MUSKEGO, Wis.—There’s a better way of measuring bond returns than most credit union managers use, according to one person.
Kevin Chiappetta, senior vice president, investment services at Corporate Central Credit Union and its credit union service organization, QuantyPhi, is calling out what he says are “bond myths” believed by the majority of balance sheet managers in the industry.
He wants to point out “what is incorrect about the traditional measurement process,” as he believes there are “severe limitations” on a traditional single measurement model, he feels.
Chiappetta’s comments are part of a series by CUToday.info examining “Fake News” within credit unions; that is, misconceptions that need to be corrected and deserve more thought.
In Chiappetta’s view, he believes credit unions should be looking for a return/risk analysis based on “multiple measurements and an understanding of how that kind of measurement works.”
“Bonds can’t do what yield-to-maturity calculations say they will do. The actual return is going to be different,” he said.
Instead, he advocates breaking down cash flows by dollars, rather than by percentages.
“What are my cash flows? What will the bond be worth one year from now? What money have I earned by having to break it down in dollars rather than percentages? A total rate of return depends on what happens over time.”
A Second Myth
A second credit union bond myth Chiappetta sees is the (untrue) truism: “It’s not a loss if you don’t sell the bond.”
He takes as an example a bond yielding 8%. “If market rates go up to 10%, the value of the bond drops. Every time I clip the coupon I’m missing 2% of the market.”
Credit unions may not have to report that loss of value, but from an economic standpoint they are behind two percentage points and should take the change in value into account.
“We’re out here preaching a gospel,” said Chiappetta.
Some credit union managers have caught on and are using it, but are still a minority. “You have to divorce yourself from years of process.”
“We should be changing the way we analyze bonds before we buy them, look at total return over a variety of scenarios,” he continued. “Rates moving up, rates moving down, get a feel for how that will perform in different rate scenarios.”
A good idea is to formulate a benchmark. (Chiappetta has written a white paper on benchmarks, “Performance Options for Credit Unions,” that can be found on the website of QuantyPhi, Corporate Central’s CUSO for balance sheet analysis here.)
“The idea is to find how the balance sheet performs, then find securities that perform in those rate environments. Manage to a series of outcomes. Find acceptable levels of risk.
If rates go up three percent tomorrow, how does the balance sheet perform?” The trick is to not put the credit union over its risk parameters while still earning an acceptable yield, he said.
“We don’t want to get over our skis” on exposure to agency securities like those issued by Freddie Mac, Fannie Mae, or the Federal Home Loan Bank System.
Chiappetta doesn’t want to see credit union managers having only two options, A or B.
“Without doing this analysis we get stuck on standard metrics. There may be option C, D or E.”
—Mark Fogarty