Q1 2011 Investment Strategy
Sample Bank
Anywhere, US
Economic and Fed Overview
The 4th Quarter of 2010 was an eventful three months for Fed Policy, market
behavior, and the economy generally. The first notable event was news that the
Fed would pursue a second round of quantitative ease (QE2) with a plan to
purchase $600 billion in medium term Treasury Notes. Bond market reaction to
that news resembled classic “buy the rumor/sell the fact” price action. In
anticipation of the Fed’s move, the 10yr yield fell below 2.4% in early October.
Once QE2 was confirmed, the market reversed and traded back up to 3%. Then, as
the holidays approached, the President and Congress agreed to a surprise
compromise on fiscal policy. This compromise exceeded what markets had
originally anticipated with an additional $300 billion (2% of GDP) in stimulus
from a payroll tax cut among other things. This caused most analysts to revise
growth expectations for the coming year. Bond yields rose accordingly and
eventually settled in a range between 3.20 – 3.50% as year-end arrived. Going
forward, it is the effect of these two events, QE2 and the fiscal stimulus, which will
drive the economy in 2011. Economists generally expect GDP growth of 3-3.5%
for the coming year, as opposed to 2.5-3.0% previously. Still, the economy will be
facing severe obstacles in the form of stubborn joblessness, depressed housing,
and a continuing debt overhang which will keep growth somewhat restrained for
years. Many economists believe yields may return to the range that predominated
during the first half of 2010, but no major trend reversal or bear market for bonds.
A test of the 2010 highs (roughly 4% on the 10yr yield) is certainly a possibility,
but any rise in rates will be somewhat self-limiting as US households continue to
struggle with massive debt burdens, weak home prices, and limited income
growth in the face of continuing distress in the labor market. The economy in
2011 will grow at a stronger relative pace to be sure, but still nothing that could
be considered a robust recovery. Ultimately, consumption will be held back by
weak household balance sheets and the threat of further deterioration in home
prices. Still half of all mortgage borrowers don’t have the 20% equity generally
required to refinance at lower rates or to move, and almost a quarter of borrowers
are in negative equity. Until these macro-economic imbalances are corrected,
growth and inflation will be weaker than normal.
Portfolio
Book Value
Dec 31, 2010
$47,000,000
Portfolio/TA
$ Gain/(Loss)
47.0%
$352,500
% Gain/(Loss)
0.75%
Tax Equiv. Yield
3.70%
Proj Avg. Life
4.12yrs
Eff. Dur/Conv
2.36/(.68)
+300bp Risk
(10.12%)
Fed Funds Futures – Current Market Expectations for FUTURE levels (as of 12/31/10):
Austin, TX | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
Page 1 of 4
Q1 2011 Investment Strategy
March 2016
Current Rates and Portfolio Strategy
Yields across the curve fell to fresh yearly lows in the middle of the 4th Quarter
before rising sharply to finish the year near 6 month highs. The rise in yields was
more dramatic on the long end with the 10-year up 80bp to 3.30% while the 2year was up less than 20bp to 0.60%. The result is one of the steepest yield curves
on record with the 2- to 10-year spread widening to within 20bp of the February
high. As a result of the rise in yields, the portfolio gain dropped from 2.5% to 0.8%
during the quarter and the projected average life of the portfolio extended from
3.3yrs to 4.1yrs as prepayment projections slowed and some agencies were no
longer expected to be called. Unfortunately, the rise in yields was not enough to
slow the drop in the overall portfolio yield, which fell 23bp to 3.70%. Effective
duration rose slightly during the quarter and remains within the Bank’s “just
above neutral” target (2.25-2.50). The rise in long-term yields and resulting drop
in portfolio value reinforces the Bank’s plan to maintain defensive strategies and
not be tempted to chase yield in the wrong sectors. However, the near record
steep yield curve also presents The Bank with a better opportunity to continue
building a modified barbell strategy that will be a combination of high-cash
flow, short duration taxable securities and longer tax-free municipal
securities. Longer maturity tax-exempt securities suffered steeper price declines
than many other sectors and provides excellent value as long as The Bank
continues to thoroughly analyze municipal credit risk. Given the governments
continued support for FNMA and FHLMC (GSEs), the Bank will continue to
emphasize the current mix of taxable investments in core GSE securities while also
adding GNMA issues when prudent. With cash still earning virtually zero, the Bank
will continue to make efficient deployment of all idle funds and evaluate all options
for enhancing income through the portfolio in a defensive manner.
Sector Distribution
CMO,
15%
MBS,
35%
Other,
2%
Agency
22%
Muni,
24%
Tax
Muni,
3%
Historical U.S. Treasury Yield Curves
5.0%
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
3/31/2010
6/30/2010
9/30/2010
12/31/2010
Austin, TX | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
Page 2 of 4
Q1 2011 Investment Strategy
March 2016
Sector Strategies
Agencies
As Treasury yields pushed higher at the end of the 4th Quarter, the Agency yield
curve steepened relative to Treasuries causing tighter spreads (~5 basis points)
on maturities less than 3 years and wider spreads (~10 basis points) for
maturities 5 years and longer.
Longer-term economic and interest rate
uncertainty will continue to preclude the Bank from chasing yield with longermaturity, negatively-convexed callable agency products. The Bank will moderate
sector duration by primarily purchasing securities with 3 to 7-year maturities.
Favored structures will be premium one-time callable securities with at least one
year, if not more, of call protection. The Bank will look to take advantage of the
pull-back in rates by adding deeply-discounted (<97 $price) 1x callable agencies
with call dates shorter than 1 year. Such securities will provide a large yield kick if
rates fall and they are called, and if not called will become highly liquid bullets.
Step-ups with 1x call, 1x step structures will also be utilized when the step coupon
provides sufficient probability of call. The Bank will also look to pick up additional
yield to call by adding 1x step-ups with canary call structures (quarterly callable
for 1 to 3 years until the step-up date, and then a bullet thereafter). Again, the
Bank will only purchase Canary Step-up securities with a step coupon that
provides sufficient probability of being called. Step-up issuance remains high and
with a varying range of structures – the Bank will avoid the uncertainty of multisteps in favor of the one-time steps with higher back-end coupons. The Bank will
continue to look for opportunities to sell short maturities and deploy the proceeds
on the intermediate portion of the curve.
Agency %
Current
Target
22%
15-25%
Eff. Duration / Convexity
Current
Target
2.08/(0.85)
1.5-2.5/(0.5)(1.0)
Municipals
Municipals have also come under pressure during the 4th quarter. Recent news of
the extension of the Bush tax cuts, elimination of the Build America Bonds, and the
“bank qualified” limit reverting back to $10 Million has pushed municipal yields
back 75 bps to 100 bps in the 10 to 20 year sector. Recent media reports have
added to concerns of the financial stability of many larger (e.g. State)
municipalities. The Bank has made an extensive effort to analyze and monitor the
credit metrics of all municipal holdings and will be very diligent in reviewing the
creditworthiness of all future purchases. Given prudent credit analysis, the
environment continues to offer excellent opportunities to add to the Municipal
sector. As the Bank begins to employ a barbell strategy, the Bank will maximize
longer municipal holdings and explore opportunities to swap out of shorter
maturities and deploy the proceeds out on the preferred range of the curve. The
Bank will also purchase BABs with 5-10 year maturities, preferring shorter
maturities because they do not have the reduced duration benefit as the tax-free
issues. The Bank will carefully review the creditworthiness of all municipal
issuers in addition to assessing the strength of the bond insurer. Preferred
insurers of municipal holdings will be the Texas PSF, Nevada PSF, Berkshire
Hathaway, AGM, Assured Guarantee as well as State Aid Withholding , Qualified
School Bond Funds and issues rated AA or better on their own.
Municipal %
Current
Target
24%
20-30%
Eff. Duration / Convexity
Current
Target
3.80/(0.05)
3.5-4.0/0(0.5)
Taxable Municipal %
Current
Target
3%
5-10%
Eff. Duration / Convexity
Current
Target
6.36/0.35
5.0-7.0/0.25(0.25)
Austin, TX | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
Page 3 of 4
Q1 2011 Investment Strategy
March 2016
MBS
The mortgage industry experienced record lows in fixed mortgage rates during
the 1st week of November 2010. As a result, Agency MBS touched their all-time
high in prices midway through the 4th Quarter. Subsequently, the MBS market
saw a rapid correction, with lower coupon MBS falling as much as 5% in value.
Alternatively, higher coupon MBS proved to be much more defensive and realized
as little as 0.50% to 1% declines in prices. Record low mortgage rates brought
about an increase on prepayments over the quarter. The primary instruments
that have felt the brunt of the increase in prepayments have been newer issue,
lower coupon (4% - 5%) securities. The #1 loan attribute to curtail extreme
prepayments continues to be pools comprised of lower loan balance mortgages.
Throughout 2010, prepayments have been a tale of the “haves” versus the “have
nots”. The mortgage market is still very difficult to enter as only those with 750+
FICO scores and 50% LTV ratios seem to be able to access refinancing options. As
a result, voluntary prepayment speeds for lesser credit MBS pools continue to
come in far below historic norms, as extremely tight underwriting standards,
declining home prices, and increasing refinancing costs more than offset the
impact of the historically low 30-year mortgage rates. Ongoing hurdles to access
the best mortgage rates combined with the nearly 100bp rate increase (to almost
5%), has prompted a rapid 50% drop in the Mortgage Bankers Association
Refinance Index to a reading of just over 2,000. The end result should be
prepayments slowing significantly over the 1st half of 2010. To balance extension
and prepayment risks, the Bank will continue to focus on higher coupon (>=5%)
specified agency MBS pools with one or more of the following loan characteristics:
1) seasoned underlying mortgages (e.g. 2005 and earlier origination), 2) pools
with particular loan attributes that should provide prepay protection (e.g. low
loan balance, investor properties, NY, FL, TX geographic concentrations, etc.), and
3) short weighted average maturities (e.g. WAM <100 months). Given the
dramatic drop in prices of lower coupon MBS, the Bank may selectively purchase a
few lower coupon "total return" MBS pools. MBS ARM: The Bank’s MBS ARM
sector continues to be quite small. With any increase in origination and/or
relative value, the Bank will evaluate new 3x1 and 5x1 Hybrid ARMs (preferably
GNMA) to enhance short-term cash flow and lower duration.
MBS %
Current
Target
35%
35-45%
Eff. Duration / Convexity
Current
Target
1.80/(0.92)
1.5-2.0/(.75)(1.25)
CMO
The steep yield curve in 2010 resulted in increased Agency CMO origination
(particularly GNMA) over the year. The swell in production allowed the Bank to
take advantage of additional supply in shorter cash flow structures, resulting in
growth of the CMO sector to 15% of the total portfolio at the end of 2010. As
supply dictates, the Bank will continue to purchase issues with cash flow
structures that should provide either short-term or “locked-out” cash flows in the
2-7 year range. To diversify MBS prepayment exposure, additional CMO collateral
types of focus will be seasoned 30yr FNMA/FHLMC as well as newer origination
30yr GNMAs. All CMO’s will be prudently analyzed for both extension and call
risks and will pass all FFIEC stress tests.
CMO %
Current
Target
15%
10-20%
Eff. Duration / Convexity
Current
Target
1.37/(1.15)
1.0-1.5/(.75)(1.25)
Austin, TX | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
Page 4 of 4