By Jonathan Jackson, CFA, FRM, Manager of Brokerage Services
The amount of credit union issued subordinated debt continues to increase. Investing in subordinated debt may offer an attractive yielding asset for your credit union’s balance sheet. Prior to investing in subordinated debt, however, it is important to perform thorough due diligence.
Five key areas can help your subordinated debt investment analysis: growth trends, loan quality, earnings capacity, liquidity and planned use of the funds.
1. Growth trends
A credit union that has growth capacity but is limited by their capital position is a prime candidate to issue subordinated debt. It’s important to assess the credit union’s probability of growing safely in the future. Will the credit union be able to grow loans at a rate that maintains positive net income, expands services to members and increases their market footprint? Pricing loans in a rapidly rising rate environment can be challenging. Has the issuing credit union been successful in pricing their loans appropriately and taking advantage of higher interest rates in 2022?
Net worth that has declined over the past few years may warrant deeper analysis to determine the cause. For example, is net worth under pressure due to deposit inflows associated with COVID stimulus money, or is it due to weak operating performance? If deposit inflows were due to COVID, review the credit union’s historical and expected loan growth, deposit growth and earnings levels to determine the issuer’s overall strength and soundness.
2. Loan quality
Poor loan quality can present operating challenges for credit unions. When you analyze subordinated debt investments, pay close attention to loan quality after a period of accelerated loan growth. Has the issuer lowered underwriting standards to attract the growth? If so, determine how that may affect long-term earnings trends. Has the issuer already adopted a plan for Current Expected Credit Losses (CECL)? If not, when are they intending to do so and how will this impact their balance sheet?
3. Earnings capacity
Long-term earnings capacity is a critical element in determining the safety of a subordinated debt note investment. Most issuers prepay subordinated debt notes with earnings as they become due. Consider the coverage that earnings provide, both for servicing the interest on the subordinated debt notes, as well as repaying the principal. A credit union that has existing net income of 10 times the sub debt interest expense will represent a lower risk profile than an issuer with net income of two times the interest expense.
It’s also beneficial to consider the rate of loan growth relative to broader asset and deposit growth. Credit union net income levels expand when loans grow and represent a larger portion of the balance sheet, as these typically contribute to a widening of net interest margin. However, as noted above, if loans grew because of lower underwriting standards or underpriced loans, it is important to take that into account.
An ideal profile to seek is a credit union with loan growth greater than asset growth and a loan-to-asset ratio that is rising without deterioration in loan quality.
4. Liquidity
With liquidity tightening for most credit unions during the second half of this year, focus on liquidity risk management. The overall liquidity position of the issuing credit union is critical. Has the issuer been prudent in their liquidity management practices? Historically, the use of borrowings has not, in isolation, been considered a deterrent to investment. When evaluating past or current borrowing activity, however, look for the justification.
Were borrowings used to support funding of additional loan growth, elevating the loan-to-share ratio and reducing liquidity? In this situation, what are the issuer’s plans to restore the credit union’s liquidity position? Or, were borrowings used as a strategic hedging strategy to lock in a yield against other earning assets?
Reviewing liquidity helps evaluate whether the issuer can prudently manage and maintain a healthy liquidity position and, consequently, justify any borrowings.
5. Planned use of funds
How does the issuer plan to use the funds to support their mission, strategy and vision? An investor should ensure that the issuer has a strong business reason for issuing subordinated debt and that the planned use of the funds aligns with the issuer’s business strategy. Review any deviation in strategy to ensure the expected outcomes are probable and that failure to execute the proposed strategy will not have a severe negative impact on the issuer’s overall operating performance.
Investing in subordinated debt can offer an attractive yielding asset for credit unions to invest in, but subordinated debt does not come without risk. By reviewing an issuer’s growth trends, loan quality, earnings capacity, liquidity risk management and how they plan to use the proceeds, an investor will be able to better perform subordinated debt investment analysis.
Catalyst Corporate’s brokerage team can answer questions about these five metrics and help your credit union perform a subordinated debt investment analysis. For more information, contact us today.
All securities are offered through CU Investment Solutions, LLC. The home office is located at 8500 W 110th St, Suite 650, Overland Park, KS 66210. CU Investment Solutions, LLC registered with the Securities and Exchange Commission (SEC) as a broker-dealer under the Securities Exchange Act of 1934. CU Investment Solutions, LLC is registered in the state of Kansas as an investment advisor. Member of FINRA and SIPC. All investments carry risk; please speak with your representative to gain a full understanding of said risks. Securities offered are not insured by the FDIC or NCUSIF and may lose value. All opinions, prices and yields are subject to change without notice.