Spread and Yield Considerations in Member Business Lending
by. Loren Houchen
Member business lending (MBL) represents an attractive asset class for credit unions when executed with due diligence. MBL can be a profitable investment with good returns accompanied by product, rate, term and geographic risk diversification opportunities. It also may enhance member satisfaction through attracting and retaining members by providing a broader array of products and services.
Credit unions investing in MBL assets need to consider desired returns and risk/return trade-offs. Loan pricing for MBL is a key component of portfolio growth and management. The application of pricing in the MBL arena usually follows the same overall approach used for other asset classes. However, when reviewing loan and portfolio interest rate criteria, credit unions may choose to follow either the spread or yield approach.
The spread approach is followed by the majority of lenders in the national credit marketplace. This method reflects loan terms expressed via an interest rate spread over a chosen index. The index is a recognized independent baseline for comparison of alternative funding costs and potential returns. Lenders typically use the 5-year Treasury as their loan index, although many use the prime rate. Use of the spread approach may provide easier administration and monitoring over the course of a budget year, although the spread target should be reviewed periodically, as market conditions change.
Some lenders follow the yield approach, where predetermined yields are sought based on the asset class, perceived risk, and desired return. Use of a target yield (e.g., 4.5%) provides a quick benchmark for application, but may have some unintended consequences. For example, higher yields are generally associated with higher risk assets. Holding out for higher yields may result in overlooking higher quality/lower yielding investment opportunities that fit better into the risk profile and asset mix of the credit union. Set yields may not identify the risk/return tradeoff inherent in credit risk and interest rates and provide greater potential for mispricing of assets over time.
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