Improving investing outcomes through interest rate management

Healthcare Financial Management, Feb, 1997 by Joan West, Sandee Glickman

FASB Statement No. 124 requires nonprofit organizations to disclose unrealized gains and losses on their balance sheets. To help meet this requirement with regard to forecasting revenue streams for investments, healthcare organizations will have to abandon their traditional use of yield-at-cost projections and adopt a more sophisticated projection of total return based on interest rate movements. Total return then can be used to calculate the market value of an organization's investment holdings, including unrealized as well as realized gains and losses.

Financial managers can take advantage of this advanced method of revenue forecasting to improve their investing results. In measuring an instrument's performance based on total return, an investment can be evaluated two ways: at the security level (ie, how its market price behaves under various interest rate scenarios) and at the portfolio level (ie, its impact on the average maturity or duration of total investment holdings).

Evaluating the Impact of Interest Rate Fluctuations

Fundamental to the management of interest rates is the fact that the longer the maturity an instrument has, the greater will be the fluctuation in its market price. For example, if U.S. Treasury notes that have three-year and five-year maturities yield 5.70 percent and 5.86 percent respectively, the difference in their yields is minimal. However, the difference in their value becomes more marked as interest rates fluctuate (see Exhibit 1).

By evaluating investments based on possible variations in future interest rates, the risk/reward trade-offs become more obvious. Exhibit 2 compares two five-year Federal National Mortgage Association (FNMA) bonds maturing in 2001. The securities yield 6 percent and 6.15 percents respectively, and the latter is callable (can be redeemed before its maturity date) in 1999. At first glance, the higher yielding security appears to be a more attractive investment. However, when the two are compared under various interest rate scenarios, the lower yielding security would generate greater returns.

Since it is to the issuer's advantage to redeem its securities when interest rates are falling to avoid paying above-market coupon rates, the [TABULAR DATA FOR EXHIBIT 1 OMITTED] [TABULAR DATA FOR EXHIBIT 2 OMITTED] market assumes that when such conditions occur, all bonds will be redeemed. Therefore, a bond's price gets capped near its call rate. A bond without a call option would participate fully in a rally.

In addition, callable bonds may not perform well in volatile interest rate markets. Often, callable bond prices decline more rapidly when interest rates rise and improve slowly when interest rates decline.

Targeting Average Duration

Another important consideration in interest rate management is duration. Duration is a measure of the price sensitivity of an instrument to changes in interest rates that factors in both instrument maturity and coupon rates. For example, a five-year note with a coupon rate of 6 percent has a longer duration than a five-year note with a 7 percent coupon rate because higher coupon payments repay the investor more quickly. Monitoring the average duration of an investment portfolio is critical to effective interest rate management. Therefore, any potential investment should be reviewed its impact on the average duration of the entire portfolio.

Organizations often liquidate soon-to-be-maturing investments to meet their cash needs without considering the overall objectives of the portfolio. For example, financial managers may liquidate short-term instruments rather than, say, five-year instruments, because the prices that can be realized on the short-term instruments are generally close to the face value of the instruments. However, liquidating short-term securities lengthens the average duration of the portfolio, inadvertently putting the entire portfolio in a more "bullish" position regarding the direction of interest rates. Such an outcome could jeopardize the investment objectives of the organization should interest rates increase.

Establishing Interest Rate Management Policies

To assure consistent interest rate management that is in accord with an organization's investment policy and objectives, organizations should select a benchmark or index to incorporate into their investment guidelines. A benchmark is a single instrument, and an index is a representative range of security types. Some commonly used market indices include:

* Merrill Lynch 1-2.99 Year Index

* Solomon 5-year U.S. Treasury Note

* Lehman Brothers Intermediate Government/Corporate Index

* Lehman Brothers Aggregate Index

The performance of a benchmark or index is a tool for measuring investment risk and return. The benchmark or index should reflect business sectors or instrument types the organization has approved for investment and should have a duration that closely mirrors the target average duration of the organization's portfolio.

Conclusion

Healthcare organizations have traditionally based their investment strategies on yield-at-cost projections. Such strategies do not take into account the effect - both positive and negative - that interest rate movements have on investments. Financial managers should adopt a more sophisticated approach to investment and cash management that considers interest rate movements.