Fixed Income Strategy for Homeowner’s Associations

Boards and board treasurers often have questions about how to most optimally structure their replacement reserve portfolios. Especially during periods of rising interest rates, there is significant fo­cus on the Federal Reserve, their decision to raise rates, and the effects of rate hikes. Even if the Fed decides to raise rates, this decision does not mean that all interest rates will rise. Having a disciplined investment strategy in place can help manage the risk associated with changing interest rates.

Portfolios structured with only short-term fixed income securities may appeal to many associations as assets are generally liquid and readily available. However, as short-term securities are continually rolled over, the maturing principal is exposed to two main risks: interest rate changes and rein­vestment risk. Therefore, we often recom­mend an investment strategy that does not rely solely on short-term investing.

During various economic cycles, the slope of the yield curve will change. The yield curve plots yields and maturities of fixed income securities such as U.S. Treasuries and corpo­rate bonds.

There are three basic shapes that the yield curve can take: normal, inverted, or flat. In a normal or “up-sloped” yield curve, higher yields are available from longer-term securities, and yields on longer-term bonds may continue to rise. However, holders of long-term securities are exposed to greater market volatility and price fluctuations prior to maturity than investors with short-term securities. In an inverted or “down-sloped” yield curve, the expectation is that yields on longer-term se­curities may fall over time, and an increased demand for these maturity dates drives the relative yield on long-term securities down. Inverted yield curves often correspond with periods of recession. A flat yield curve usu­ally arises during changing economic con­ditions, such as from recession to recovery. In an attempt to boost returns in any kind of interest-rate environment, our investment recommendations are derived from one yield curve strategy.

As financial advisors to homeowners as­sociations, we recommend that associa­tions adopt a diversified portfolio of CDs or Treasuries with different maturity dates to increase a portfolios potential return and reduce exposure to reinvestment risk while maintaining liquidity. Blending invest­ments in short, intermediate, and long-term securities may allow an association to take advantage of the liquid aspects of shorter term securities while attaining the higher yields typically available through longer term securities. Using this strategy, an investor can lock in higher coupon income in longer maturities during a declining interest rate environment, while offering periodic reinvestment opportuni­ties to capture attractive yields when rates are rising.

Most community bylaws prohibit the use of non-guaranteed securities (stocks, mutual funds, or corporate and municipal bonds, etc.) which we support. As history proves, no one can accurately and consistently pre­dict when or how much interest rates will change, which is why we recommend lad­dered portfolios equally weighted from one through seven years. Considering the need for preservation of capital and adequate li­quidity to meet planned and unplanned re­serve expenditures, the ladder approach is a reliable strategy in both the short term and over time.

Although each association has its own unique investment policy, replacement re­serve schedule, and cash flow needs, the laddered portfolio frequently remains the centerpiece of our recommendations to the associations we advise.

By Theodore Hart
Ted is the senior vice president and portfolio management director with The Hart Group at Morgan Stanley. He began his career with Dean Witter in 1989. His clientele includes foundations, endowments, municipalities, associations, and high net worth individuals. Mr. Hart has focused his work on helping associations develop Investment Policy Statements and managing assets effectively and efficiently.

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