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Rate Shock

08/01/2020 4:33 PM | CAI Rocky Mountain Chapter (Administrator)

By Nicole Bailey, RBC Wealth Management 

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The chart above illustrates the interest rate movement of the U.S. ten year Treasury note.  The historically low rates we have today signify borrowing rates that can benefit homeowners and other borrowers.  Mortgage rates are at new lows and many homeowners and buyers are taking advantage of more affordable financing options.  The benchmark U. S. ten-year Treasury Note hit an all-time low yield of 0.398% on March 9th.  While this is great news for many, community associations and other savers are now being forced to re-evaluate their investment strategies.  This article aims to provide context around the current interest rate environment, how it will impact community associations, and strategies to consider moving forward.  

 

On September 21, 1981, the U.S. ten-year Treasury Note was 15.68%.  As shown in the charts, interest rates have been declining ever since. In December 2019, the rate had fallen to 1.92%, and on March 9th, the benchmark rate traded during the day at 0.398%.  The global demand on United States fixed income has been largely driven by the roughly fifteen trillion dollars of international sovereign debt that offers negative interest rates.  In Germany, for example, if you want to buy a ten year German bond (called the Bund), you have to pay the government to take your money.   This sounds crazy, but it has been this way for some time now.  Investors worldwide seeking to purchase fixed income have been drawn to the United States because our bonds are still, for the time being, offering positive rates of return.  In addition to this fundamental change in interest rates worldwide, the Coronavirus and its impact on global economies has further exacerbated the low interest rate environment through a ‘flight to quality’ where investors sell ‘riskier’ assets and buy ‘risk free’ assets such as government bonds.  In an effort to provide stimulus and liquidity to the U.S. economy amid the concerns for our economy, on March 3rd, the Federal Open Market Committee cut the Federal funds rate (overnight rates charged between banks) to 0%--0.25%.   


It is common knowledge that the price of goods and services increase over time and thus the value of the dollar (your purchasing power) decreases over time.  The rate of these changes is calculated by the rate of inflation, or consumer price index (CPI).  When considering the effect of inflation on a community association, it is important to consider the types of goods and services the association is purchasing.  While, hypothetically, the CPI in a particular geographic area may be 2.00% +/-, the inflation rate for a community association may be considerably higher due to costs unique to our industry, such as insurance or the cost of contractors.  


The impact of inflation rates should be considered in the context of association investment policies. If a community association has an Investment Policy restricting their investments to certificates of deposit (CDs) and other U.S. government securities, the board has a responsibility to consider the effects of inflation on those assets.  Assumptions made in our industry starting decades ago would consider earnings on reserve funds and the inflation on those reserve fund assets to be a wash.  This ‘theory’ has not been accurate for many years now and going forward could even be a bigger problem. For example, the deficit of earnings rates vs. the inflation rate for community associations can no longer be assumed to net zero.  What does this mean to your association?  It means the board needs to be more diligent than ever in keeping the reserve study and projected costs up to date.  Instead of updating the reserve study every three to five years, these numbers may need to be updated every year or two.  The consequences of not doing so may result in a reserve fund being unexpectedly underfunded.  As we all know, this is a surprise no board would welcome. 


Many boards over the past ten years or so have decided to amend their Investment Policy statements to incorporate certain other asset classes that historically have provided higher returns than traditional CDs.  The goal in doing so is not to try and ‘get rich’ or be an investment ‘guru’,  but rather to simply try and keep up with the rate of inflation, and thus protect the association’s purchasing power of reserve fund assets.  We only need to allocate a small portion of a reserve account to accomplish this.  For example---a $100,000 reserve account is invested as follows:  $70,000 in ‘laddered’ CDs or other government securities that earn 1.5% and $30,000 in other another asset class or classes that earn 5%.  The blended return for the Reserve account is 3%.  This is far closer to the rate of inflation, and has the potential of maintaining your purchasing power versus the 1.5% you would have earned on traditional CDs.  


Many may argue that associations should not ‘risk’ association assets at all.  Others argue that the real ‘risk’ may be losing purchasing power.  These points are both valid discussion points.  Drawing an example from a different industry, the Employee Retirement Income Security Act of 1974 (ERISA), which provides guidance on investment strategies for pension plans, requires diversification among all asset classes.  This would include traditional asset classes like stocks, bonds, and real estate.  Why should we look at this law when considering how to invest association assets?  What is the purpose of a pension fund?  It is to provide a reliable source of retirement income to many people.  Most would agree this is a very important responsibility.  The people charged with the duty of managing these assets are ‘managing funds, on behalf of other people, to be used on a future date.’  Does that responsibility sound familiar?  Generally speaking, this is what boards are doing when they manage the investments of a reserve fund. Both parties are seeking to provide funding for a later dated purpose. 

 

Some states have specific statutes that govern the investment of association assets.  Most do not.  Investment Policies should be used by all associations, regardless of their statutes.   In addition to state statutes, associations need to review their governing documents to determine if there is any language pertaining to investment of funds.  Generally, a ‘policy’ (Investment or otherwise) can be changed anytime by a board vote.  As with other services associations receive from their vendors, we believe it is very important to use investment advisors who are well versed in providing services to Community Associations.   Critical to any association investment strategy is first and foremost understanding liquidity needs, both short and long term.   When providing investment services to an association, a qualified financial advisor will also be versed in the servicing aspect (administrative) and communication aspect, (both with boards and managers) of providing investment services for an association. 


Whatever investment strategy your association uses, the board needs to be keenly aware of the effects inflation has on the future purchasing power of the reserve fund assets.  We recommend all associations at a minimum, have a discussion regarding their long-term investment strategy and the impact of inflation on the reserve fund assets in the future.    


Nicole brings a broad background in community management in the Atlanta and Denver areas to her role on the West Wealth Management team. She actively volunteers with the Rocky Mountain Chapter of Community Associations Institute on the Marketing and Membership Committee. 


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