Don't Overlook Internal Factors In Rate Scenarios

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During the past 12 months or so, there have been numerous articles dedicated to the topic of rising interest rates. In fact, there have even been entire seminars and webcasts dedicated to this pressing issue. Generally, discussion revolves around what economic and political factors are expected to influence the Fed's rate decision, and so on.

Of course, an understanding of interest rates and their influences is vital to the success of an investment manager. However, too much focus on "external" factors, such as interest rates, and not enough on "internal" factors, such as your response to changes in rates, can be detrimental to the health of your portfolio.

In Stephen R. Covey's book, "The 7 Habits of Highly Effective People," Covey discusses the concept of being proactive (Be Proactive-Habit 1). Specifically in this section, Covey talks about the dual concepts of the "Circle of Influence" and the "Circle of Concern." In summary, he says that we all have a wide range of concerns, whether personal (our family, our health, etc.) or more far-reaching in nature (e.g., national debt, world peace). Covey identifies this as the Circle of Concerns. There are typically many things in this circle that we have no control over, and many things that we have at least a fair amount of control over. Covey refers to the latter group as the Circle of Influence.

Now, you may be wondering what this has to do with managing a credit union investment portfolio. How is this analogous? Permit me to share my thoughts with you.

The Circle of Influence and Investing

Interest rates, in this case, are a clear example of something outside of (external to) our circle of influence (presumably no one reading this article is on the Federal Reserve Board of Governors!)

However, as Covey states, successful people generally focus their efforts not on things they can't influence, but on those things inside their circle of influence. For successful investment managers, this means concentrating not so much on changing interest rates, but on the response to this change. In other words, a successful investment manager will pay very close attention to those factors in his or her control that are affected by rising interest rates.

Even within the circle of influence, there are varying degrees of control that an investment professional may have. To demonstrate this, let's take the potential rise in rates to its natural conclusion. The reason rising rates are a concern for most credit unions is that, in general, rising rates tend to erode the value of both loan products and investment products, especially those that are long-term in nature. This acts to change the risk/return profile of both the investment portfolio as well as the balance sheet, and oftentimes causes the portfolio manager to be very cautious. In fact, some of the advice given to investment professionals (often by other investment professionals) is to "stay short" if you think rates are going to rise. While this advice MAY be the best solution for a credit union, we can only know if it is the optimal tactic by focusing on ALL of the factors that an investment manager can influence (internal factors, that is to say).

Degrees of Control

While there are many items that an investment manager can use to alter the risk/return profile of his or her credit union, we will focus our discussion in three very specific areas where managers generally have a great deal of control:

* Stress testing the portfolio.

* The type of instruments that make up the portfolio.

* Wholesale borrowing.

This is not to say that these are the only tools that can be used in response to changes in interest rates. Other tools that can be considered as well are the rates being offered on loans and/or deposits, though any efforts placed here tend to have an impact only over a much longer time period. In other words, a change in a credit unions loan or deposit pricing generally takes longer to flow through the balance sheet, whereas changes in the investment portfolio can have an immediate effect.

Stress Testing the Portfolio

In response to changing interest rates, it is especially important that investment managers continually stress test their portfolio. Again, rates may go up, or rates may go down, but the point of stress testing is to know, in advance, how your portfolio may be impacted. In addition, a roll-up of this information to the entire balance sheet can aid in measuring the total interest rate risk for the credit union. And, simply shocking the portfolio up and down 100, 200, and 300 basis points immediately (as required by regulation) will not suffice, though, this is reasonable as a first step.

There should be two goals for portfolio managers when stress-testing the portfolio. The first, and generally the most frequently done, is to measure the market value change of the portfolio. This is certainly an important step in determining the overall interest rate risk position of the credit union. However, in order to apply some judgment to the process, a portfolio manager will need to know what kind of return the portfolio will provide the credit union in each scenario. And, understanding the TOTAL RETURN on the portfolio will involve changing interest rates over some time horizon, rather than simply occurring instantaneously. It is only at this point that both components of total return, change in market value and total income received, can be observed in relation to the overall risk being generated.

So, first, when confronted with the challenge of changing interest rates, shocking a portfolio with many parallel, and non-parallel rate shifts over varying time horizons is important. This is especially true when rising rates are a concern for the following reason. By simply measuring the market value change in a portfolio, an investment manager may come to the conclusion that shorter-term, lower-yielding, investments are in order. While this could certainly act to reduce interest rates, the decline in long-term income can be problematic and chronic. Again, measuring income over some time horizon can lead to a portfolio that, while longer-term in nature, generates more than enough income to offset the increased interest rate risk.

Types of Instruments in the Portfolio

The types of instruments that credit unions purchase, such as agency securities and corporate credit union certificates, tend to be quite liquid. Because of this, investment managers can quickly and cheaply buy and sell investments to alter their portfolio's behavior. Contrast this with most credit union loan products that, while offering better relative returns than most investments, can be cumbersome to buy or sell wholesale, and have an impact on the member relationship.

So when the detailed analytics of changing interest rates call for changes in a balance sheet profile, a prudent investment manager will have the ability AND authority to efficiently transact his or her investments to meet the larger goal. This means having a good understanding of the behavior that each investment displays when rates change, and buying and selling accordingly.

Wholesale Borrowing

Remember that the purpose of the investment portfolio is to provide safety, liquidity, and yield. Oftentimes, when confronted with the challenge of rising rates, many investment managers get very conservative, and build liquidity through investment liquidation.

While this is sometimes an appropriate decision, it can cause a material decline in long-term investment earnings. One item that managers may want to consider, and that most have under their control, is the ability to go on loan (i.e., borrow) when warranted. This strategy can help managers get over any short-term tightening in liquidity without having to sell and buy frequently. After all, while it is relatively inexpensive to trade credit union investments, it's not free.


While none of us can have an impact on the direction of interest rates, we can and should respond to changes that have an impact on our specific portfolio and balance sheet. While it is important to know the factors that could potentially cause interest rates to change, it is infinitely more important to be able to respond to those changes in a manner that ensures the long-term success of the credit union. This oftentimes involves taking a total return approach to portfolio management, rather than focusing almost entirely on portfolio market value changes.

In other words, by concentrating on issues inside your circles of influence, rather than on external issues, the quality of your decisions tend to improve, as does the portfolio's performance.

Ron Araujo is an investment advisor with WesCorp Investment Services, LLC, San Dimas, Calif. He can be reached at raraujo

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