Taper talk: How to protect the balance sheet into rising rates

by. Geetika Bansal

As talks of tapering continue to dominate the near term investment landscape, portfolio managers are focused on reducing interest rate sensitivity both in the portfolio and on the balance sheet. Even though loan growth has picked up, it has mostly been sporadic and inconsistent. As a result, the investment portfolio remains the primary source of liquidity and earnings for many credit unions. Balancing between yield and spread pickup versus future price volatility can be challenging, but there are certain tools and strategic maneuvers that can make the process more efficient.

To begin, we can always implement changes within the existing portfolio to boost performance. Investment decisions that were applicable at a certain point in time may no longer be valid with a shift in rates. Thus, it is useful to periodically assess the risk/reward potential of existing investments. For example, the callable agencies highlighted in Table 1 below have a combined book yield of 0.84% for a 2.5 yrs average life. The effective duration of these holdings is 2.33 (a little over 2.5 times the yield on the bonds). The effective duration can be used as an approximate gauge of the price volatility of an investment given a 100 bps shift in rates. Consequently, these investments will lose 2.3% of their market value for every instantaneous 100 bps move in rates. In the $2MM book value example below, the interest income earned over 1 year is $16,734. The possible loss exposure with rates up 300 bps is $139,182.

Table 1

From a risk/reward perspective, these investments are not very appealing given the potential extension risk and price volatility. The risk/reward column on the far right of Table 1 highlights the underperformance of these holdings. Typically, ratios over 1 indicate above average performance, and ratios over 0.75 indicate average performance. Ratios below 0.25 are indicative of poor performance.

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