Groups may discover that ‘safe' portion of reserves is vulnerable in years ahead

Bond yields—already up dramatically from historic lows in the past five months—are likely to rise further in the years ahead, hurting association reserve portfolios since bond prices fall when rates climb.

Investment professionals who manage association money see a higher-risk, lower-return environment for the fixed-income investments that form the core of association portfolios.

Association clients are increasingly concerned.

"It definitely has been a hot topic," Kevin Jestice, head of Vanguard Group's Nonprofit and Institutional Advisory Services, told CEO Update. Vanguard's nonprofit group manages $30 billion, including about $5 billion in association and professional society assets.

"There's always questions of, ‘What do you have in your crystal ball?'" he said. "We've gotten that with greater frequency over the past six to 12 months."

A rising rate environment is difficult for organizations that are looking for safety and stability in their portfolios, Jestice said.

"It's a challenging time for a lot of institutional investors. There's opportunity ahead but there are a lot of macroeconomic risks as well. We're looking forward to a period of diminished return expectations compared with what a lot of folks experienced over the last 10 to 20 years," he said.

Mohney

"I think everybody's concerned about the rising interest rates," said Mary Mohney, CFO of the $102 million-revenue, Alexandria, Va.-based, Society for Human Resource Management. SHRM had a $107 million reserve portfolio as of its latest IRS Form 990.

"Bonds used to be known as the safe portion of client portfolios, and over the last several years even added significant return," said Ahmed Farruk of McLean, Va.-based Orion Investment Advisors, which deals almost exclusively with association clients. "Those salad days are over. Not only are bond portfolios not quite safe, but they present capital risk.

"[Clients] need to challenge their comfort zone as it relates to bonds," Farruk said. "The things that worked over the last 20 years may in fact be the strategies that are least successful over the next 20 years."

Association volunteer leaders should be prepared for the new environment, said Cynthia Keith, executive director-investments and senior portfolio manager of the Omega Group, a unit of Oppenheimer & Co. The Omega Group has $225 million in assets under management, with about $55 million in association portfolios.

"If the board or finance committee are not used to seeing negative numbers then it can be a good idea for the CFO to report that to give them a heads up that this is what they may see going forward," she said.

Both Orion's Farruk and Oppenheimer's Keith said they are investing clients' money in shorter-term bonds—within the requirements of their investment policies—to minimize exposure to rising rates. When those bonds mature they can be reinvested at higher rates, Keith said.

Mohney said SHRM is doing the same.

"We are not making any drastic changes to our allocation to fixed income," Mohney said. "What we are doing is looking at what we are investing in within fixed income. We are reducing the duration of the bond portfolio and allocating more to global fixed income." Duration is a measure of interest-rate sensitivity for bond portfolios.

Orion is working with some clients to change their investment policies regarding what securities can be included in the portfolio, Farruk said. Floating-rate debt and futures and options that hedge against rising rates or even profit from them are part of Orion's arsenal, Farruk said.

Vanguard's Jestice said the investment manager does not try to forecast short-term moves in interest rates. But the company's view is that interest rates will rise over the next 10 years.

"We don't aggressively reduce duration," Jestice said. "We don't try to add substantial value to client portfolios through duration management."

Jestice said interest rate predictions by economists—and even the market itself—have frequently been wrong.

Whereas bonds have returned 5 to 6 percent in the past 10 years, investors should expect more like 2 to 3 percent in the next 10, he said.

"We might be shifting from when we saw bonds as return-enhancing to where we see them still having a role but primarily for diversification and risk reduction," he said. "It doesn't reduce their role and need in the portfolio."

Vanguard's advice is to build a portfolio that matches your investment objectives and stick to it. Diminished potential returns highlight the need to keep investment costs low, he said.

Fine

One association not sweating a possible rise in rates is the Independent Community Bankers of America, said CEO Cam Fine. ICBA had $82 million in reserves listed on its latest Form 990.

That's because the association invests in short-term Treasury securities and certificates of deposit and holds them to maturity, even though short-term yields have been very low, he said.

"ICBA has always been very, very conservative in the investment of its reserves," Fine said.

ICBA buys CDs in the $100,000 to $250,000 range (within FDIC-insured limits) from member banks, which Fine says benefits his members as well as the communities they serve by making more loans available.

"I know we've given up some income over the years," Fine said. "Our philosophy is that we're more interested in the return of our money than return on our money."