protect portfolio performance. The presenters were Mike Philbin, vice president and Jon Jeffreys, assistant vice president, both of Callahan Financial Services, Inc.; Bob Burrell, executive vice president/CIO and Dave Trinder, vice president, balance sheet management, both of WesCorp. The key question for credit unions centered on whether they are experiencing "interest-rate margin compression" with discussion on structure, terminology and payment conventions; selecting the right index; embedding options for higher yield; and evaluating potential performance. By the third quarter of this year, there was a shift in investment strategy, Philbin pointed out. The Cost of Funds ratio had gone from 1.57% in the second quarter to 1.43% in the third quarter. Likewise, the yield on investments dropped from 2.51% to 2.44% and the yield of loans had also decreased from 6.37% to 6% for the same period. All the data is culled from Callahan's First Look, which looked at third quarter data from 831 credit unions with $202 billion in assets. Floating rate instruments can offer protection against rising rates; provide matching against floating-rate and short-term liability repricing; help shorten the credit union's overall duration of assets; and allow investors to select securities that will meet their individual needs. The Federal Reserve Board has raised the Fed Fund rate four times since June, each at 25 basis points and its on average to increase again in June 2005 to 2.82%. Indeed, credit unions are shortening their investment portfolio in anticipation of higher rates. Still, credit unions need to consider the volatility of underlying indexes; reset dates; spread; how the security complements the existing portfolio and balance sheet; and if the security is backed by mortgages how will the underlying collateral behave in a rising rate environment. The presenters pointed out NCUA's Rule 703.14 on permissible investments, which allows a federal credit union to invest in a variable rate investment as long as the index is tied to domestic interest rates and not, for example, to foreign currencies, foreign interest rates, or domestic or foreign commodity prices, equity prices or inflation rates. -

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