Sponsored Content

The Truth Is, We Already Do Derivatives

Credit union investment officers have been purchasing callable agencies and mortgage-backed securities as part of their core investment portfolio for years.

The recent passing of legislation that allows credit unions to hedge their portfolio using derivatives has brought with it additional new rules and regulations with which credit unions must comply. In reality, though, credit unions have been using a form of derivatives for quite some time. Credit union investment officers have been purchasing callable agencies and mortgage-backed securities (MBS) as part of their core investment portfolio for years. In fact, at year-end 2013, agencies and MBS accounted for $192 billion of credit unions’ $1.05 trillion asset base that’s 18% of total assets.

Look more closely at a callable bond, and you’ll see you can break it down by its coupon, maturity, and call feature. When you purchase a callable bond, you are in fact buying an income stream for a fixed period and selling an option back to the issuer that allows it to take away that income stream. The call option is often referred to as an embedded option.

Compare And Contrast: A Hypothetical Example

You’re considering purchasing a recently priced, fairly common agency bond with a five-year maturity, non-call, one-year structure. We will call this Bond A. The issue comes with a 1.83% coupon, 3/5/2019 maturity, and isn’t callable for the first year. The bond is issued with a Bermudian call, which can only be called on the interest payment dates. This means you purchase the right to that coupon for one year and then sell an option back to the issuer that gives it the right to call the security. How do you begin to value that option? Is it worth it?

Bond B: This one-year, non-call agency bond has a .125% yield. If you look at this versus other one-year securities, it appears to offer a big pickup in yield that would result in a 1.7% yield advantage for the first year.

Bond C: This five-year, non-call agency bond has a 1.60% yield. This yield offers an approximate 10-basis-point pickup versus the U.S. Treasury five-year note at 1.50%. Is it worth the extra 23 basis points in yield 1.60% versus 1.83% to purchase the five-year callable bond instead of buying the non-call issue at 1.60%? To answer that, you must measure the uncertainty in the duration of the callable bond versus the certainty of the non-callable issue.

To Whom Do You Sell Your Options?

When looking at callable agencies and mortgage-backed securities, you must take into account to whom they are selling options. When you purchase a callable agency, you are selling your options to financing desks that are in the market everyday issuing securities. They will call securities for a small difference to lower their interest costs. They will also not call securities when they can’t lower their financing costs. When you purchase a mortgage-backed security, the option you sell is spread out over numerous mortgages that comprise a specific security. These pools are composed of individual homeowners that aren’t always efficient when refinancing. There are a number of factors that comprise the prepayment rate on MBS rate, loan-to-value, homeowner cash flow, future funding needs, and refinance costs all influence the call feature of MBS.

So when you look at selling options, the question to ask is: Who do you want to sell them to? If you’re not comfortable selling options to a financing desk that is actively going to make use of them and your credit union does not hold a large amount of 30-year mortgages, you might be better off purchasing mortgage-backed securities.

Along with senior management and the board, it is incumbent upon the credit union investment officer to have a clear understanding of the derivatives market. For a clearer understanding of the recent regulations, read Michael Emancipator’s article NCUA Final Rule On Permitted Use Of Derivatives available on www.trustcu.com.

When Is It Time To Turn To A Professional Manager?

In many credit unions, the investment manager function falls within the duties of the chief financial officer or the vice president of finance. As your credit union’s portfolio grows, this might be an area that needs more attention. Professionally managed investment options are one alternative to consider.

TRUST helps credit unions serve their members by providing a professionally managed family of mutual funds exclusive to credit unions as well as the information and analysis they need to support investment decisions. Created by leading credit unions with oversight by a board of trustees, TRUST’s mutual fund options keep credit unions always invested, are professionally managed, and are based on the cooperative values of credit unions. Today, credit unions have invested nearly $1.3 billion in TRUST’s three portfolios.

Find more information about TRUST’s three portfolios at www.trustcu.com.

The Trust for Credit Unions (TCU) is a family of institutional mutual funds offered exclusively to credit unions. Callahan Financial Services is a wholly owned subsidiary of Callahan Associates and is the distributor of the TCU mutual funds. Goldman Sachs Asset Management. L.P. is the investment adviser of the TCU mutual funds. To obtain a prospectus that contains detailed fund information including investment policies, risk considerations, charges and expenses, call Callahan Financial Services, Inc. at 800-CFS-5678. Please read the prospectus carefully.
This article is sponsored by a recognized solutions provider in the credit union industry. Callahan & Associates does not endorse vendors or the solutions they offer, and the views and opinions offered here might not reflect those of Callahan. If you are interested in contributing an article on CreditUnions.com, please contact the Callahan team at ads@creditunions.com or 1-800-446-7453.
March 10, 2014

Keep Reading

View all posts in:
More on:
Scroll to Top
Verified by MonsterInsights