What Did I Just Buy?

August 2020
By Daniel McIntyre
Vice President Investment Services at Corporate Central Credit Union and QuantyPhi

Many credit unions continue to deal with record amounts of deposit activity as stimulus checks are safely stored in savings accounts. With loan demand slower, this has forced many credit unions to look to investment options to produce income.

Given that the credit union industry is devoted to helping people, our focus at QuantyPhi tends to avoid the investment markets. Our understanding of local deposit rates, loan preferences, and how our members are coping with today’s economic trends is exceptional. Our knowledge on current market trends, how certain securities work, and what each feature is worth is not our top priority. Some credit unions have staff with deeper investment knowledge, but many do not have the resources necessary to have people singularly devoted to following investment markets and trends. This is not news to us, nor is it news to others who may wish to take advantage of the knowledge gap, and present overpriced securities as solutions to our current deposit surge.

With this in mind, let’s now review a few basics of the investment markets.

What am I getting?

On a recent webinar, QuantyPhi reviewed some basics of investment returns. As we should know, yield is not a measure of a true return of an investment. However, yield does give us a starting point of how we are compensated on a financial commitment. For purposes of this article, we will focus on yield, knowing that yield is an incomplete return measure. As we also know, yield is affected by the price we pay. The higher the dollar price, the lower the yield. As such, we can focus on yield to get an idea of our value decision when reviewing investment decisions.

We will begin by reviewing the components of our yield. Remember in our entry level finance class, we were told that yield is a sum of all the risk factors associated with the investment. In short:

Risk free interest rate (think U.S. Treasury rate)

+ time risk (maturity of the instrument)

+ cash flow uncertainty (when do I get my interest and my principal back?)

+ credit risk (will I get my principal returned?)

+ liquidity risk (can I sell this at or near the actual value of the investment if necessary?)

To receive the fair value of the investment, we must receive the fair yield for each component listed above. If we are not taking any of the listed risks, we should not be compensated for that risk. As we add a risk component to the list, the return, in our case, the yield must increase.

At what price?

As mentioned above, yield is affected by price. The more risk we take, the higher the yield we should see priced into our investment. If the yield is not high enough to compensate for the risk, the price of the investment must be lowered to reflect that. It is that simple. For example, when comparing an investment of similar maturity and call features, we can determine if the instrument is mis-priced. A 2-year municipal security has more credit risk than a 2-year U.S. Agency security and should have a higher yield. If these securities have the same yield, the price of the higher risk security is too high.

Each risk factor listed above requires close inspection to ensure we are getting fairly compensated for our risk exposure. Knowing how much we should be compensated requires more knowledge of the risks, observations of where these risks are priced, and what the risk exposures are worth to the investor. Most of this knowledge comes from understanding the risk exposure and better market insight.

There is some good news on the second point. Many investment markets are becoming more transparent. Knowledge of where markets are pricing risk assets, like investment securities, can be found for many types of securities. This can help us understand if we are seeing appropriately priced investment options, or simply transferring our credit union’s funds to the people selling us the investments. While market pricing of certain risks changes and may be overpriced or underpriced, at least we can see where the markets are pricing these risks. If a security has already changed owners at a price one, or even two, points lower than where is being offered in the same day, it is very likely you are not seeing a fairly priced offer.

Does it fit?

Lastly, we need to mention the fit of the security. We have mentioned pricing, market price, and risk components, but not fit. All of these are not important if the security does not help a credit union achieve its goals. The first filter we should use to see if we should explore the investment is not price, but whether it fits our investing goals or not. For more information, please see our paper on benchmarking and using portfolio management techniques to achieve optimization. Remember, if it does not help us with our mission, the cost is irrelevant. We should be adding only the investments that help us support our mission to help our members.

*Securities offered through Concourse Financial Group Securities, Inc. (CFGS), Member FINRA/SIPC. Advisory services offered through Pershing Advisor Solutions, a DBA for CFGS, a Registered Investment Advisor. QuantyPhi, LLC. is independent of CFGS.

**Securities offered through Concourse Financial Group Securities, Inc. (CFGS), Member FINRA/SIPC. QuantyPhi, LLC. is independent of CFGS. Check the background of your financial professional on FINRA’s BrokerCheck.