Investing Within the Context of Your Balance Sheet

Over the years, there have been many articles on investment strategies for credit unions. One specific topic that has been written about countless times is investing in a rising rate environment. However, the one thing rarely discussed is how to develop strategies to invest within the context of your credit union’s unique financial position to achieve your credit union’s overall goals. With that in mind, this article will not be about the hottest new investment strategy for credit unions. In fact, it is more about asking the right questions versus providing specific answers, since the answers must come from your own balance sheet, insights, and forecasts. Being proactive in developing a strategy that meets the needs of your credit union is a key to setting yourself up for success. This article is a framework that can be used for developing your own unique strategy.

One-Size-Fits-All Strategies Fall Short
While all credit unions have certain things in common, just like their members, each has its own unique set of circumstances. Therefore, applying a generic, one-size-fits-all strategy is not the best approach. For example, if your credit union’s typical loan-to-share ratio is 50 percent, your investment strategy will likely need to be very different than a credit union that regularly runs closer to 85 percent. To determine the path forward, let’s look at some questions that need to be asked when developing your strategy.

Define Your Investment Portfolio Goals
First, what are the goals for your investment portfolio? Your investments are a key component of your overall balance sheet that should not be managed in isolation. They are a complement to your loan portfolios and should provide income and cashflows while offsetting risks in other areas. Does your investment portfolio need to provide you with liquidity in the near term? What level of income does your portfolio need to generate? Is your investment portfolio intended to be a replacement for loans in the short term or longer term? These are all important questions, and there’s an argument to be made that smaller credit unions, with lower loan-to-shares, have the greatest need for investment expertise. However, since that expertise can be difficult for many credit unions to obtain internally, assistance in developing, modeling, and implementing a strategy can also be obtained via firms that provide expertise in investments and balance sheet optimization.

Establish Your Investment Horizon
Next, what is your investment horizon? You know the things that make your credit union unique and should leverage your knowledge and insight into your current balance sheet. Consider things like cashflow expectations, growth strategies and your expected future balance sheet, membership needs, local and geographic characteristics, and other factors that affect your credit union. These items, among others, will flow into the forecasts you will develop, to determine your investment horizon. Establishing your investment horizon will help you optimize your results.

Build a Forecast for Your Strategy
After that, what is your forecast over your investment horizon? Create a forecast using available information such as Fed Funds futures, forward curves, economic reports, economist forecasts, and other relevant external data, while layering in your own internal information. All credit unions are impacted by certain things, like economic, interest rate, liquidity, and credit cycles. Seasonality also impacts all credit unions, but to differing extents. Understanding where we are in those cycles can be tricky but incredibly important for determining your strategy within your investment horizon.

Align Your Strategy with Budgeting and Scenarios
We all create budgets each year using forecasts for interest rates, loan and share growth, balance sheet cashflows, changing member needs, etc. This same process should inform your investment strategy. If you forecast a slowing economy, lower short-term interest rates, share growth outpacing loan growth, and increasing loan portfolio runoff, maybe now is the time to be proactive and develop an investment strategy that aligns with that forecast. However, it is important to always model the potential for actual results to deviate from your forecast prior to implementing the strategy. Look at multiple scenarios such as expected, best-case, and worst-case to determine the risks if things don’t play out the way you expect. If the risks are unacceptable, you know in advance and can adjust your strategy prior to implementation.

Understand Your Credit Union’s Risk Tolerance
Next, what is your credit union’s risk tolerance? This will come from many sources, such as policy and regulation, your board and culture, your credit union’s current risk profile, your forecasting, and possibly level of expertise. There are many risks to consider when making this assessment, including interest rate risk, liquidity risk, cash-flow risk, credit risk, reputation risk, strategic risk, and concentration risk, which can encompass any of the other categories of risk. It’s also important to keep in mind that one form of risk can impact other types of risk. For example, interest rate risk and credit risk can both lead to liquidity risk, and cash-flow risk can increase both interest rate risk and liquidity risk. An understanding of these risks is critically important and should inform your risk analysis when determining your risk tolerance and developing a strategy. Many investors just chase the highest yield, wherever it may be, without a good understanding of the risks they’re taking on. Don’t make that mistake. Instead, understand the risks and how they fit within your balance sheet, determine your tolerances, and incorporate those items into your strategy. Make sure you are considering both the percentage changes and actual dollars at risk.

Balance Risk and Return
Finally, what is the risk/return goal and are you getting paid enough? You have likely heard the saying “There’s No Such Thing as a Free Lunch.” In the context of investing, this means there is always some form of risk you are taking on to earn your return. It’s a give and take relationship. In other words, a higher level of risk should be compensated with a higher level of return. On the other hand, if you avoid risks altogether, you may not earn enough return on your funds to cover the bills and keep the lights on. Therefore, balancing risk and expected return is key.

So, the risk/return goal is to maximize the return you expect for a given level of risk or minimize the risk you take on to receive a given level of return. This should be viewed in the context of the income needs for your portfolio. This is where relative value assessment and risks versus returns come into play. Relative value between various investments always exists but is also ever changing. Sometimes you get paid more to take on different types of risk, other times less. Therefore, you need to answer the following question: what are the risks you are taking and are you getting paid enough to take on those risks? In the context of your investment horizon, use a total return framework to determine what investments will add the most value under various or expected outcomes. This is a key aspect of implementing your strategy via your investment selection while also always keeping diversification in mind.

Building Your Strategy Framework
Putting it all together, it’s important to develop an investment strategy that fits the unique needs of your credit union. That entails asking yourself the right questions. Determining the goals of your investment portfolio is the first step. Your strategy will be different if your needs are to provide near-term liquidity versus provide income or replace loans. Next, your investment horizon will be essential, because your investment options and strategy may vary significantly assuming different horizons. Creating a forecast for the short term and longer term will offer necessary context for establishing your strategy. If interest rates are expected to go up, and liquidity is expected to tighten, your investment strategy should be different than if you anticipate rates to go down, lending to slow, and liquidity to grow. Identifying your credit union’s risk tolerance will be key to ensuring you are not taking on too much, or too little, risk to ultimately meet the goals of your investment portfolio and your credit union. Make sure you fully understand the various risks and how they can impact each other. Understand the risk/return goal and whether you are getting paid enough. Use ongoing relative value assessments and a total return framework to add the most value under various outcomes. Lastly, always model the impacts of your strategy under multiple scenarios before you act and adjust your strategy as needed and remember; this isn’t a one and done. Managing a balance sheet, and the investment portfolio strategy within it, is an ongoing exercise. Continuous monitoring, measuring, and adjusting are crucial to ensuring ongoing success.

Remember, you know your credit union’s situation better than anyone else. The “best bond in the street” may be ideal for someone, but not necessarily for you. Proactively develop your own strategy, so someone else doesn’t sell you theirs.

Strategic Support When You Need It
If you need assistance developing a strategy to optimize your results, Corporate Central’s balance sheet management CUSO, QuantyPhi, can help. QuantyPhi specializes in credit union balance sheet optimization, offering advanced Asset Liability Management (ALM) modeling, ALM validation, liquidity framework reviews, and investment consulting. Their team provides tailored solutions that align your investment strategy with your credit union’s unique goals and risk profile. Learn more about QuantyPhi’s approach to balance sheet management and investment strategy at quantyphi.com.