Q2 2014 Investment Strategy
Sample Bank
Anywhere, US
Economic and Fed Overview
The US economy slowed down during the first quarter of 2014, partly due to harsh
winter weather conditions. Growth appears to be tracking a 2% pace for the first
three months of this year, after a healthy 3.35% rate for the second half of 2013.
This continues a pattern of generally slow but steady growth, punctuated by
alternating periods of acceleration and slowdown. The outlook remains positive
for this year as contractionary fiscal policy subsides and job creation continues.
The all-important consumption component of the Q4 GDP report showed a 3.3%
growth rate, the most since 2010, though it remains to be seen whether that pace
can be carried through this year. Inflation continues to be well behaved as the PCE
Core Price Index rose just 1.1% year-over-year through the end of February.
The first quarter also saw a transition in Federal Reserve leadership as new Fed
Chair Janet Yellen took over from the outgoing Ben Bernanke. The process of
“tapering” QE asset purchases continued as the FOMC voted to lop off another $10
billion from the buy program. The committee also decided to modify guidance
strategy away from explicit thresholds such as the previously-identified 6.5%
unemployment level as a prerequisite for raising the policy rate. Instead, the Fed
promises to provide more “qualitative” guidance in the form of additional
descriptive and explanatory communication to accompany central tendency
forecasts. The FOMC s also reiterated that economic conditions…
Portfolio
Book Value
Portfolio/TA
$ Gain/(Loss)
% Gain/(Loss)
Tax Equiv. Yield
Mar 31, 2014
$54,000,000
54%
($108,000)
(0.20%)
2.83%
Proj Avg. Life
4.57yrs
Eff. Dur/Conv
2.73/(0.61)
+300bp Risk
(10.95%)
“…may for some time warrant keeping the target federal funds rate below levels
the Committee views as normal in the long run.”
The 10yr T-Note yield has traded in a 56bps range (2.47% – 3.03%) since the
middle of last year, and currently sits near the mid-point of that range. The
interesting thing is how well longer-term bond yields have held within this range
after last summer’s selloff and the first three rounds of tapering which has now
sculpted the QE buy program down to $55 billion. The yield curve continues to
hold the steep slope it achieved after the “taper tantrum” of last summer when
longer term yields jumped while short maturities remain anchored near zero.
As we close the first quarter, the yield spread between two-year and ten-year
Treasuries sits at 230bps, versus 160bps a year earlier. More recent indications
that the Fed may begin tightening sometime next year have caused some upward
drift in shorter-term yields. The two-year Treasury note, for example, has
averaged 36bps since the beginning of this year after averaging just 28bps for the
entire 28-month period from August of 2011 through last December. Still, the
yield curve slope continues to have a beneficial effect on Net Interest Margin and
Earnings for banks as balance sheets continue to enjoy an extremely low cost of
funds even while investment yields are now higher.
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Q2 2014 Investment Strategy
March 2016
Fed Funds Futures – Current Market Expectations for FUTURE levels (as of 3/31/14):
0.300%
0.200%
0.100%
0.000%
0.130% 0.145%
0.100% 0.110% 0.120%
0.075% 0.080% 0.085% 0.085% 0.095%
0.175%
0.205%
Apr '14 May '14 Jun '14 Jul '14 Aug '14 Sep '14 Oct '14 Nov '14 Dec '14 Jan '15 Feb '15 Mar '15
Current Portfolio Position and Strategy
The Federal Reserve finally began to wind down their 3rd round of quantitative
easing during the 1st quarter, reducing monthly bond purchases by $30 billion
(from $85b to $55b). Despite the significant drop in longer term asset purchases,
the 10-year Treasury yield actually fell 30bp during the 1st quarter and mortgages
spreads tightened another 20bp. This seemingly counterintuitive market move
shows that the Fed is not acting in a vacuum and the recent drop in MBS issuance
(given the significant decline in refinance activity) has far outweighed the drop in
Fed purchases. On the shorter end of the curve, 2- and 3-year yields actually rose
slightly as the market began to anticipate the eventual Fed tightening cycle
expected to begin mid-2015, resulting in a flatter yield curve. The combination of
lower long-term yields and tighter spreads helped to reduce the unrealized loss on
the portfolio to 0.2%. The yield of the portfolio also showed improvement, rising
another 5bp to 2.83% and marking the 8th consecutive month of improving yields.
The increase in portfolio yield is primarily due to two reasons: reinvesting
cashflows at higher market yields and a slowdown in MBS/CMO prepayments.
The Bank’s investment strategy has been focused on building a portfolio of stable
cash flow and the higher yields available today are the perfect opportunity to
continue deploying some of that cash flow to increase portfolio income and fight
margin erosion.
Sector Distribution
CMO,
8%
MBS/
CMO
FL, 7%
Other,
4%
Agency,
14%
Muni,
30%
MBS,
34%
Tax
Muni,
3%
The portfolio’s average life, duration and price volatility all fell slightly during the
1st quarter as the Bank has actively fought extension risk and worked to push
duration toward a more neutral level. Just as the Bank had to work hard to keep
portfolio duration from contracting too much when rates were at a record low, the
Bank must now work hard to keep the duration from extending too much as rates
rise. For this reason, the current strategy will be to reduce duration toward
neutral from its current above neutral position.
The significant rise in yields in the 2nd half of 2013 combined with notable
average life extension and falling portfolio values has attracted the attention of
regulators. The OCC and FDIC have put out numerous advisories and articles
highlighting the importance of prudent interest rate risk management and they
have been focusing more attention than usual on IRR during exams. The Bank has
built a conservative portfolio and resisted the urge to “chase yield” in higher risk
assets, so we are confident the drop in the value of our portfolio has been less than
what other higher risk portfolios have experienced. Nevertheless, the Bank will
continue to focus on managing the interest rate risk position of the portfolio and
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Q2 2014 Investment Strategy
March 2016
the entire balance sheet and making sure the bank remains within all requisite
policy limits.
The Bank will continue to build a cash flow barbell with a short-to-intermediate
range ladder of MBS/CMO cashflow combined with longer maturity tax-exempt
municipals. In order to achieve the goal of reducing portfolio duration towards
neutral, the Bank will increase its allocation of shorter duration options including
higher coupon MBS, short high cash flow CMOs, Hybrid ARMs, floaters and shorter
1X callable agencies. Despite the desire to reduce duration to neutral, the relative
value in longer municipals is the best it’s been in years and the Bank will look for
opportunities to add longer municipals to increase and stabilize portfolio yield.
Portfolio allocations will continue to be managed based on anticipated needs for
liquidity, cash flow and earnings. With an understanding that the worst bonds are
normally purchased at peaks and troughs in interest rates, security selection has
never been more critical and the Bank will avoid high risk securities. Purchase
decisions will be focused on structure, credit, loan attributes, cash flow volatility,
price risk and optimal relative value between and among sectors.
Historical U.S. Treasury Yield Curves
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
6/30/2013
9/30/2013
12/31/2013
1.0%
3/31/2014
0.5%
0.0%
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Q2 2014 Investment Strategy
March 2016
Sector Strategies
Agencies
In Q1 agency spreads remained at all-time lows in the 0-6-year maturity sector. 2year bullet agencies are flat to treasuries and 5-year bullets are +6 basis points.
The Bank will continue to moderate sector duration by primarily purchasing
securities with 3- to 7-year maturities. Favored structures will continue to be
premium one-time callable securities with at least one year of call protection and
deeply discounted callables with some spread to matched-maturity bullets and a
significant yield kick if called. The Bank will look to add 5-10-year maturity stepups with coupon and call structures that limit extension risk and provide a high
likelihood of being called prior to maturity. Favored structures will continue to be
those with a “bullet” feature on the back-end of the call schedule, including 1x
call/1x step and Canary call structures (usually quarterly callable for 2-5 years,
then a high-coupon bullet for 2-5 years). The Bank will avoid sacrificing structure
and cash flow stability for marginal increases in yield. The Bank will continue to
look for opportunities to sell short maturities and deploy the proceeds on the
intermediate portion of the curve. In general, the Bank will look to take advantage
of market fluctuations by adding slightly longer duration instruments (discounted
callables and intermediate-maturity bullets) when rates rise, and focusing on
premium 1x-calls in the lower part of the trading range.
Agency %
Curr/Last
Target
14%/14%
10-25%
Eff. Duration / Convexity
Curr/Last
Target
2.9/(0.8)
2.9/(0.8)
1.5-2.5
/(0.5)(1.0)
CDs
The bank’s CD sector remains quite small. Spreads on CDs also remained very low
in Q1, so it is important for the bank to focus on buying only CDs that offer some
spread to bullet agencies. Which currently will have the bank focusing on CDs
with 1- to 7-year maturities. The Bank will buy only marketable FDIC-insured CDs,
where it can expect to pick up 5-40 bps to bullet agencies in the desired maturity
range. Like agencies, the Bank will avoid longer-maturity, option-heavy
structures. FDIC insurance covers up to $250,000 per issuer, including accrued
interest. The bank will limit holdings of CDs under these constraints per issuer.
The supply of unique issuers remains limited, so the Bank will look to take
advantage quickly when new opportunities arise.
CD %
Curr/Last
Target
2%/2%
0-5%
Eff. Duration / Convexity
Curr/Last
Target
1.3/(0.3)
1.3/(0.3)
1.52.5/(0.5)(1.0)
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Q2 2014 Investment Strategy
March 2016
Municipals
Municipals continued to be attractive to investors during the first quarter as
demand outpaced issuance. As a result Municipal bonds returned 3% during this
period. The Bank will deploy funds in the 6 to 13 year range taking advantage of
any market sell-off. The Bank will purchase higher coupons preferring a 3.50% or
higher to reduce price volatility. As a percentage of treasuries, municipals
continue to be 80% to 90% along the curve. The historical percentage has been
around 75% to 80%. 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 continues 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 continue to buy general obligation municipals and will purchase
essential-purpose revenue municipals with a minimum of 1.25x coverage and
preferring a 1.5x or higher coverage. The Bank will also purchase taxables with 510 year maturities, preferring shorter maturities because they do not have the
same 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, State Aid Withholding, Qualified School Bond Funds, and issues rated A
or better on their own. The Bank will purchase municipals with AGM, Assured
Guaranty, Build America Mutual, and Municipal Assurance Corp. insurance that
have an A or better underlying rating.
MBS
The Federal Reserve has continued to taper announcing a reduction of Treasury
and Agency MBS purchases by $5Billion each per month at both the January 29
and March 19 FOMC meetings. After mortgage rates reacted to the initial taper
announcement in Dec 2013 by rising to just over 4.5% to end the year, the current
30yr conventional mortgage rate stands 16 basis points lower at 4.34%
Severe winter weather and higher mortgage rates relative to a year ago have
resulted in a continued slowdown in refinancing activity. The Mortgage Bankers
Association refinancing index averaged just over 1,500 in Q1 2014 versus an
average of 3,070 in 2013 with a peak reading of 5,230 in May of last year.
Overall, prepayments on MBS have followed suit, slowing about 50% from the
peak last year. As we move into the Spring and Summer months, it is expected by
many analysts that prepayments should pick up roughly 20% given the current
rate scenario.
Municipal %
Curr/Last
Target
30%/30%
25-35%
Eff. Duration / Convexity
Curr/Last
Target
3.4/(0.4)
3.5/(0.3)
3.5-4.0/0-(0.5)
Taxable Municipal %
Curr/Last
Target
4%/4%
0-10%
Eff. Duration / Convexity
Curr/Last
Target
5.1/(0.2)
5.3/(0.1)
5.0-7.0/0.3-(0.3)
MBS %
Curr/Prev
Target
34%/35%
30-45%
Eff. Duration / Convexity
Curr/Prev
Target
2.4/(0.8)
2.4/(0.8)
1.5-2.0/
(0.7)-(1.3)
While current refinancing activity has essentially vanished, there is still risk to
higher prepayments if the recovery from The Great Recession was to stall and the
Fed was to increase stimulus. Additionally, risk of stimulus from the Government
is still elevated as the Obama administration was able to push through the
nomination of Mel Watt to head the FHFA at the end of 2013. Watt indicated he
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Q2 2014 Investment Strategy
March 2016
would take 90 days to evaluate the situation, but it is believed he will push for
reducing barriers to allow more borrowers to access a low cost mortgage through
government programs. The HARP 2 program has continued to be successful in
allowing eligible underwater homeowners to take advantage of a tremendous
opportunity to obtain an artificially low cost mortgage. The program was
originally set to expire at the end of 2013 and will now be in place through Dec 31,
2015. Specifically, borrowers with loans packaged into FNMA or FHLMC MBS
experiencing no delinquencies over the past 12 months and an underwater loan
(>80LTV) originated before June 1, 2009, have the opportunity to streamline
refinance, with very low costs. In GNMA space, the FHA streamline program
continues to provide incentives to refinance for borrowers with loans also
originated prior to June 1, 2009. These pre-June 2009 FHA loans are
grandfathered from having to pay the higher current annual Mortgage Insurance
Premiums (Grandfathered MIP = 55pb vs. 130-135bp currently) and the upfront
premium is only 1 basis point (vs. 1.75% for non-grandfathered loans
The role of the MBS portfolio continues to provide steady front-end cash flow
while maximizing risk/reward benefits.
With the slowdown in current
prepayments, but the risk of a potential stall in the recovery and a pro credit FHFA
director in Mel Watt, our strategy to balance both contraction and extension risk
in all mortgage related investments will remain intact. The MBS sector allocation
dropped 1% to 34%, while the effective duration and convexity remained at 2.2
and (0.8) respectively. The Bank continues to review all holdings in the MBS
portfolio and will continue to evaluate the benefits of liquidating securities that
underperformed in the back-up in rates or could be negatively impacted by
current or potential future Government refinance programs.
Higher mortgage rates and slower prepayments reinforces the Banks mantra of
striving to hold securities that provide consistent prepay protection while offering
extension mitigation and more defensive price volatility characteristics. Higher
coupon and/or shorter weighted average maturities are the primary attributes the
Bank will employ to reduce depreciation risk. To counter the premium risk
inherent in higher coupon MBS, the Bank will strive to find securities that should
be less susceptible to faster prepayments. The #1 loan attribute to curtail fast
prepayments, and also provide higher base case turnover rates, continues to be
pools comprised of lower loan balance mortgages. These low loan balance
mortgagees have less economic incentive to refinance into lower rates when they
are low but have increased mobility due to smaller loan sizes when rates are
higher. To balance extension and prepayment risks, the Bank will continue to
focus on shorter-term (<=20yr) and relatively higher coupon (>=3.5%) specified
agency MBS pools. 10-year MBS pools would be the exception to the coupon
parameters, in that the shorter final maturity and high scheduled principal cash
flow reduces the need for a higher coupon to limit price volatility risk. Pools will
be selected with one or more of the following loan characteristics that should
provide prepay protection: 1) low loan balance, 2) investor and vacation
properties, 3) NY, TX, NJ, FL geographic concentrations, 4) Higher LTV (>90%),
and 5) FHA Loans (GNMAs) originated after June 1, 2009 and prior to April 2011.
Although the prepay protection may not be needed if rates continue to rise, the
current cost for attaining these attributes has dropped significantly and should be
good insurance if the economy falters and we experience a drop in rates.
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Q2 2014 Investment Strategy
March 2016
ARM/Float
The Bank reinvested very little cash flow into the ARM sector over the second half
of 2013 and the 1st quarter of 2014, resulting in portfolio allocation ending the
year at 6%. As the overall portfolio duration is approaching the upper end of the
Banks target level, the Bank will continue to search for opportunities to enhance
future rate sensitivity with minimal yield give up. As opportunities present, an
additional focus for the sector will be seasoned post-reset ARMS. These loans may
have had initial fixed-rate periods for 5 or 7-years, but were originated prior to
2007 and currently have annual resets with a 2% annual collar. Over the past two
years, the Bank added a small allocation of newer GNMA 3x1 and 5x1 Hybrid
ARMs with 2.0% to 3.5% coupons. Due to record low rates, a very steep yield
curve and aggressive refinancing, this sector has prepaid faster than anticipated.
However, an almost 100bp increase in 5x1 borrowing rates coupled with the
increase in FHA Mortgage insurance Premiums should cause prepayments in this
sector to decline significantly over the coming months. The Bank will look to find
value and increase allocation in this sector if prices fall and premium risk can be
minimized.
ARM/Float %
Curr / Prev
Target
6%/6%
0-10%
Eff. Duration / Convexity
Current / Prev
Target
0.7/(0.6)
0.7 / (0.6)
0.8-1.5/
(0.3)-(0.8)
CMO
The performance of the CMO sector has improved substantially as prepayments
have slowed over the second half of 2013 and into 2014. Given the slowdown in
prepayments, all CMO structures continue to be evaluated for potential extension
risk and those identified with greater risk have been/will be targeted for
liquidation. The Bank will look to take advantage of higher rates and a steeper
yield curve by pursuing CMO structures that have 2-5 year projected average lives
with limited extension risk. To reduce overall premium risk in the portfolio, the
Bank will look for opportunities to add these preferred cash flow structures with
lower coupons backed by higher WAC collateral. Additionally, very short average
life CMOs (1-2yrs) will be utilized when available to provide a spread to cash
alternatives over the next 18-24 months while the Fed keeps short-term rates
anchored. To diversify mortgage prepayment exposure and take advantage of the
more stable prepayment characteristics, 30 year GNMA MBS (post June1, 2009
origination) will be the preferred CMO collateral. Foremost, FHA loans originated
after June 1, 2009 are not eligible to refinance under the FHA HARP program. FHA
loans originated prior to April 2011 (and after June 1, 2009) have provided
excellent prepayment protection as the FHA has increased the annual Mortgage
Insurance Premium by 80bps. The increased premium results in an additional
rate incentive needed for an FHA borrower to achieve the required 5% Net
Tangible Benefit to refinance. Furthermore, GNMA collateral can offer superior
extension protection as base case turnover should remain brisk due to ongoing
buyouts of lesser credit FHA borrowers. Preferred FNMA/FHLMC collateral will
have underlying loan attributes as stressed in the MBS sector (low loan balance,
investor and vacation properties, NY, TX, NJ, FL geographic concentrations, higher
LTV MHA loans, etc.) that should provide prepay protection. All CMO’s will be
prudently analyzed and continually monitored for both extension and call risks
and will be managed to maximize risk/reward benefits.
CMO %
Curr/Prev
Target
8%/8%
5-15%
Eff. Duration / Convexity
Current/Prev
Target
2.1/(0.9)
2.1/(1.0)
1.2-2.0/
(0.5)-(1.2)
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Member: FINRA & SIPC
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