Yield Curve
Jim Reber, CPA, CFA
President
ICBA Securities
1
Treasury Yield Curve in 2015
Curve C15
2
Fed Funds
• Target Rate is established by the Federal Open Market Committee (FOMC)
• Effective Rate is maintained through open market operations
• Fed Funds highly influences short‐term interest rates, Prime and LIBOR
3
Fed Funds vs. 2‐yr Treasury
4
Fed Funds vs. 10‐yr Treasury
5
Implied Forward Yield Curve
Curve C18
“Indifference Curve”
6
Is It a Good Predictor?
Why not?
7
Yield Curve Theories
• Pure Expectations Theory
• Liquidity Preference Theory
• Market Segmentation Theory
8
Pure Expectations Theory
• Reflects expectations of future interest rates
• Quantified in the implied forward yield curve
9
Liquidity Preference Theory
Contends investors prefer liquidity
Risk‐averse investors who are concerned with opportunity cost
Will forego yield today
Tends to lower yields on the short end, and make the curve steeper than is warranted
10
Market Segmentation Theory
• Contends that investors prefer certain points on the curve to the exclusion of others
• Often institutional investors who are required to maintain certain durations
• Tends to make the curve flatter than is warranted
11
What Is Normal?
25yr Average
25yr Avg
Fed Funds
3 mo T-Bill
6 mo T-Bill
1yr Treas
2 yr Treas
3 yr Treas
5 yr Treas
10 yr Treas
1-10yr
3.05
2.85
2.99
3.18
3.45
3.74
4.13
4.73
10yr Average
Slope to
Prior Spread to
Point
Funds
(0.20)
0.14
0.19
0.27
0.29
0.39
0.60
0.13
0.40
0.69
1.08
1.68
1.55
10yr Avg
1.46
1.19
1.29
1.37
1.56
1.72
2.31
3.14
5yr Average
Slope to
Prior Spread to
Point
Funds
(0.27)
0.10
0.08
0.19
0.16
0.59
0.83
(0.09)
0.10
0.26
0.85
1.68
1.77
5yr Avg
0.25
0.05
0.10
0.18
0.41
0.70
1.31
2.33
Current - 10/23/2015
Slope to
Prior Spread to
Point
Funds
(0.20)
0.05
0.08
0.23
0.29
0.61
1.02
(0.07)
0.16
0.45
1.06
2.08
2.15
Current
0.25
0.03
0.12
0.26
0.61
0.89
1.35
2.03
Slope to
Prior Spread to
Point
Funds
(0.22)
0.09
0.14
0.35
0.28
0.46
0.68
0.01
0.36
0.64
1.10
1.78
1.77
12
Yield Curve “Norms”
• Flat/inverted curve = expectation of lower rates ahead
• Flat curves give little time to react (months)
• Steep curve = expectation of higher rates ahead
• Steep curves tend to give ample time to react (year or more)
13
Yield Curve Summary
• Yield curves represent investors’ expectations of future interest rates
• Implied forward yield curve is a poor predictor of future rates; however:
• Flat curves have been good indicators of falling rate environments
• Liquidity preference and market segmentation create the poor predictive attribute
14
Questions?
15
Bond Basics
Jim Reber, CPA, CFA
President
ICBA Securities
1
Debt Securities
• Loan, versus ownership
• Higher priority than equity in a dissolution
• Characterized by periodic interest payment and defined maturity
• Periodic interest payments fit well into a bank’s cash flow patterns
2
Debt Securities
• Most securities suitable for banks have a third‐party quality evaluation called a “credit rating.”
• Your ability to rely on the credit rating exclusively was removed by Dodd‐Frank
• Regulators have a further quality evaluation known as a “risk weighting.”
3
Credit Ratings Scales
Moody's
Standard & Poor's
Long-Term Debt
Long-Term Issuer Credit
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
Ba1
Ba2
Ba3
B1
B2
B3
Caa1
Caa2
Caa3
Ca
C
WR
NR
AAA
AA+
AA
AA‐
A+
A
A‐
BBB+
BBB BBB‐
BB+
BB BB‐
B+
B B‐
CCC+
CCC CCC‐
CC
R
SD and D
NR
Lowest Investment Grade Ratings: Baa3/BBB‐
4
Risk Weighting Table
5
Risk Weighting Table
6
Debt Securities
• Investors are primarily institutional
• Analytics on bonds are much simpler than on stocks
• Future prices of bonds can be calculated with certainty, given:
‐ Future interest rates
‐ Horizon dates
7
Debt Securities
• Two incontrovertible facts about bonds:
1. Prices move in the opposite direction of yields, and
2. Bond math is not linear
8
U. S. Treasury Debt
• Bills (< 1 yr), notes (2 yrs – 10 yrs), bonds (30 yrs)
• Auctioned according to Dutch auction rules
• Non‐competitive bids are allowed
• Bills are auctioned weekly; 2’s, 5’s and 7’s monthly; 3’s, 10’s and 30’s quarterly
9
On‐the‐run Treasuries
10
Price/Yield Table
5‐Year Treasury Note
11
Price/Yield Graph
5‐Year Treasury Note
12
Price
Price equals the present value of future cash flows (both principal and interest)
13
Pricing a Two‐Year Treasury
• $1 million invested
• 4.25% coupon, paid semi‐annually
• Price: 100.00
Semi‐annual Period
1
2
3
4
Cash Flow
21,250
21,250
21,250
1,021,250
Total
Present Value @ 4.25%
20,808
20,375
19,951
938,866
1,000,000
14
Duration
The weighted average maturity of the security’s cash flows, where the present values of the cash flows serve as the weights. The greater the duration of a security, the greater its percentage price volatility.
Also known as MacCauley’s Duration
15
Duration Calculation
• $1 million invested
• 4.25% coupon, paid semi‐annually
• Price: 100.00
Duration = 1,938,438/1,000,000 = 1.94 Years
Modified Duration = 1.94/(1 + 4.25%) =1.86 Years
16
Price Volatility Tables
5‐Year Treasury Note
3‐Year Treasury Note
17
Duration
• Duration measures the slope of the price curve and approximates the change in value of a bond under rising or falling rates. Price
Slope
4.25%
Yield
Yield
18
Price Volatility
• $1 million invested
• 4.25% coupon, paid semi‐annually
• Price: 100.00
Semi‐Annual Period
Cash Flow
Present Value @ 1.25%
Present Value @ 2.25%
Present Value @ 3.25%
Present Value @ 5.25%
Present Value @ 4.25%
Present Value @ 6.25%
Present Value @ 7.25%
1
21,250
21,118
21,014
20,910
20,808
20,706
20,606
20,506
2
21,250
20,987
20,780
20,576
20,375
20,117
19,982
19,789
3
21,250
20,856
20,549
20,247
19,951
19,661
19,376
19,097
4
1,021,250
996,113
976,558
957,480
938,866
920,703
902,976
885,674
Total
1,085,000
1,059,074
1,038,901
1,019,213
1,000,000
981,187
962,940
945,066
Bond Price
105.907
103.890
101.921
100.000
98.125
96.294
94.507
Price Change
59,074
38,901
19,213
0
‐18,813
‐37,060
‐54,934
Percent Change
5.91%
3.89%
1.92%
0.00%
‐1.88%
‐3.71%
‐5.49%
19
Price Volatility vs. Maturity
• 3.00% Coupon
Maturity
Rates Up 1.0%
Rates Down 1.0%
100.99
0.99%
3
97.20
‐2.80%
102.89
2.89%
5
95.51
‐4.49%
104.74
4.74%
10
91.82
‐8.18%
109.02
9.02%
30
82.62
‐17.38%
122.48
22.48%
Price Volatility
‐0.97%
Price Volatility
99.03
Maturity
1
20
Bonds with Different Coupons
3.00% Coupon
Maturity
Rates Up 1.0%
5.00% Coupon
Rates Up 1.0%
‐0.97%
99.04
‐0.96%
3
97.20
‐2.80%
97.29
‐2.71%
5
95.51
‐4.49%
95.73
‐4.27%
10
91.82
‐8.18%
92.56
‐7.44%
30
82.62
‐17.38%
86.16
‐13.84%
Price Volatility
99.03
Cash Flow
1
21
Taxable vs. Tax‐Free Price Volatilities
Immediate Price % Change
‐200bps
‐100bps
+100bps
+200bps
+300bps
5 Year Treasury
15.4
10.0
4.9
‐4.6
‐9.0
‐13.1
5 Year Muni
9.7
6.3
3.1
‐3.0
‐5.9
‐8.7
Price Volatility
Taxes Paid
‐300bps
22
Summary of Price Volatility Relationships
Maturity increases
• Cash flow decreases
• Taxes apply
• Coupon is fixed
•
Increases When:
Price Volatility
Decreases When:
•
•
•
•
Maturity decreases
Cash flow increases
Taxes do not apply
Coupon floats
23
Convexity
The second derivative of a security’s price with respect to its yield, divided by the security’s price. A security exhibits positive convexity when its price rises more for a downward turn in its yield than its price declines for an equal upward move in its yield.
Source: Bloomberg 24
Price Volatility vs. Maturity
• 3.00% Coupon
+22.5%
30 Year Bond
Value
Par
‐17.4%
2.0 3.0 4.0 Yield
25
FHLB 1.25 9‐14‐18 “Bullet”
26
Horizon Price
FHLB 1.25 9‐14‐18 “Bullet”
107.40
106.40
105.40
104.40
103.40
102.40
101.40
100.40
99.60
98.60
97.60
96.60
95.60
94.60
93.60
‐300 ‐200 ‐100 0 +100 +200 +300
Rate Shift
27
FNMA 1.00 10‐26‐18/15 Callable
28
Horizon Price
FNMA 1.00 10‐26‐18/15 Callable
107.00
106.00
105.00
104.00
103.00
102.00
101.00
100.00
99.00
98.00
97.00
96.00
95.00
94.00
93.00
‐300 ‐200 ‐100 0 +100 +200 +300
29
Convexity
• Positively convexed bonds:
‐ Treasuries
‐ Bullet agencies
‐ Non‐callable corporates
‐ Munis that are non‐callable for the majority of the term
‐ Very well‐structured CMOs
• All other bonds are negatively convexed!
30
Summary
• Price = Present value of future cash flows
• Duration = Weighted period of time to receive all principal and interest; also a means of estimating price volatility
• Convexity = The ability of a bond to appreciate in value more as rates fall than it depreciates as rates rise
31
Questions?
32
4th Quarter Economic Outlook
U.S. Stability amidst Global Turmoil – And a Rate Hike … Maybe
Craig Dismuke
Chief Economist, Vining Sparks
cdismuke@viningsparks.com
Topics
 Current U.S. and Global Economic Environment –
Divergence
 Long-Term Headwinds for U.S. Growth
 Why This Rate Cycle Will Be Different
 Market Lessons from Previous Rates Cycles
Payroll Growth Good, Slowing
3
Nonfarm payroll growth continues to trend above 150k per month. However, the pace of net job
growth has slowed in 2015 to 198k per month from 260k in 2014.
450 Annual Average
115k
400
146k
165k
260k
198k
Change in NonFarm Payrolls (142k)
3M Average (Total)
350
300
250
200
167K
142K
150
100
50
0
2011
2012
2013
Sources: BLS, Vining Sparks
2014
2015
Unemployment Rate Keeps Falling
4
The unemployment rate continues to decline from 9.98% in 2009 to 5.05% in September. In fact,
the pace of decline has not slowed since the labor recovery began.
10%
9%
8%
7%
6%
5%
5.05%
4%
2007
2008
2009
2010
2011
Sources: BLS, Vining Sparks
2012
2013
2014
2015
Job Openings Highest on Record
5
Job openings have risen to 5.75 million and have surpassed the highest levels on record.
Meanwhile, layoffs remain historically low although quits have leveled out.
6,000
5.75M
Quits
5,500
Layoffs
5,000
Openings
4,500
4,000
3,500
3,000
2,500
2.70M
2,000
1,500
1.61M
1,000
2003
2004
2005
2006
2007
2008
2009
Sources: BLS, Vining Sparks
2010
2011
2012
2013
2014
2015
Tighter Labor Market, Wages Stuck
6
Despite all of the improvement in the labor market, which can be seen in how few unemployed
persons there are for every job opening, wages have not held their historical correlation.
0.0
6.0
Unemployed Persons per Every Job Opening (Adv. 9M)
Average Hourly Earnings (YoY)
1.0
3.0
3.0
2.0
4.0
1.0
5.0
0.0
-1.0
6.0
-2.0
# Unemployed Persons for
Every Job Opening Declining
7.0
Average Hourly Earnings - All Employees (3M/3M, Ann)
Employee Cost Index - Wages (QoQ, Ann)
5.0
4.0
2.0
6.0%
5.0%
4.0%
3.0%
2.0%
1.95%
1.0%
-3.0
8.0
0.6%
-4.0 0.0%
2001
2003
2005
2007
2009
2011
2013
2015
Sources: BLS, Vining Sparks
2002
2004
2006
2008
2010
2012
2014
Retail Sales Rebound after Cool Start
7
Finally… consumers have begun spending some of their savings from lower gasoline prices.
Consumption rose 3.6% in 2Q and is on pace to grow 3.0% or more in 3Q.
1.0%
Core Retail Sales (MoM)
0.8%
0.6%
8.0%
0.90%
0.81%
7.0%
Core Retail Sales (3M/3M)
0.60%
6.0%
0.48%
0.4%
5.0%
0.31%
4.0%
0.16%
0.2%
3.0%
0.0%
-0.2%
-0.05%
-0.05%
-0.06%
2.0%
1.0%
-0.28%
-0.4%
0.0%
-0.39%
-0.6%
-1.0%
Nov
Dec
Jan
Feb
Mar
Apr
May
Sources: Census Bureau, Vining Sparks
Jun
Jul
Aug
Sep
Consumption Driven Growth
8
Finally… consumers have begun spending some of their savings from lower gasoline prices.
Consumption rose 3.6% in 2Q and is on pace to grow 3.0% or more in 3Q.
15%
7%
Personal Consumption (3M/3M SAAR, GDP)
Retail Sales Less Autos, Build. Mat., Gasoline (Q/Q Tracking, SAAR)
10%
6%
5%
4%
5%
3%
2%
0%
1%
0%
-5%
-1%
-2%
-10%
-3%
-4%
-15%
-5%
2002
2003
2004
2005
2006
2007
2008
2009
2010
Sources: BEA, Census Bureau, Vining Sparks
2011
2012
2013
2014
2015
Chinese Slowdown
9
While no one seems to know China’s true rate of economic growth, the PMI data is very weak
and the government has been unable to keep stock prices inflated.
5,500
China Manufacturing PMI
Shanghai Composite Index
56
5,000
54
4,500
52
4,000
50
3,500
48
3,000
46
2,500
44
2,000
42
1,500
Jan-14
40
Sep-12
Jul-14
Jan-15
Jul-15
Sources: Bloomberg, Caixin, Vining Sparks
Mar-13
Sep-13
Mar-14
Sep-14
Mar-15
Canadian Recession
10
Canada’s economy contracted for a second consecutive quarter in 2Q. Low oil prices are having a
significant effect on the U.S.’s largest consumer of exported goods.
8
6
4
2
0
-2
-4
Canada GDP
-6
-8
-10
2000
2002
2004
2006
Sources: STCA, Vining Sparks
2008
2010
2012
2014
Eurozone Deflation
11
The Eurozone’s unemployment rate remains excessively high at 11%. Of more acute concern for
the ECB, headline inflation fell back into negative territory in 3Q.
13
5.0
EU Unemployment Rate
EU CPI YoY
12
4.0
EU Core CPI YoY
11
3.0
10
2.0
9
1.0
8
0.0
7
-1.0
2000
2002
2004
2006
2008
Sources: Eurostats, Vining Sparks
2010
2012
2014
International Trade Partners
12
The stronger Dollar and widespread, global weakness is taking a toll on U.S. exporters and
manufacturers.
Share of U.S. Exports by Country
50%
U.S. Exports to China
U.S. Exports to Eurozone
U.S. Exports to Canada
40%
30%
20%
10%
0%
-5% YoY
-10% YoY
-13% YoY
-10%
-20%
2010
2011
2012
2013
2014
2015
Sources: Census Bureau, Vining Sparks
Greece
Portugal
Ireland
Spain
Russia
Venezuela
Italy
France
U.K.
Germany
Japan
China
Eurozone
Mexico
Canada
0.0%
0.1%
0.3%
0.6%
0.7%
0.9%
1.2%
2.3%
3.2%
3.2%
4.0%
7.7%
12.7%
14.2%
19.1%
0%
10%
20%
Divergence
2015 has been a year of divergence in economic growth rates as well as monetary policies. While
the Fed is debating a rate increase, other central banks are going in the opposite direction.
13
Result of Divergence: Stronger Dollar
14
After the run in 2014, the Dollar has retained its strength versus a trade-weighted basket of
currencies, up 20% from its post-recession average.
100
Trade-Weighted Dollar Index
98
96
94
92
90
88
86
84
82
80
78
76
74
72
70
2006
2007
2008
2009
+20%
2010
2011
Sources: Bloomberg, Vining Sparks
2012
2013
2014
2015
Stronger Dollar Is Disinflationary
15
As the Fed tries to get off zero interest rates, they are caught in a Catch-22. The process of
tightening strengthens the Dollar which causes them to miss their inflation target.
Strong Dollar, Lower Commodity Prices
500
Dollar
Strengthening
450
40
160
50
140
60
400
70
350
Stronger Dollar, Lower Oil Prices
Dollar
Strengthening
60
70
120
80
100
80
300
80
90
90
250
100
200
110
CRB Commodity Price Index
150
US Dollar (Trade Weighted)
100
2000
2002
2004
2006
2008 2010
2012
2014
60
100
40
WTI Crude
120
20
130
0
110
Dollar
120
2000 2002 2004 2006 2008 2010 2012 2014
Sources: CRB Commodity Price Index, Bloomberg, Vining Sparks
Stronger Dollar Is Disinflationary
16
Apart from wage growth, commodity prices have one of the strongest correlations with core
inflation of any input. They currently point to Core CPI falling to below 1% in late-2016.
60%
3.50
40%
3.00
2.50
20%
2.00
0%
1.50
-20%
-40%
1.00
Commodity Prices (YoY, Adv. 18M)
Core CPI (YoY)
0.50
-60%
0.00
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Sources: BLS, CRB Commodity Price Index, Vining Sparks
Today’s Global Economic Environment
U.S. stability amidst global weakness keeping the Dollar strong > Stronger Dollar and weak global
growth keeping commodity and oil prices low > Creating disinflationary pressure > Fed concerned
about missing inflation target > Hesitant to raise rates
Tighter Labor Market
Stronger Dollar
Weak Chinese Growth
Strengthening
Consumer
Lower Commodity
Prices
Weak Eurozone Growth
Stable U.S. Economy
Lower Oil Prices
Eurozone Deflation
Fed Slowly Tightening
Tepid Wage Growth
Disinflationary Pressure
Fed Afraid to Hike
17
Topics
 Current U.S. and Global Economic Environment –
Divergence
 Long-Term Headwinds for U.S. Growth
 Why This Rate Cycle Will Be Different
 Market Lessons from Previous Rates Cycles
18
CBO’s GDP Projections
19
The Congressional Budget Office projects that GDP growth will slow from 3.3% (from 1965 to
2007) to 2.3% (from 2015 to 2025)
8%
GDP (YoY)
6%
Average Rate of Growth Since 1965: 3.3%
4%
Potential GDP
2%
0%
-2%
-4%
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Sources: Congressional Budget Office January 2015 Baseline Projections, Vining Sparks
2020
2025
Federal Reserve’s GDP Projections
While the Fed believes GDP will grow in the mid-2.0% range for the next three years, they also
project that growth will slow to 2.0 to 2.3% over the longer-run
Sources: Federal Reserve December 2014 Summary of Economic Projections, Vining Sparks
20
Headwind #1: Aging Population
21
375
300
Millions
Over the next 15 years, there will be almost 30 million more people over the age of 65. However,
there is very little growth in other age cohorts.
225
Projected
65 and Over
55-64
45-54
35-44
25-34
16-24
0-15
22.2%
14.5%
8.1%
150
-
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
2024
2026
2028
2030
75
Sources: Census Bureau, Vining Sparks
Change in Output Potential
22
If workers continue to retire between 65 and 67 years-of-age, pool of available labor growth
slows to 0.1% over the next 10 years, 0.4% through 2060.
8%
Productivity Growth (YoY)
16-65 Population Growth (YoY)
GDP Growth
6%
Average Since 1950
Productivity Growth: 2.1%
16-65 Population Growth: 1.2%
4%
2%
0%
-2%
-4%
1953
1963
1973
1983
1993
2003
2013
Sources: Census Bureau, Vining Sparks
2023
2033
2043
2053
Change in Consumption Habits
23
People consume goods and services differently as they age also, spending more on medical
expenses but spending much less overall.
$70,000
$60,000
Other
Entertainment
$50,000
Medical Expenses
$40,000
Transportation
Apparel
$30,000
Housing
$20,000
Food and Beverages
$10,000
$0
18-24
25-34
35-44
45-54
55-64
65-74
75+
Sources: Federal Reserve Consumer Expenditure Survey, Vining Sparks
Change in Leverage Habits
24
Aging households do not leverage like younger households, slowing the velocity of money.
$250,000
$6,000
Average Value of Real Estate Assets
Average Annual Mortgage Payments
$5,000
$200,000
$4,000
$150,000
$3,000
$100,000
$2,000
$50,000
$1,000
$0
$0
18-24
25-34
35-44
Sources: Federal Reserve Consumer Expenditure Survey, Vining Sparks
45-54
55-64
65-74
75+
Headwind #2: Net Interest Expense
25
The severity of the problem is acute with interest expense projected to increase $600 billion over
the next 10 years.
$900
$827 B
$800
$700
$600
$500
$400
Annual Interest Expense
$300
$229 B
$200
$100
$0
1965
1970
1975
1980
Sources: Congressional Budget Office, Vining Sparks
1985
1990
1995
2000
2005
2010
2015
2020
2025
Growth of Debt Difficult to Slow
26
Inflating the country out of its debt problem is not an option this time. Growth in spending is
primarily in mandatory items and interest expense which will be very difficult to cut.
$3,000
Projected Growth in Annual Outlays and Revenues from 2014 to 2025
$2,613
Defense
$115
Non-Defense Discretionary
$106
$2,500
$2,009
$2,000
Social Security
$719
$1,500
Healthcare Programs
$874
$1,000
Other Mandatory Items
$201
$500
Interest Expense
$598
$Annual Outlays
Annual Revenues
Sources: Congressional Budget Office, Vining Sparks
$0
$500
$1,000
Headwind #3: Changing Housing Dynamics
New and existing homes sales fell 13.3% from their 2013 peak after a marginal increase in
mortgage rates.
9,000
New and Existing Home Sales Combined
8,000
7,000
6,000
5,000
-13.3%
3,000
000s
4,000
2005
2006
2007
2008
2009
2010
2011
2012
Sources: National Association of Realtors, Vining Sparks
2013
2014
2015
27
Changing Dynamics in Housing
28
Housing market appears to be more rate-sensitive during this cycle than in the 80s or 90s
because of who is purchasing homes – investors.
42.0MM 43
76.5MM
40
74.6MM
70
37
65
34
32.9MM
60
31
Renter-Occupied Housing Units
55
50
1980
28
25
1985
1990
1995
2000
Sources: Census Bureau, Vining Sparks
2005
2010
Renter-Occupied Units
Owner-Occupied Housing Units
Millions
Owner-Occupied Units
75
Millions
80
Headwind #4 - Asset Bubbles
29
Total stock market capitalization as a percentage of GDP has risen to near 120%, the highest since
the frothy tech bubble.
160%
140%
Total Stock Market Capitalization to GDP Ratio
120%
100%
80%
Average Since 1971: 73%
60%
40%
20%
0%
1971
1976
1981
1986
1991
1996
Sources: BEA, Wilshire 5000, Vining Sparks
2001
2006
2011
Asset Bubbles – Bond Yields
30
Treasury yields remain below levels consistent with 3.0% to 4.0% nominal GDP growth.
15.0
13.0
Nominal GDP
11.0
10-Year Treasury Yield
9.0
7.0
5.0
3.0
1.0
-1.0
-3.0
-5.0
1981
1986
1991
1996
Sources: BEA, Bloomberg, Vining Sparks
2001
2006
2011
Topics
 Current U.S. and Global Economic Environment –
Divergence
 Long-Term Headwinds for U.S. Growth
 Why This Rate Cycle Will Be Different
 Market Lessons from Previous Rates Cycles
31
Rate Cycles During Modern Fed Era
Including a small rate hike in 1997, there have been four periods when the Fed has seen fit to
raise its Target Overnight rate.
Feb ‘94
10
Mar ‘97
Jun ‘99
Jun ‘04
9
Fed Funds
8
2-Year Treasury
7
5-Year Treasury
6
10-Year Treasury
5
4
3
2
1
0
1989
1992
Sources: Bloomberg, Vining Sparks
1995
1998
2001
2004
2007
2010
2013
32
Comparing Economic Environments
33
In every other rate hike experience during the Modern Fed era, there has either been a hot labor
market, inflationary pressures building, or both. Today’s environment is much more fragile.
Feb ‘94
Mar ‘97
Jun ‘99
Jun ‘04
Oct ‘15
300 bps
13 mos.
25 bps
1 mos.
175 bps
12 mos.
425 bps
25 mos.
N/A
N/A
Unemployment
Participation
Hourly Earnings
6.6%
62.3%
2.8%
5.2%
63.6%
4.0%
4.3%
64.2%
3.9%
5.6%
62.3%
2.1%
5.1%
59.2%
1.9%
PCE Inflation
Core PCE Inflation
Commodity Prices
Oil Prices
2.1%
2.3%
+6.2%
-29.7%
2.1%
1.9%
+2.4%
-4.9%
1.4%
1.3%
-15.4%
+44.5%
2.8%
2.0%
+23.2%
+44.9%
0.3%
1.3%
-16.0%
-50.5%
5.8%
6.4%
6.3%
7.1%
3.7%
Rate Inc. Amount
Rate Inc. Amount
Nominal GDP
Sources: BLS, BEA, CRB, Bloomberg, Vining Sparks
Topics
 Current U.S. and Global Economic Environment –
Divergence
 Long-Term Headwinds for U.S. Growth
 Why This Rate Cycle Will Be Different
 Market Lessons from Previous Rates Cycles
34
Rate Cycles During Modern Fed Era
There have been three defined rate cycles during the Modern Fed era, with a fourth playing out
now. Included in those cycles have been three prolonged periods of tightening.
10
9
Fed Funds
8
2-Year Treasury
7
5-Year Treasury
10-Year Treasury
6
5
4
3
2
1
0
1989
1992
1995
1998
2001
Sources: Bloomberg, Vining Sparks
2004
2007
2010
2013
35
2004 to 2006 Rate Hike
36
The Fed was relatively transparent during this rate cycle and the market moved in anticipation of
the Fed actually raising rates. The market expected the Fed to end its hikes at 4.50%.
6.0
Last Rate Cut
First Rate Hike
5.0
+160 BPS
4.80
Last Rate Hike
+42 BPS
5.22
5.18
5.23
+120 BPS
3.98
4.0
+185 BPS
3.0
3.20
2.77
+246 BPS
+152 BPS
2.0
Fed Funds
2.13
2-Year Treasury
1.0
5-Year Treasury
1.25
10-Year Treasury
0.0
2003
Sources: Bloomberg, Vining Sparks
2004
2005
2006
Lessons from Previous Rate Cycles
These general lessons have been consistent through recent rate cycles; however, FOMC
transparency has changed the way markets respond prior to a tightening cycle.

Yields trough near last rate cut
 As Fed has become more transparent, longer rates rise in anticipation of
Target Rate increases while shorter rates rise in tandem with Target Rate
increases
 Short maturities (0-3 years) are fundamentally valued at the cumulative
expected overnight rate for the duration of the security
 Longer rates tend to rise to the expected terminal level for the overnight
Target Rate – the Fed has already lowered this to 3.50% (it is not
unreasonable to think they will lower it further)
37
Expectations for Longer Maturities
Longer rates tend to rise to the expected terminal level for the overnight Target Rate. The Fed
has lowered their median longer-run rate projection from 4.25% in 2012 to 3.50% today.
4.50
4.25
4.00
3.75
3.50
3.25
3.00
FOMC's Median Longer-Run Rate Projection
38
Expectations for Longer Maturities
39
Exogenous forces continue to depress intermediate and longer maturity Treasury yields and are
likely to continue to do so for quite a while (ECB QE, Global Weakness, Etc…)
2.00
3.00
1.80
10-Year German Bund
1.60
10-Year Treasury
2.80
1.40
2.60
1.20
1.00
2.40
0.80
2.20
0.60
2.00
0.40
0.20
1.80
0.00
-0.20
1.60
J
F
M
A
M
J
J
A
S
O
N
D
J
F
M
A
M
J
J
A
S
Expectations for Shorter Maturities
40
Short maturities (0-3 years) are fundamentally valued at the cumulative expected overnight rate
for the duration of the security
Market-Based Expectations
FOMC Projections
4.00
Fed Funds Futures Contracts: October 9, 2015
3.50
3.00
3.00
2.50
2.50
0.57%
FOMC Range of Projections
FOMC Median Projection
2.63
2.31
2.00
2.00
2.00
1.50
1.00
0.50
FOMC Target Rate Projections (September SEP)
Assumes Linear Intra-Year Path Based on Year-End Projections
0.19
0.30
0.40
0.50
0.65
0.80
0.93
1.02
1.14
1.38
1.50
1.13
0.88
1.00
0.50
0.00
0.00
-0.50
-0.50
October 2015
November 2015
December 2015
January 2016
February 2016
March 2016
April 2016
May 2016
June 2016
July 2016
August 2016
September 2016
October 2016
November 2016
December 2016
January 2017
February 2017
March 2017
April 2017
May 2017
June 2017
July 2017
August 2017
September 2017
October 2017
November 2017
December 2017
1.69
0.63
0.38
October 2015
November 2015
December 2015
January 2016
February 2016
March 2016
April 2016
May 2016
June 2016
July 2016
August 2016
September 2016
October 2016
November 2016
December 2016
January 2017
February 2017
March 2017
April 2017
May 2017
June 2017
July 2017
August 2017
September 2017
October 2017
November 2017
December 2017
3.50
4.00
Sources: Fed Funds Futures Contracts: Oct. 9, 2015, FOMC Summary of Economic Projections: Sept. 18, 2015, Vining Sparks
Expectations for Shorter Maturities
41
Based on expectations reflected in Fed Funds futures contracts, the 2-year Treasury yield is likely
to rise very gradually to end 2016 near 1.15%.
1.20
Futures Implied 2-Year Treasury Yield
1.00
0.80
0.60
0.56
0.60
0.64
0.68
0.72
0.76
0.80
0.84
0.89
0.93
0.97
1.01
1.05
1.10
1.15
0.40
0.20
0.00
O
N
D
J
F
M
A
M
Sources: Bloomberg, Vining Sparks
J
J
A
S
O
N
D
YE2016 Interest Rate Projection
42
Expectations that the Fed will raise rates slowly keep the short-end anchored while longer maturities try
to anticipate the terminal rate. Exogenous factors continue to keep longer yields depressed somewhat.
4.50
Bloomberg Survey Range
Bloomberg Median Forecast
Vining Sparks Projections
Forward Curve
4.00
3.50
3.00
2.91
2.50
2.00
1.50
1.72
1.30
1.00
0.50
0.00
FF
3M
1Y
2Y
3Y
4Y
5Y
6Y
Sources: October 2015 Bloomberg Survey of Economists, Vining Sparks, Bloomberg Data, Fed Funds Futures
7Y
8Y
9Y
10Y
Summary

Today’s economic environment is different than previous rate tightening cycles




Therefor…




More signs of disinflation than inflation
Weak nominal GDP growth (with weak longer-run growth forecast)
Structural change taking place in the labor market
If/when the Fed raises rates, it will be a slow process
The terminal overnight rate is expected to be lower than in previous cycles
Longer yields are likely to price in the majority of the expected rate hike quickly
with shorter yields following more slowly
Exogenous factors are likely to continue skewing intermediate and longer maturity
Treasuries from their fundamental valuations
43
Summary of Interest Rate Projections
Fed Funds Target Rate 4Q2015 1Q2016 2Q2016 3Q2016 4Q2016
3M Treasury Bill
Bloomberg Survey Low
Bloomberg Survey Median
Bloomberg Survey High
Vining Sparks Projections
Fed Funds Futures
FOMC Sept. SEP
Bloomberg Survey Low
Bloomberg Survey Median
Bloomberg Survey High
Vining Sparks Projections
Forward Curve
2Y Treasury Note
0.25
0.40
0.50
0.38
0.19
0.38
0.25
0.60
0.75
0.38
0.29
0.25
0.80
1.25
0.63
0.39
0.25
1.05
1.75
0.88
0.49
0.25
1.30
2.00
1.13
0.64
1.38
Bloomberg Survey Low
Bloomberg Survey Median
Bloomberg Survey High
Vining Sparks Projections
Forward Curve
0.55
0.89
1.70
0.80
0.77
0.50
1.11
1.70
0.85
0.94
0.45
1.33
2.10
0.90
1.10
0.40
1.54
2.70
1.00
1.25
4Q2015 1Q2016 2Q2016 3Q2016 4Q2016
10Y Treasury Note
4Q2015 1Q2016 2Q2016 3Q2016 4Q2016
0.40
1.72
3.00
1.15
1.37
44
0.15
0.45
1.00
0.40
0.12
0.25
0.66
1.20
0.43
0.32
0.30
0.89
1.70
0.70
0.50
0.25
1.15
2.50
0.95
0.71
0.25
1.35
2.30
1.18
0.90
4Q2015 1Q2016 2Q2016 3Q2016 4Q2016
Bloomberg Survey Low
Bloomberg Survey Median
Bloomberg Survey High
Vining Sparks Projections
Forward Curve
2.00
2.33
3.00
2.35
2.12
2.00
2.32
3.20
2.25
2.19
1.90
2.65
3.50
2.50
2.25
1.85
2.80
3.85
2.75
2.31
1.65
2.91
4.00
2.75
2.36
Fed Funds Futures Projections (October 9, 2015)
October
2015
0.13
November
2015
0.15
December
2015
0.19
January
2016
0.23
February
2016
0.27
March
2016
0.30
April
2016
0.33
May
2016
0.36
June
2016
0.40
July
2016
0.44
August
2016
0.47
September
2016
0.50
Sources: October 2015 Bloomberg Survey, Vining Sparks, Bloomberg Data, Fed Funds Futures, September FOMC SEP
October
2016
0.55
November
2016
0.61
December
2016
0.65
INTENDED FOR INSTITUTIONAL INVESTORS ONLY. The information included herein has been obtained from sources deemed reliable, but it is not in any way guaranteed, and
it, together with any opinions expressed, is subject to change at any time. Any and all details offered in this publication are preliminary and are therefore subject to change
at any time. This has been prepared for general information purposes only and does not consider the specific investment objectives, financial situation and particular needs
of any individual or institution. This information is, by its very nature, incomplete and specifically lacks information critical to making final investment decisions. Investors
should seek financial advice as to the appropriateness of investing in any securities or investment strategies mentioned or recommended. The accuracy of the financial
projections is dependent on the occurrence of future events which cannot be assured; therefore, the actual results achieved during the projection period may vary from the
projections. The firm may have positions, long or short, in any or all securities mentioned. Member FINRA/SIPC.
Agencies
Katie Hopkins
Senior Vice President
Strategic Solutions Group
1
Overview
• Why agencies?
• Agency concepts/terminology
• Types of agency structures
‐ Bullet
‐ Callable
‐ Step‐up
2
Why Do Banks Purchase Agencies?
Banks purchase agency securities because:
‐ Highly liquid assets ‐ Pledging for public deposits / wholesale borrowings
‐ Target cash flow ladder with bullets
‐ Low credit risk, 20% risk weight
‐ Non‐complex security (no due diligence required)
Because of these attributes, agency securities offer a lower yield than most other types of securities
3
How Are Bond Prices Quoted?
• Prices are quoted as a percent of par (decimal/fraction)
Price
Interpret Price as Discount/Par/Premium
Par
Purchased
Cash Outlay
98.00
98% of Par
Discount
$1,000,000
$980,000
98‐0/32
98% of Par
Discount
$1,000,000
$980,000
100.00
100% of Par
Par
$1,000,000
$1,000,000
100‐0/32
100% of Par
Par
$1,000,000
$1,000,000
102.25
102.25% of Par
Premium
$1,000,000
$1,022,500
102‐8/32
102.25% of Par
Premium
$1,000,000
$1,022,500
4
Yield Measures
Also Known As:
Yield To Maturity
Yield To Call
Yield To Worst
YTM
YTC
YTW
The yield (discount rate) that The yield (discount rate) that The lowest of the Yield to makes the present value of makes the present value of the Maturity or Yield to Call.
the cash flows to maturity cash flows to the call date equal Definition: equal to the market price plus to the market price plus accrued accrued interest.
interest.
Applies To:
Bullets/Callables/Step
Callables/Step
For a security with a step coupon schedule, yields are calculated to every possible call date and the lowest possible one represents the YTC.
Callables/Step
5
Spreads
5yr Agency Bullet
2.00%
Similar‐duration Tsy ‐ 1.90%
Spread to Tsy
0.10%
The yield on the “subject bond”
(Less) the yield on a comparable “benchmark security”
Equals the spread
6
Basic Questions When Lending Money (Buying Bonds)
• Who am I lending to?
‐ U.S. Government, Agencies, Small Business Administration, etc.
• What is their track record of meeting obligations?
‐ Credit risk
• How much am I willing to lend?
‐ Legal/Internal limits (think portfolio allocations)
• What rate of interest will I charge earn?
‐ We are market takers (your choice whether to take it or not though!)
• When will I get my principal amount back?
‐ At maturity, before maturity, periodically until maturity
‐ Does it depend on events outside my control?
7
Typical Issuers of Agency Debt
“Who am I lending to?”
FNMA
FHLMC
FHLB
FFCB
Federal National Federal Home Federal Farm Credit Federal Home Long Name
Mortgage Loan Mortgage Banks Funding Loan Bank System
Association
Corporation
Corporation
Typically Called Fannie Mae
Freddie Mac
Home Loan
Farm Credit
Full Faith and Credit
No
No
No
No
Founded
1938
1970
1932
1916
2015 YTD Bond $35 Billion
$128 Billion
$244 Billion
$77 Billion
Issuance*
Total Debt $426 Billion
$414 Billion
$857 Billion
$230 Billion
Outstanding**
Farm Credit Federal Oversight
FHFA
FHFA
FHFA
Administration
* Excludes discount notes
** Includes discount notes
8
Agency Structures: Bullets
• Defined maturity
• No optionality of cash flows
• Ability to generate unrealized gains / total return from rolling down the curve
• Good for targeting holes in cash flow ladder
• Highest price volatility
9
What Are You Investing In?
• A stream of cash flows consisting of interest and principal occurring in the future
Date Cash Flows Description
9/30/2015 ‐$1,000,000 Purchased $1mm Par at $100.00
3/30/2016
$10,000
Interest Payment Received
9/30/2016
$10,000
Interest Payment Received
3/30/2017
$10,000
Interest Payment Received
9/30/2017
$10,000
Interest Payment Received
3/30/2018
$10,000
Interest Payment Received
9/30/2018
$10,000
Interest Payment Received
3/30/2019
$10,000
Interest Payment Received
9/30/2019
$10,000
Interest Payment Received
3/30/2020
$10,000
Interest Payment Received
9/30/2020 $1,010,000 Principal Balance +Interest Payment Received
5yr 2% Bullet Investment
Settle: 9/30/2015
Maturity: 9/30/2020
Coupon: 2.00%
Coupon Paid: Semi‐Annual
Price: $100.00
10
Bullet Principal Cash Flows
• Purchased:
‐ 3yr Bullet
‐ 4yr Bullet
‐ 5yr Bullet
‐ 7yr Bullet
• Cash flows stay the same no matter the rate environment
11
Agency Structures: Callable
What is a callable bond?
Debt security with an embedded call option *As a bondholder, you are SELLING the call option; agency is buying the call option
When will a bond be called?
When the issuer can borrow money at a cheaper rate at the call date
12
Types of Calls
American
Bermudan
European
Also Known As:
Continuous
Quarterly (typically)
One‐time
Frequency:
Any time
Regular intervals
Single call date
Call Protection:
Low
Medium
High
Coupon Effect:
High
Medium
Low
Rule of thumb, more call protection = less coupon since the bond will act more like a bullet.
13
5y NC 1y – Cash Flow Profiles
European call
Bermudan Call – Can CF Any Quarter
Lockout
Principal Cash Flow
Extends To Final
American Call – Can CF Anytime
14
Types of Calls
Bermuda
15
What Affects Option Value?
Option value impacted by:
• Volatility
• Lockout period and call frequency
• Shape of the yield curve
‐ Steep (least option value)
‐ Flat (larger option value)
‐ Inverted (largest option value)
16
Agency Callable Offering Breakdown
Bermudan Call
5yr Final Maturity
5yrNC3mo BERM
3 months of “Lockout”
Lockout ‐ Period of time the bond cannot be called by the issuer. The longer the lockout period, the lower the yield
17
Rate Movements and Call Options
Time Until Principal Returned (Years) by Rate Scenario
‐300
‐200
‐100
0
+100
+200
+300
+400
5yr Bullet 5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5yrNC3mo Cont. 0.25
0.25
0.25
0.25
3.44
5.00
5.00
5.00
The callable bond is called since the issuer can re‐finance at a lower rate.
The callable bond is expected to cash flow at maturity.
18
Callable Cash Flows: Agency vs. MBS
5Yr NC 3Mo
15yr 3% MBS
19
Yield, Coupon, and Price
Yield
Coupon
Price
Discount/Par/Premium Maturity
2.00%
1.00%
$95.26
Discount
5 Years
2.00%
1.50%
$97.63
Discount
5 Years
2.00%
2.00%
$100.00
Par
5 Years
2.00%
2.50%
$102.37
Premium
5 Years
2.00%
3.00%
$104.74
Premium
5 Years
Price
Coupon (Rate of Interest)
Yield (required return)
20
Basic Interest Rate Risk
Interest Rate Risk ‐ Risk that an investment’s value will change due to a change in the level of interest rates
Price Volatility ‐ % change in price caused by a move in interest rates (usually immediately and parallel)
Effective Duration ‐ An estimation of price volatility ‐ not a time until expected maturity 21
Less Risk
More Risk
Basic Risk and Reward
Credit Risk
Duration (Interest Rate Risk)
Lending to whom?
Price Volatility
Optionality Risk
Callable / Not Callable
More Risk = More expected reward
Understand what you are investing in
22
Basic Optionality
• Optionality ‐ Embedded options in a bond may cause its cash flow to behave differently as interest rates move
• Weighted Average Life (WAL) ‐ Weighted average time to principal repayment
• Reinvestment Risk
‐ The risk that rates fall and cash flows are reinvested at a lower rate
• Negative Convexity ‐ Embedded options in a bond may put a “ceiling” on how much a price can increase
23
Simple Bond Structures: Bullet
Bullet
FHLB
2.00%
Semi‐Annual
9/30/2020
NA
$100.00
2.00%
NA
4.7
4.9%
‐4.6%
‐13.1%
$110.00
$108.00
$106.00
$104.00
$102.00
Price
Characteristic
Issued by:
Coupon:
Paid:
Maturity:
Call Date:
Price:
Yield To Maturity:
Yield To Call:
Eff. Duration
Price Vol ‐100
Price Vol +100
Price Vol +300
$100.00
$98.00
$96.00
$94.00
$92.00
R² = 0.9992
$90.00
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
Yield
Duration is a measure of interest rate risk
Greater duration = more interest rate risk
It is NOT a time until expected maturity (only coincidence)
24
Simple Bond Structures: Callable
Callable
FHLB
2.10%
Semi‐Annual
9/30/2020
9/30/2016
$100.00
2.10%
2.10%
3.0
1.7
‐3.6%
‐11.7%
$110.00
$108.00
$106.00
$104.00
$102.00
Price
Characteristic
Issued by:
Coupon:
Paid:
Maturity:
Call Date:
Price:
Yield To Maturity:
Yield To Call:
Eff. Duration
Price Vol ‐100
Price Vol +100
Price Vol +300
$100.00
$98.00
$96.00
$94.00
$92.00
$90.00
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
Yield
25
Price/Yield: Bullet vs Callable
110
Bullet
Callable
108
106
104
Price
102
100
98
96
94
92
90
0.00%
1.00%
2.00%
3.00%
4.00%
Yield
26
Yield Comparison: Maturity and Lockout
Higher yields with longer maturities
Higher yields with less lockout
27
Yield Comparison: Call Structures
Bond
3Y nc 1Y CONT
3Y nc 1Y OTC
5Y nc 1Y CONT
5Y nc 1Y OTC
7Y nc 2Y CONT
7Y nc 2Y OTC
Yield
+300 Px Vol Eff Dur
1.05 +1bp ‐7.9
1.04
‐8.1
1.64 +9bp ‐11.8
1.55
‐12.3
1.99
‐15.6
+2bp
1.97
‐16.1
2.2 2.2 3.0 3.0 4.6 4.6 Selling the agencies a better option earns a potential higher yield…
…which comes with more risk
28
Callable Agency Risks
• Negative Convexity
‐Bond will not participate in a rally because it will be called (low opportunity for price appreciation)
‐When interest rates rise, the duration of callable bonds extend at a time when liquidity may be needed the most (i.e. loan demand increases)
• Reinvestment Risk
‐Rates fall, bonds are called, proceeds invested at lower rates (recent environment)
• Cash Flow Uncertainty
‐Highest cash flow uncertainty (optionality) in continuous calls (American style)
• Spread Risk
‐Agency spreads can widen reducing total return
29
Historical Agency Spreads
Spread to Treasuries
300
250
200
150
Historical Spreads
Credit crisis
5yr nc 3mo
5yr nc 6mo
5yr nc 1yr
5yr nc 2yr
5yr Agy Bullet
100
50
0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
30
Spread to Treasuries
Agency Spreads: Last 12 Months
50
45
40
35
30
25
20
15
10
5
0
Historical Spreads
5yr nc 3mo
5yr nc 6mo
5yr nc 1yr
5yr nc 2yr
5yr Agy Bullet
31
Agency Step‐Ups
• Initially pay the investor an above market yield for a short no call period and then, if not called, "step up" to a higher coupon rate (which can be below current market rates). ‐ The investor initially receives a higher yield because of having implicitly sold a call option. • A multi‐step has a series of fixed and successively higher coupons over its life
• At each call date, if the bond is not called, the coupon rate increases.
32
Agency Step‐Ups
• Potentially defensive investment that gives future protection against higher rates, although there is a cost in the near term.
• One‐time step with lock out provides defense against increasing rates and short‐term volatility.
• Multi‐step structures provide protection against increasing rates….amount of protection is correlated with initial coupon (or cost).
• May benefit by diversifying step structures in investment portfolio.
33
Single Step
34
Multi‐Step
35
Characteristics to Consider
• Final Maturity
• Coupon
• Callable?
‐ Lockout/call structure/cash flow variability
• Initial Coupon
• Step up? ‐ Number/magnitude/timing of steps
DIVERSIFICATION IS KEY
36
Review
• Risk/Reward
• Bullets: lower yield for more certain cash flows
• Callables: potential higher yield for less certain cash flows
‐ Longer maturities, shorter lockout, more generous call structures earn higher yield, more uncertainty
• Assess risk tolerances, DIVERSIFY 37
Investment Policy Michael Erhardt, CPA
Senior Vice President
Strategic Solutions Group
1
Investment Policy • Regulatory guidance on investment activities
• Board and Senior Management oversight
• Risk identification, measurement, and reporting
• Policy template and checklist
2
Investment Policy Investments tend to fall under the purview of the institution’s Asset/Liability Committee (ALCO), which is also responsible for measuring and monitoring interest rate risk, and liquidity. Overall Asset/Liability Management
Interest Rate Risk
Investments Liquidity 3
FFEIC Policy Guidance
The Supervisory Policy Statement on Investment Securities was adopted by the primary regulatory agencies effective May 26, 1998. The Statement provides guidance and sound principles for managing investment securities risk. Notably the Statement covers: ‐ Board and Senior Management Oversight
‐ Risk Management Process
‐ Risk Identification, Measurement, and Reporting
‐ Internal Controls
4
Management of Risk Risk Management programs will differ among institutions, but there are certain elements that are fundamental to all sound risk management programs.
‐ Board and senior management oversight
‐ Comprehensive risk management process
5
Board Oversight The BOD is responsible for the following:
‐ Adopting a comprehensive written policy for conducting investment activities (approved at least annually)
‐ Establishing clear investment goals and risk limits
‐ Ensuring that management has the requisite skills to manage the risk associated with such activities
‐ Establishing an independent review function and reviewing its reports
‐ Reviewing and acting upon Management’s reports 6
Board Oversight To properly discharge its oversight responsibilities, the board should:
Review Portfolio Activity
Review Risk Levels
Require Policy & Risk Limit Compliance
“Boards should have an adequate understanding of investment activities. Boards that do not should obtain professional advice to enhance understanding of the investment activity oversight, so as to enable them to meet their responsibilities under this Statement.”
Source: 1998 Supervisory Guidance on Investment Activities
7
Board Oversight Specific Responsibilities:
‐ Approve suitable securities list ‐ Approve pre‐and post‐purchase analysis procedures
‐ Approve risk limits
8
Board Oversight Assessments the BOD must make:
• Do we have sufficient expertise and understanding?
‐ Do we have the expertise we need?
‐ What Board education is needed?
• What will our process be?
‐
‐
‐
‐
‐
Policies
Procedures
Management Measurement systems
Reporting • How restrictive will we be in our policies?
‐ Risk tolerances
• How will we stay on top of things?
‐ Board report content
‐ Frequency of review 9
Senior Management Oversight
Senior Management is responsible for:
‐ Daily management of an institution’s investments (proper segregation of duties/independence)
‐ Establishing and enforcing policies and procedures for conducting investment activities
‐ Understanding the nature and level of various risk involved and how such risks fit within the institution’s overall business strategies
‐ Reporting investment activity and risks to the BOD
‐ Ensure that its staff is competent and adequately trained
10
Senior Management Oversight
Management should ensure that the risk management process is commensurate with the:
Size
Scope Complexity of the institution’s holdings.
11
Risk Management Process
An effective risk management process for investment activities includes
1. Policies, procedures, and limits
2. Identification, measurement, and reporting of risk exposures
3. System of internal controls
12
Policies, Procedures, and Limits
Policies should be consistent with the organization’s:
1.
2.
3.
4.
Broader business strategies
Capital adequacy (constraints)
Technical expertise
Risk Tolerances
13
Policies, Procedures, and Limits
Policies should identify the following with respect to the acquisition and ongoing management of securities:
Objectives
• Providing Liquidity • Hedging Risk
• Generating Earnings
Constraints
• Permissible Investments
• Risk: Credit, Operational, Legal, Market, and Concentration
Guidelines
• Lines of Responsibility and Authority
• Segregation / Independence
14
Risk Identification Institutions should identify and measure risk associated with transactions….
‐ Prior to acquisition (meant to discover and quantify all relevant risks in the investment)
‐ Periodically after purchase
• Institutional level • Portfolio level • Instrument level 15
Post‐Purchase Risk Limits
Limits should be structured in the form of:
….and expressed in relation to meaningful benchmarks: Institutional Limits
Capital Investment Portfolio Limits
Earnings
Portfolio Segment Limits
Total Assets
Individual Instrument Limits
Total Investments 16
Reporting Reports to the BOD and Senior Management should periodically provide the following:
‐
‐
‐
‐
‐
Summary of all investment activity OTTI analysis Credit rating changes
IRR/Liquidity reports
Information that clearly illustrates investment portfolio risk and return (example: portfolio composition, yield, duration, and fair market values) ‐ List of exceptions to internal policy limits and regulatory requirements
Reporting should be frequent enough to provide timely and adequate information to judge the changing nature of the institution’s risk profile. 17
Internal Control Program
Effective internal controls are the first line of defense in supervising investment activity operating risks. An internal program should include procedures for the following:
‐
‐
‐
‐
‐
‐
‐
Portfolio valuation
Personnel
Settlement
Physical control
Conflicts of interest
Accounting and reporting Independent review
18
Independent Audit
Periodic independent audits should include a review of the following:
1. Compliance with and the appropriateness of investment policies;
2. The institution’s risk measurement system given the nature, scope, and complexity of its activities;
3. The timeliness, integrity, and usefulness of reports to the board of directors and senior management.
The audit report should include policy exceptions and suggested corrective actions. 19
Unsuitable Investment Activities
A bank’s internal control program should be designed to prevent the following unsuitable investment activities:
‐
‐
‐
‐
‐
‐
Gains trading
When‐issued trading
Pair‐offs
Extended settlement
Repositioning repurchase agreements
Adjusted trading
20
Risk Definitions and Limits
FFEIC Defined Risks:
Other risks include cash flow risks (prepayment and extension) and concentration risk. Credit Operational Liquidity Legal Market 21
Credit Risk • Exposure:
‐ The possibility of loss due to a counterparty’s or issuer’s default
‐ Limits should generally restrict Management to investment grade instruments
‐ Non‐rated bonds should be consistent with investment grade standards
• Responsibilities:
‐
‐
‐
‐
Determine risk capacity (willingness, ability)
Determine credit review process and limits
Establish monitoring process
Review exceptions / decide resolution
22
Operational Risk • Exposure:
‐ Unexpected loss due to inadequate procedures, human error, system failure, or fraud (example: valuation)
• Remedies: ‐
‐
‐
‐
Strong internal control program
Separation of duties and supervision
Personnel training
Establish conflicts of interest for personnel authorized to purchase and sell securities (guidelines that address employee relationships with broker/dealers and circumstances under which employees/directors may accept gifts, gratuities, and travel expenses from broker/dealers. 23
Operation Risk ‐ Valuation
• Procedures should ensure independent portfolio pricing. For thinly traded securities, pricing may be difficult to obtain (level 2 and level 3 securities). • Management is responsible for reviewing and understanding the process and assumptions used to price the instrument. KPMG’s Defining Issues, December 2011, No. 11‐65
24
Liquidity Risk • Exposure:
‐ Inadequate market depth (transactional liquidity)
‐ Inadequate cash flows (internal liquidity)
‐ Liquid items that become illiquid due to external event (TRUPs, Preferred Stock) ‐ Bonds that suffer credit downgrades
• Remedies: ‐ Avoid illiquid positions or restrict positions in less marketable instruments
‐ Ensure the organization has other liquidity sources
25
Market Risk Market risk is the possibility that an instrument will lose value due to a change in the price of an underlying instrument, change in the value of an index of financial instruments, changes in interest rates, or other factors. The three principal types of market risks include:
‐ Price risk (price fluctuations could impact income or capital)
‐ Interest rate risk (values change in response to current or expected interest rate changes)
‐ Basis risk (possibility an instrument’s value will fluctuate differently than the value of related instrument…example the imperfect correlation between funding cost and asset yields)
26
Market Risk For most institutions, the most significant market risk of investment securities is interest rate risk. In order to be compliance with the 1998 FFIEC policy statement, an institution should at least quantify maximum permissible portfolio or individual price sensitivity as a percentage of capital or earnings. 27
Price Risk Measures
There are several different strategies used to identify and measure price risk:
‐ Maximum exposure of ‐20% +300 bps rate change on single bond
‐ Maximum exposure of ‐12% +300 bps rate change on portfolio
‐ Maximum exposure of 25 to 30% +300 bps rate change measured as depreciation after tax as a percentage of equity
‐ Be sure to assess the price change and average life over a wide range of scenarios. ‐ Potential depreciation should also be factored into a bank’s Contingency Funding Plan 28
Other Risk Limits
• Asset Type Limits – Should limit concentrations in specific issuers, market sectors, and instrument types For example, the board may limit total investment in a particular instrument type to a specific percentage of capital
• Maturity Limits – Should place restrictions on the maximum stated maturity, weighted average maturity, or duration of instruments that Management may purchase. Maturity limits should complement market risk limits, liquidity risk limits, and the BOD’s investment goals. 29
Investment Policy
The Investment Policy should be tailored to each bank’s specific needs and should address:
‐
‐
‐
‐
‐
‐
‐
‐
The BOD’s investment goals
Authorized activities and instruments
Internal controls and independent review
Selecting broker/dealers
Risk limits
Risk and performance measurement
Reporting
Accounting and taxation
30
Investment Strategies
• Management should employ reasonable investment strategies to achieve the board’s objectives
• Strategies will vary widely between banks, ranging from simple to complex
• Any strategy should be documented, reasonable, and supportable
31
Investment Policy Updates Comptroller of the Currency (OCC)
• Determining Whether Securities Are Eligible for Investment – June 13, 2012 (effective Jan. 1, 2013)
• Alternatives to the Use of External Credit Ratings– June 13, 2012 (effective Jan. 1, 2013)
• Determining Whether A Corporate Debt Security is Eligible for Investment – July 24, 2012 (effective July 21, 2012)
FDIC
• Revised Standards of Creditworthiness for Investment Securities: FDIC FIL‐48‐
2012 – November 16, 2012
Federal Reserve Bank
• Investing in Securities without Reliance on Nationally Recognized Statistical Rating Organization Ratings: SR‐15 – November 15, 2012
32
ICBA Resources ICBA provides a broad range of information that is available on our website to institutions that sign‐up for access. 33
ICBA Resources ICBA provides sample policies addressing key areas including Liquidity, Asset/Liability Management, and Investments
34
Investment Policy Template
Our Sample Policy has been updated with the most recent regulatory guidance. 35
Investment Policy Checklist
The following represent the minimum policies and procedures that should be addressed pertaining to investment activities:
Limits on the volume of securities
purchases and sales in a pre‐defined
period
Types of permitted securities
Limits on the authority of officers
Credit quality of security issues
Selection of securities dealers
(consider
credit
quality
of
counterparties)
Limits on price risk (both at the
security level and portfolio level)
Settlement
dealers
Reporting of investment transactions
Standards for transaction execution
Documentation of pre‐purchase analyses
Policy exceptions
Off‐premises trading
Conflict of interest
Planned frequency and scope of
board policy reviews
Periodic assessment of investment
risk and compliance with bank
policies
Securities lending and repos
Personnel authorized to conduct
securities transactions
limits
for
securities
Outline of the MIS reports that
management will use to monitor and
control risk in investment activities
Possession and control of securities
Portfolio diversification
Internal control requirements
36
Common Regulatory Issues
The following represent some of the more common regulatory findings related to investment activities:
‐
‐
‐
‐
‐
‐
‐
Non‐compliance with written investment policy (limits) Missing documentation of trading activity purpose Lack of sufficient credit analysis Annual board approval for investment policy Missing confirmation and/or prospectus Lack of understanding on products purchased
Excessive price risk 37
Investment Accounting Update
FASB has recently reviewed the existing GAAP guidance as it relates to the length of time for amortizing / accreting premiums and discounts on investments. Existing Guidance
ASC 942‐320‐35‐1 – The period of amortization or accretion for debt securities shall generally extend from the purchase date to the maturity date, not an earlier call date.”
Recent Board Deliberation – September 2015
“Disclosures about Interest Income on Purchased Debt Securities and Loans. The Board discussed whether to amend the scope of the project to include the amortization period for purchased callable debt securities. The Board decided to amortize all premiums to the first call date and all discounts to the maturity date. 38
Investment Policy
Questions?
39
Disclaimer
40
Mortgage Backed Securities
James Plunkett
Director of Investment Product Strategies
1
Investors Own Fractional Interests in
the Same Pool of Loans
investor
homeowner
homeowner
homeowner
Servicer
Collects pmts
Receives fee
homeowner
homeowner
homeowner
investor
investor
homeowner
homeowner
investor
Agencies
Guarantee loans
Pay investors
Receive fee
investor
investor
investor
investor
homeowner
homeowner
2
What Are Mortgage Backed Securities?
• Represent an ownership interest in mortgage loans to finance borrowers’ purchase of real estate
• Individual loans are “pooled” for sale to investors
• Basic structure is known as a “pass‐through”
3
Pass-Through Flow Chart
Investor
Homeowner
Servicer
Homeowner
Homeowner
• Collects Payments
• Receive Fee
Agency Guarantees Loan
Investor
• Pay Investors
• Receive Fee
Investors own fractional interests in the same pool of loans
Investor
4
Primary Issuers
• Fannie Mae – Federal National Mortgage Association
‐ Government Sponsored
‐ Formerly publicly owned, now in conservatorship
‐ Implicit guarantee
• Freddie Mac – Federal Home Loan Mortgage Corporation
‐ Government Sponsored
‐ Formerly publicly owned, now in conservatorship
‐ Implicit guarantee
• Ginnie Mae – Government National Mortgage Association
‐ Government owned
‐ Explicit guarantee
• “Private Label”
‐ Corporations purchase non-conforming loans and issue their own pools
‐ No guarantee, but often have credit enhancements
5
Agency Loan Descriptions
• Fully Amortizing
• Maximum Sizes ‐
‐
FNMA/FHLMC – “conforming” sizes < $417,000 for contiguous states, < $625,500 for Alaska, Hawaii, Guam, Virgin Islands, and “high cost areas”
GNMA – FHA up to 115% of median home price for market, VA resembles “conforming”
• Loan‐to‐value (LTV)
‐
‐
FNMA/FHLMC – 80% without PMI, 95% with
GNMA – FHA generally up to 97%, VA up to 100%
• Qualifications
‐
‐
‐
FNMA, FHLMC based on creditworthiness of borrower
FHA generally for those with less access to credit, such as first time borrowers and low‐to‐moderate income borrowers VA limited to veterans
6
Issuer Securities Characteristics
7
Historical Agency Issuance
8
Common Mortgage Investments
• Mortgage pools (MBS)
‐ 15 year and 30 year most common, 10 year and 20 year available
• ARMs
‐ Fixed to Float (Hybrids)
‐ Full floating • CMOs
‐ Collateralized Mortgage Obligations 9
MBS Terminology
•
•
•
•
•
•
•
•
•
•
Pool Collateral
Weighted Average Coupon (WAC)
Weighted Average Maturity (WAM)
Weighted Average Loan Age (WALA)
Coupon
Maturity
Factor
Average Life
Prepayment Speed
10
Pool Name
Maturity
WAC/
WAM/
WALA
Collateral
Coupon
Factor
Average Life
11
Average Life
• MBS securities pay principal and interest every month
• Maturity, while relevant, is not the most important
determinant of cash flow and investment term
• Average life is a measure of how long principal is
outstanding
12
Average Life Examples
13
Cashflow Comparison: All‐or‐Nothing vs. Monthly
5Yr NC 3Mo
15yr 3% MBS
14
Prepayments
• Mortgage holders can prepay their loans
‐ Refinance
‐ Move
‐ Default
• Additional principal passed through to bond holders
• Prepayments are one of the most important factors when determining your return
15
Rates Impact Refis/Prepays; Inverse Relationship
16
What Impacts Mortgage Prepayment Speeds?
•
•
•
•
•
•
•
•
•
•
Mortgage Rates
Product Type
Loan size
Loan age (WALA)
Weighted average coupon (WAC)
Occupancy
Servicer
Loan‐to‐value
FICO Score/Borrower Debt‐to‐Income
Policy
17
Prepayment Speeds Vary by Coupon
18
High vs. Low Loan Size: Refi Incentive?
Loan Amount
Total Interest Savings
Monthly Savings
Time
$500,000
$54,245
$151
2 years
$100,000
$10,849
$30
9 years
19
Prepayment Measurements
Most common terms:
• CPR – Constant Prepayment Rate
‐ Prepayments per year as % of balance
• PSA – A ramp which works as follows:
‐ If < 30 months old, [(CPR)(16.667)] (30 / seasoning)
‐ If > 30 months old, (CPR)(16.667) or (CPR / 0.06)
20
Constant Prepayment Rate (CPR)
• Annualized percentage of principal reduction of a pool based on the
last month, last 3 months, or other historical periods
• Often referred to as “speed”
• Speed is a measure of a mortgage pool’s prepayment rate
21
Using CPR to Project Prepayments
(Example)
22
PSA Ramp works as follows:
If < 30 months old, [(CPR)(16.667)] (30 / seasoning)
If > 30 months old, (CPR)(16.667) or (CPR / 0.06)
23
PSA Advantages and Limitations
• Appropriate for new current coupons
• Accounts for non-economic prepays
• Seasoned above-market coupons not handled well
• Refinancing waves not subject to ramping
• CPR is more intuitive than PSA
• Life speeds – not vectored
24
30-Year MBS: Yield Table Using PSA
25
Median Prepayment Projections
26
30-Year MBS: Yield Table Using CPR
27
Spread Conventions and Bloomberg Screens
• I‐Spread ‐ Spread to the "Interpolated" Treasury curve's average life point.
• Z‐Spread ‐ Spread that must be added to the stripped, zero‐coupon curve so that a security's discounted cashflows equals its mid price, with each dated cashflow discounted at its own rate.
• E‐Spread ‐ Spread that must be added to the Eurodollar spot cure (IMM) so that a security's discounted cashflows equals its mid price, with each dated cashflow discounted at its own rate.
• N‐Spread ‐ Spread to the Eurodollar/swap curve's average life point.
28
30-Year MBS: Cash Flows Using CPR
29
30-Year MBS: Cash Flows Using PSA
30
Price and Prepayment Speed Affect Yield
FNMA 2.5% MBS at a
price of 98‐10
FNMA 3.5% MBS at a price of 104‐24
31
Prices and Prepayment Differences Interact
FNMA 2.5% MBS at a
price of 98‐10
FNMA 3.5% MBS at a price of 104‐24
32
Premium, Discount, and Yield Changes
• Yields for higher‐coupon MBS with prices above 100 (par) increase as rates rise and prepayment speeds slow, decrease as interest rates fall
• Yields for lower‐coupon MBS with prices below 100 (par) increase as rates fall and prepayment speeds slow, decrease as interest rates rise 33
MBS Price Exposure to Rate Depends on . . .
• Price (premium over or discount under par)
• Remaining Term (WAM)
• Coupon and Price – higher prices and higher coupons usually = less price exposure to rising rates • Prepayments
‐ Faster speeds = shorter average life = less price exposure
‐ Less variability of prepayments = less price exposure
34
Comparison of Price Sensitivities to Rate Changes
FNMA 15yr 3% MBS at a
price of 104‐20
FNMA 30yr 4% MBS at a price of 107
35
Collateralized Mortgage Obligations
James Plunkett
Director of Investment Product Strategies
36
CMO Advantages
• Coupon variety – Lower fixed coupons = less premium, more discount
– Higher coupons = less rising rate exposure
– Floating coupons possible
• Structuring possibilities
– Reduce or increase cashflow variability
– Limit extension risk – Reduce prepayment risk
– Tailor cash flows
• Collateral diversity
– Higher loan counts
– Broader spectrum of servicers, geography, etc
• Sometimes less payup for some loan traits versus collateral 37
CMO Structures
Straight Vanilla CMO
A
Collateral
Cash Flow
B
CMO with PAC/TAC Bond
C
Paid Off
After first Tranche paid off
Collateral
Cash Flow
Interest
Principal
A
A
Collateral
Cash Flow
Interest
Prioritized Principal
B
PAC
C
B
C
38
CMO Market
• Most backed by FHLMC, FNMA, or GNMA MBS
• Fixed‐rate classes most common
• Wide variety of cash flow terms and structures
• Broad spectrum of coupons
• Short stabilized structures fit most banks
• GNMA 0%, FN/FH 20%, AAA through AA‐ 20% RBC
39
CMO Terms
• Average Life
• Tranche
• Class type or tranche type
• Coupon and coupon type
• Collateral type or cohort
• Window
• Lockout
40
CMO Class or Tranche Types
• “Well structured” – PAC, TAC, VADM, accretion directed
• Sequential / Vanilla
• Support
• Names and labels may not be indicative of stability or risk
41
CMO Prepayments
• Obvious but easy to forget – based on collateral, not class structure
• PSA speeds standard for new deals
• Median speeds = dealer estimates
• Prepayments for term of CMO do not usually equal life speeds for collateral
• CPR and vectored speeds useful
42
PSA Advantages and Limitations
• Appropriate for new current coupons
• Accounts for non‐economic prepays
• Seasoned above‐market coupons not handled well
• Refinancing waves not subject to ramping • CPR is more intuitive than PSA
• Life speeds – not vectored
43
PSA Ramp
44
CMO versus MBS Collateral
45
A Simple Coupon Reduction
46
Principal Cash Flows Same as Pass‐Through MBS
47
Price Shock Applied
48
Archaic FMED Test
49
What is “better structured”?
• Less average life variation
• Tighter cash flow windows
• More shock absorbing principal support
• Not necessarily less risky
• Often but not necessarily determined by class type
50
Structure vs Yield Tradeoff
• Less structure
‐
‐
‐
‐
Greater spread and yield
More extension risk
Greater cash flow variability
More negative convexity
• More structure
‐ Less yield, spread
‐ More predictable cash flow
‐ Yield curve ride
51
Structure Spectrum
• Support and similar CMO
• Premium pass‐throughs
• Current coupon pass‐throughs
• Sequential and similar CMO
• PAC, VADM, and similar CMO structures with readily prepayable
collateral
• Discount pass‐throughs
• Prepayment protected multifamily and similar
• PAC, VADM, and similar structures with lower coupon collateral
52
Cash Flow for all Tranches at 8 CPR
53
Same Bond at 24 CPR
54
PAC Example
PAC Band
55
PAC Average Lives at PSA Speeds
PAC Band
Average Life
56
Less Extension = Less Price Volatility
57
Same Principal Cash Flows, Different Coupons (Coupon Cuts)
Same Collateral
Different bond
coupons
58
Coupon Difference Tweaks Outcomes
FHR 4480 QD (2.5%)
FHR 4386 LA (3.5%)
59
CMO Floater Generalities
• 30‐day LIBOR index prevalent
• Full range of principal structures ‐ PAC, support, PT, sequential, etc.
• Often less structuring versus fixed tranches
• Predominately priced near par at issue
• Inverse relationship between discount margin/yield and rate cap
• Inverse relationship between discount margin/yield and level of structuring
• More margin = less rate defense
60
CMO Floater Advantages
• Better yields than
–money markets
–short Treasuries
–short Agencies
–some short corporates
• Limited yield downside
• Generous yield upside
• Refuge from prepayment acceleration
• Barbell strategy effectiveness
• Absorbs abundant excess cash and liquidity
61
CMO Floater Example
Discount
Margins
Yields
62
Why Buy Floaters?
• Short end of barbell
• Short‐term objectives
‐ Collateral for short‐term borrowings
‐ Temporary and seasonal fund inflows
• Offset to balance sheet exposure
• Portfolio too long
• Bearish rate outlook
63
Considerations for Defensive Selections • For bearish investors or those with special portfolio requirements
• Yield curve slope = cost
• Each basis point yield = 1bp risk
• Liquidity = less rate exposure
• Flattest available curve = best for reducing rate risk
• Most defensive is not always best!
64
CMO Terminology
Average life: On a mortgage security, the average time to receipt of each dollar of principal, weighted by the amount of each principal payment, based on prepayment assumptions. CMO (Collateralized Mortgage Obligation): A multiclass bond backed by a pool of mortgage pass‐through securities or mortgage loans.
Collateral: Securities or property pledged by a borrower to secure payment of a loan. If the borrower fails to repay the loan, the lender may take ownership of the collateral. Collateral for CMOs consists primarily of mortgage pass‐through securities or mortgage loans, although it may also encompass letters of credit, insurance policies, or other credit enhancements.
Companion tranche: A CMO tranche that absorbs a higher level of the impact of collateral prepayment variability in order to stabilize the principal payment schedule for a PAC or TAC tranche in the same offering.
CPR (Constant Prepayment Rate): The percentage of outstanding mortgage loan principal that prepays in one year, based on the annualization of the Single Monthly Mortality (SMM), which reflects the outstanding mortgage loan principal that prepays in one month.
Current face: The current remaining monthly principal on a mortgage security. Current face is computed by multiplying the original face value of the security by the current principal balance factor.
Factor: A decimal value reflecting the proportion of the outstanding principal balance of a mortgage security, which changes over time, in relation to its original principal value. The Bond Buyer publishes the "Monthly Factor Report," which contains a list of factors for Ginnie Mae, Fannie Mae, and Freddie Mac securities. Fannie Mae, Freddie Mac, and trustees of private‐label CMOs also publish CMO tranche factors.
65
CMO Terminology
Floating‐rate CMO: A CMO tranche which pays an adjustable rate of interest tied to a representative interest rate index such as the London Interbank Offered Rate (LIBOR), the Constant Maturity Treasury (CMT), or the Cost of Funds Index (COFI).
IO (interest‐only) security: In the case of a CMO, an IO tranche is created deliberately to pay investors only interest and not principal. IO securities are priced at a deep discount to the "notional" amount of principal used to calculate the amount of interest due. LIBOR (London Interbank Offered Rate): The interest rate banks charge each other for short‐term Eurodollar loans ranging from overnight to five years in maturity.
PAC (Planned amortization class) tranche: A CMO tranche that uses a mechanism similar to a sinking fund to determine a fixed principal payment schedule that will apply over a range of prepayment assumptions. The effect of the prepayment variability that is removed from a PAC bond is transferred to a companion tranche.
Plain‐vanilla CMO: See “Sequential‐pay CMO”
PO (principal‐only‐security): In the case of a CMO, a PO tranche is created deliberately to pay investors principal only and not interest. PO securities are priced at a deep discount from their face value.
Prepayment: The unscheduled partial or complete payment of the principal amount outstanding on a mortgage loan or other debt before it is due.
66
CMO Terminology
Private label: The term used to describe a mortgage security whose issuer is an entity other than a U.S. government agency or U.S. government‐sponsored enterprise. Such issuers may be subsidiaries of investment banks, financial institutions, or home builders.
Sequential‐pay CMO: The most basic type of CMO, in which all tranches receive regular interest payments, but principal payments are directed initially only to the first tranche until it is completely retired. Once the first tranche is retired, the principal payments are applied to the second tranche until it is fully retired, and so on.
Super PO: A principal‐only security structured as a companion bond.
Superfloater: A floating‐rate CMO tranche whose rate is based on a formulaic relationship to a representative interest rate index.
Support tranche: See “Companion tranche”.
TAC tranche: Targeted amortization class tranche. A TAC tranche uses a mechanism similar to a sinking fund to determine a fixed principal payment schedule based on an assumed prepayment rate. The effect of prepayment variability that is removed from the TAC tranche is transferred to a companion tranche.
Tranche: A class of bonds in a CMO offering which shares the same characteristics. "Tranche" is the French word for “slice”.
Weighted average coupon (WAC): The weighted average interest rate of the underlying mortgage loans or pools that serve as collateral for a security, weighted by the size of the principal loan balances.
67
Floating Rate Securities
Greg Roll, CFA
Senior Vice President
Strategic Solutions Group
1
2003‐2006: INTEREST RATES
First Rate Hike
Last Rate Cut
6.0
5.0
Last Rate Hike
10Y Treasury
4.0
Yields Peak
5Y Treasury
3.0
2Y Treasury
2.0
10Y: 4.80% ‐ 5.22% (+42 bps)
5Y: 3.97% ‐ 5.18% (+121 bps)
2Y: 2.84% ‐ 5.23% (+239 bps)
FDTR: 1.00% ‐ 5.25% (+425 bps)
1.0
Yields Trough
0.0
2003
2004
2005
2006
Sources: Bloomberg, Vining Sparks
2
Floating Rate Security Roles
• Alternative to cash • Low price volatility/duration
• Investors that believe interest rates and/or inflation may rise
• Manage overall exposure to rising rates
‐ Earnings at Risk ‐ Net Economic Value of Equity
• Allow other purchases of longer fixed‐rate securities (barbell strategy)
3
Most Common Floating Rate Alternatives
• Corporate
• Private CMOs
• Floating rate Treasuries • Agency Floaters
• ABS
• Floating Rate CMOs (GNMA, FNMA, FHLMC)
• SBA Floaters
• Hybrid ARMs
4
Floating Rate Alternatives
• Floating Rate CMOs
‐ Amortizing, Low Premium, Subject to Caps, Agency Backed
• SBA Floaters
‐ Amortizing, Higher Premium, No Caps, Gov’t Gtd
• Hybrid ARMs
‐ Amortizing, Lower Premium, Caps (annual and life), Resets Periodically, Agency Backed
• Municipals (swapped to float)
5
CMO Floater Generalities
• Coupon resets periodically at specified spread over a specified index • Subject to interest rate cap and floor
• Typical index rates include:
‐ LIBOR (30‐day most prevalent)
‐ CMT ‐ COFI
• Full range of principal structures – PAC, pass‐through, sequential, etc.
• Predominantly priced near par at issue
• Subject to price risk due to cap • More margin = more price risk (less defensive or more prepayment exposure
6
CMO Floater Example CMO
3136AAJ71
CMO 0.4939 08/41 FNMA $75.8mm
11/25/2012
FLT, SEQ
1mo Libor
+30 bps
Monthly
None
6.50%
100.19
Short‐term (< 1yr)
Price Volatility
1.0
0.0
Interest Rate Shift
Type/Characteristic
Cusip
Desription
Issuer
Original Size
Issue Date
Class
Index
Margin
Adjusts
Period Cap
Life Cap
Price
Call Report Class
‐1.0
‐2.0
‐3.0
‐4.0
‐5.0
‐6.0
0.5
Rate Scenario
‐300
‐200
‐100
‐50
0
Price
100.69 100.57 100.52 100.41 100.19
% Change in Price
0.50
0.38
0.33
0.22
0.00
Book Yield
0.24
0.24
0.26
0.27
0.45
Market Yield
0.04
0.07
0.15
0.21
0.45
Effective Duration
2.39
1.43
1.43
0.90
0.46
Weighted Average Life
2.50
2.52
3.13
3.75
4.66
Speed
19.48 16.71 11.02
8.33
8.33
0.4
0.3
0.2
0.0
‐0.3
‐0.6
‐1.7
‐3.2
‐5.4
Percent Change in Price
+50
99.93
‐0.26
0.95
0.99
0.61
5.55
7.26
+100
99.57
‐0.61
1.44
1.54
0.83
6.53
6.79
+200
98.53
‐1.66
2.42
2.69
1.32
7.17
5.88
+300
96.97
‐3.22
3.40
3.91
1.90
7.77
5.10
+400
94.81
‐5.37
4.37
5.25
2.59
8.29
4.58
Calculations Performed on The Yield Book
7
Current CMO Floater Advantages
• Superior yields compared to:
• Overnight funds at a corporate credit union
• Money markets
• Short Treasuries
• Short Agencies
• Limited yield downside (margin is implied floor)
• Generous yield upside
• Modest premium risk
• Effective as counterbalance to longer term fixed rate bonds (barbell strategy)
• Scheduled cash flow and transactional liquidity 8
Small Business Administration Pools
• Underlying SBA 7(a) floating rate loans • Full faith and credit guarantee of U.S. Government • Uncapped floaters • Monthly or Quarterly resets with Prime Lending Rate
• Superior yields to other high‐quality uncapped floaters
• Fully amortizing (monthly cash flow)
• Moderate market size ($2.5bn in new loans sales annually)
• Premium risk from prepayments/defaults
9
SBA Maturity Ranges
Working Capital
1
2 3 4 5 6 7
Equipment/Machinery
Real Estate 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
‐‐Maturity in Years ‐‐
Generally:
<15yr loans = Equipment Loans
>15yr loans = Real estate
Remember, these float uncapped, do not let the longer maturities unnecessarily deter you
10
SBA Pools
• A pool is a securitized group of loans
• Minimum original pool size of $1mm
• Minimum of four loans in a pool
• Maximum guaranteed loan size is $5mm ($338k average)
• No single loan can comprise more than 25% of a pool
• Coupon rate limited to +/‐ 2% difference
• Maturity dispersion limited to ‐20% of longest maturity
11
SBAs: Anatomy of a Pool Fully guaranteed SBA loan
Typically purchased by depositories
IO strip (optional)
Poolers (Vining Sparks) can create these to lower premiums on pools.
Loan servicing
Unguaranteed portion
retained by Loan Originator
The lender retains 25% typically.
12
SBAs: How a Pool Works
• Monthly principal and interest payments (25th of the month)
• Floating rates reset on the 1st business day of month/quarter
• SBA recasts the amortization of each pool based on:
• Final maturity of pool
• Net pool interest rate at each reset
13
SBAs: What are the Risks?
• Premium (ranging from $111 to $117)
• How to mitigate premium risk?
• Diversify: By origination year
• Diversify: By loan count
• Diversify: By single loan exposure in any given pool 14
SBAs: Prepayment Considerations
• SBA prepayments are correlated with the age of the loans rather than with interest rates
• SBA prepayments are very stable compared to MBS prepayments
• Since the borrower rates on SBA loans are of the floating type, there is generally less incentive to refinance than with fixed‐rate loans
• Pools are normally very diverse – multiple purposes and sizes
• An SBA loan cannot be refinanced with another SBA loan, thereby reducing refinancing‐based prepayments
• Lenders required to maintain vested interests in the loans they underwrite
• Long‐Term real‐estate loans have prepay penalties of 5% for the 1st yr, 3% for the 2nd yr, and 1% for the 3rd yr; not passed through to investor
15
SBAs: Prepayments
SBA loan prepayments tend to have:
• Bell shaped patterns
• Very slow speeds during the early years
• Increase and peak during the interim years
• A return to lower speeds as defaults and refinancing stabilize
The most important characteristic affecting prepayment related performance is seasoning!
16
SBAs: Prepayments 10 Year Rolling Prepay Rates by Years from Issuance
Yearly Prepay Rate
14.0
11.6
12.0
10.1
10.0
8.4
7.8
8.0
4.8
5.9
6.0
5.1
4.7
4.1
3.8
9
10
4.0
2.0
0.0
1
2
3
4
5
6
7
8
Years From Issuance
• Prepayments are typically defaults
• Fewer economic incentives and ability to refinance than residential
17
Historical CPR SBA RE Pools
Total Pools = 1,148 Life CPR 8.8
18
Prepay Vector SBA RE Pools
SBA
SBA
SBA
SBA
SBA
SBA
SBA
SBA
19
SBAs: Pool Example
Loan Characteristics:
• 98 Real Estate Loans
• Largest makes up 2.4% of pool
• Top 4 customers make up 9% of pool
• Max: $1,642,500 / Min: $179,563 / Average: $702,282 20
SBAs: Current Advantages •Higher initial yield
•Very sensitive to movements in rates
•No period cap
•No life cap
21
Adjustable Rate Mortgages (ARMs)
• Investment pools of 1‐4 Family Residential Adjustable Rate Mortgages (ARMs)
• Most prevalent are referred to as Hybrid ARMs because…
• Fixed for a period (3,5,7,10 years)
• Float for remainder of loan subject to…
Floating Rate Terms FNMA, FHLMC
Index
1yr Libor
Margin
Varies
Periodic Cap
2.00%
Life Caps
7% ‐ 8%
GNMA
1yr CMT
1.50%
1.00%
7% ‐ 8%
22
Hybrid ARMs: Rate Caps
Life
Initial
Life
Initial
1/1/5
2/2/5
Periodic
Periodic
• Three different kinds of caps: initial adjustment cap, periodic adjustment cap, and lifetime adjustment cap
• Cap structures dictate how the coupon can move in either direction
23
Hybrid ARMs: Payment Characteristics
•Think about the borrower
•May frequently relocate
•May expect to move up
•Match the fixed period to fit their expectations
•Borrower expectations met: Payoffs occur around reset
•Borrower expectations not met: Rate resets
24
Hybrid ARMs: Sample
G2 GNMA 5yr / 1yr CMT
25
Why Invest in ARMs?
•Can enhance income today and provide protection from higher rates in the future
•Moderate premiums
•Amortizing product with current cash flow
26
Hybrid ARM Prepayments
• Mortgage rates, loan size, loan age, borrower’s rate, servicer, credit, buyouts
• Borrowers are self‐selecting
• ARM‐specific: reset type and months to reset 27
Hybrid ARM Prepayments by Reset Type
28
Hybrid Prepay Speeds by Months to Reset
29
Compare 5/1 ARMs vs. 10yr MBS
Coupon
5/1 Hybrid
2.50%
10yr MBS
2.50%
Security Description
FNCN 10yr 2.5
GN 1/1/5 1yrT 61 MTR
Security Description
FNCN 10yr 2.5
GN 1/1/5 1yrT 61 MTR
Cpn
2.50
2.50
‐100
3.00
1.96
‐100
1.36
0.89
‐50
2.69
2.13
Top 25%
Top 50%
Bottom 50%
Bottom 25%
Base
1.61
1.39
Yield
1.39%
1.61%
Yield
100
1.66
2.03
Base
1.86
1.77
200
1.68
2.42
50
0.74
1.16
300
1.70
2.84
‐100
2.1
1.1
Coupon Cap
7.50%
2.50%
Price Volatility
100
200
‐3.3
‐6.7
‐3.1
‐7.5
12 Month Total Return
100
200
300
‐0.49
‐3.05
‐5.64
0.14
‐3.26
‐7.50
Bull Flat
Bull Flat
2.40
1.74
Flat
Eff Dur
LIBOR
300
Base 200
OAS
‐10.1 3.0 3.7
9.7
‐12.5 2.3 5.5
‐7.8
Flat
1.75
1.01
Bear Flat
Bear Flat
‐1.59
‐1.04
Description of Vectors:
Current Tsy
3m
0.02
0.02
1.00
2.75
1.50
2y
0.65
0.44
1.00
2.75
1.86
5y
1.39
0.93
1.00
2.75
2.29
10y
2.07
1.38
1.00
2.75
3.00
OUTL
‐0.38
0.22
OUTL
30
Comparison
Type/Characteristic
CMOs
ARMs
SBAs
FH,FN,GN
FH,FN,GN
SBA
Libor
Libor, 1yr CMT
Prime
Margin
0.30 ‐ 0.50
1.50 ‐ 1.75
Varies
Adjusts
Mo. / Qtrly
Yearly
Mo. / Qtrly
None
1% or 2%
None
Life Cap
6% to 7%
6% to 9%
None
Price
$99 ‐ $101
$102 ‐ $105
$107 ‐ $116
Yield/+300 Yield
0.49%/3.49%
1.17%/2.89%
1.17%/3.74%
WAL/+300 WAL
5.0/8.5 Years
4.1/6.2 Years
5.9/6.2 Years
Price Vol. +300
‐2.85%
‐8.93%
‐1.37%
Agency Backed
Index
Period Cap
31
Final Notes
•Short term rates are historically more volatile to Fed action.
•These investments help prepare for that potential volatility.
•They help prepare with floating rates, cashflow, and current yields higher than cash alternatives.
•Let your balance sheet structure, risk tolerances, and rate outlook guide your investments.
32
High Performing Portfolios
Randy Wade, CFA
Executive Vice President
Director of Sales
1
High Performing Portfolios
• What has changed?
• What makes a high performing
portfolio?
• What are the risks?
• What will happen when rates rise?
2
What Has Changed?
3
Deposit Growth Has Exceeded Loan Growth
4
Bank Portfolios have grown…
Bank Investable Funds
All Commercial Banks
FFS
Int Bear Bal
Inv. Securities
5,500
5,000
4,500
$ in Billions
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
‐
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
5
% of Assets is significant…
Portfolio % of Assets
All Commercial Banks
36%
34%
32%
30%
28%
26%
24%
22%
20%
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
6
Margins continue to struggle…
Net Interest Margin
All Commercial Banks <$1Billion
5.00%
4.50%
4.00%
3.50%
3.00%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
* Source: FDIC
7
Higher Yields Produce Higher ROAs
Population: All C Corp Banks $300MM - $1B in Assets– December 31, 2014
TEY
Investment %
of Assets
Average Assets
ROA
Highest Quartile
277 Banks
3.47%
27%
$538 Million
.98%
Lowest Quartile
277 Banks
1.60%
25%
$524 Million
.72%
Difference
1.87%
2%
$14 Million
.26%
Source: FDIC, Vining Sparks
8
8
What makes a High Performing Portfolio?
9
Why 187 BPs More?
Population: All C Corp Banks $300MM - $1B in Assets– December 31, 2014
Source: FDIC
10
Bond Accounting Statistics
11
Mix of HPPs…From Bond Accounting Statistics
(Banks – June 2015)
Treas/Agencies, 7%
Other, 6%
MBS, 20%
Munis, 42%
ARMs/SBAs, 6%
CMOs, 12%
Corporates, 4%
12
Average Portfolio Yields
6.00
5.00
4.00
3.00
2.00
1.00
0.00
2yr CMT
Portfolio Ylds
13
1st Quartile
Jun‐15
Dec‐14
Jun‐14
Dec‐13
Jun‐13
Dec‐12
Jun‐12
Dec‐11
Jun‐11
Dec‐10
Jun‐10
Dec‐09
Jun‐09
Dec‐08
Jun‐08
Dec‐07
Jun‐07
Dec‐06
Jun‐06
Dec‐05
Jun‐05
Dec‐04
Jun‐04
Dec‐03
Jun‐03
Dec‐02
Jun‐02
Dec‐01
Jun‐01
Dec‐00
Jun‐00
Dec‐99
Jun‐99
Dec‐98
Jun‐98
Dec‐97
Yields
Quartile 1 vs. 4 Yields
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
4th Quartile
14
What are the risks?
15
2‐Year Treasury Yields
• Bullet Point 1
• Bullet Point 2
‐ Sub Bullet Point 1
‐ Sub Bullet Point 2
16
Sample Stress Test
17
Current Mix of Qtl 1 vs. Qtl 4
18
Historical Price Changes
6.00%
5.00%
MTM Taxables
MTM Munis
4.00%
3.00%
2.00%
1.00%
0.00%
‐1.00%
‐2.00%
‐3.00%
‐4.00%
‐5.00%
19
Yield of 10-Year Tax Free Muni
10 Year Raw Muni Yield 01/2004 ‐ present
4.5
4
3.5
3
2.5
2
1.5
1
1/1/2004
1/1/2005
1/1/2006
1/1/2007
1/1/2008
1/1/2009
1/1/2010
1/1/2011
1/1/2012
1/1/2013
1/1/2014
20
Optionality
Two Callable
Securities
5 Year / 3 month
Call Window •
1
5 Year / 3 Year
2
3
4
5
years
5 Year / 3 year
Call Window 1
2
3
4
5
years
21
22
23
What Will Happen When Rates Rise?
24
2‐Year Treasury Yields
• Bullet Point 1
• Bullet Point 2
‐ Sub Bullet Point 1
‐ Sub Bullet Point 2
25
Logical Questions
• How much yield pickup did average portfolios
have from mid-2003 to mid-2007?
• Which sectors increased in yield the most from
2003 to 2007?
26
Average Portfolio Yields
6.00
5.00
4.00
3.00
2.00
1.00
0.00
2yr CMT
Portfolio Ylds
27
Portfolio Yields vs. 2-Year CMT
2yr CMT Portfolio Ylds
4.97
5.21
2yr CMT
Portfolio Ylds
June-07
June-03
1.23
4.21
Sep-07
4.00
5.27
Sep-03
1.65
4.12
Dec-07
3.18
5.31
Dec-03
1.83
4.20
March-08
1.57
5.15
March-04
1.54
4.07
June-08
2.73
5.11
June-04
2.76
4.30
Sep-08
2.17
5.09
Rate Change
3.87
Sep-04
2.55
4.26
Dec-08
.83
5.03
Port Yield Change
1.24
Dec-04
2.99
4.34
March-09
.93
4.88
March-05
3.70
4.42
June-09
1.22
4.64
June-05
3.64
4.46
Sep-09
.96
4.48
Sep-05
3.95
4.53
Dec-09
.91
4.28
Dec-05
4.40
4.63
March-10
.98
4.05
March-06
4.75
4.78
June-10
.70
3.90
June-06
5.10
4.88
Sep-10
.50
3.63
Sep-06
4.76
4.96
Dec-10
.60
3.44
Dec-06
4.68
5.06
Mar-11
.67
3.39
March-07
4.60
5.12
June-11
.43
3.38
% Difference 32%
28
Average Yield Change by Sector
March ‘04
December ‘07
Difference
Treasuries
2.78%
3.66%
.88%
Agency Bullets
3.31%
4.37%
1.06%
Agency Callables
3.72%
5.12%
1.40%
MBS Fixed
4.24%
5.05%
.81%
GNMA ARMs
2.55%
4.75%
2.20%
FHLMC/ FNMA ARMs
3.42%
5.30%
1.88%
SBA Pools
2.27%
5.52%
3.25%
CMO Fixed
3.46%
5.05%
1.59%
CMO Floaters
2.34%
5.49%
3.15%
Corporates
5.08%
5.75%
.67%
Other
3.68%
6.52%
2.84%
Municipals
6.28%
6.04%
(.24%)
4.07%
5.31%
1.24%
2.3 years
2.7 years
Average
Duration Average
29
Average Yield Change by Sector (with mix %’s)
Mar ‘04
Dec ‘07
Diff
Mix ‘04
Mix ‘07
Treasuries
2.78%
3.66%
.88%
.93%
.40%
Agency Bullets
3.31%
4.37%
1.06%
7.37%
7.35%
Agency Callables
3.72%
5.12%
1.40%
13.93%
18.77%
MBS Fixed
4.24%
5.05%
.81%
21.79%
25.38%
GNMA ARMs
2.55%
4.75%
2.20%
4.11%
2.20%
FHLMC/ FNMA ARMs
3.42%
5.30%
1.88%
9.03%
5.81%
SBA Pools
2.27%
5.52%
3.25%
.41%
.77%
CMO Fixed
3.46%
5.05%
1.59%
12.01%
11.32%
CMO Floaters
2.34%
5.49%
3.15%
6.24%
3.21%
Corporates
5.08%
5.75%
.67%
3.24%
2.66%
Other
3.68%
6.52%
2.84%
6.75%
4.85%
Municipals
6.28%
6.04%
(.24%)
14.18%
17.27%
4.07%
5.31%
1.24%
100.00%
100.00%
2.3 years
2.7 years
Average
Duration Average
30
High Performing Portfolios
• What has changed?
• What makes a high performing
portfolio?
• What are the risks?
• What will happen when rates rise?
31