DEPT Bank Invest.8e 5/9/02 2:21 PM Page 1
Bank I nves tment s
Riding the Yield Curve
The current steep yield-curve makes this strategy profitable again
it h t h e cu rr e n t
ste ep yie ld cur ve,
riding the yield curve,
or RTYC as it is more
tersely called , is once
again becoming a popular strategy for adding
by C.J.
y i e l d t o c o m m un i t y
b a nk s’ l i q ui d i t y l a d Pickering
d e rs . B u y i ng t wo- o r
three-year Treasuries or agencies and
holding them to maturity construct the
traditional liquidity ladder. Currently,
the large spread between agencies and
Treasuries favors agency ladders.
Ig n o ri n g di f f e ri n g s ea s o na l c a s h
n e e ds , a t y p i c a l tw o - y e a r l a d d e r
would look like Example A in Table
I. There is a $100,000 agency maturing in each of the next eight quarters.
Ea c h m a t ur i n g a g e n c y i s r ep l a ce d
with a new two-year agency.
T he two -y e ar RTYC l add er c on tains the same number of agencies,
but is constructed by buying two-year
agencies, selling them one year prior
to maturity and replacing them with
new two-years. As shown in Example
B of Table I, this strategy builds a ladder with no maturities during the first
four quarters and $200,000 maturing
in each of quarters five through eight.
The advantage is higher yields at the
cost of an increase of six months in
the ladder’s average life.
W
R i d i n g t h e C u r ve f o r P r o f i t s
Table II on page 65 shows RTYC examples under level, rising and falling
64 J a n u a r y 2002
Learn More
Riding the Yield Curve is an excellent way to add yield to a community bank’s
liquidity ladder, without adding undo risk. ICBA Securities members are invited to
call (800) 422-6442 for a comparative analysis of your current liquidity strategies
versus the strategy of Riding the Yield Curve.
Table I
Liquidity Ladders – Traditional Versus RTYC*
Example A – Traditional Ladder
Example B – RTYC Ladder
$200,000
$100,000
$100,000
1 2 3
4 5 6 7 8
Time in Quarters
* RTYC = Riding the Yield Curve
rates. Column A shows initial rates of
5 percent and 6 percent for one-year
and two-year age nc ies, respectively.
Assume the two-year agency is purchased at 6 percent and one-year later
rates are unchanged.
T he tw o - y ea r , 6 pe rc e n t a g en c y
originally purchased is now one year
from maturity and, since rates have
not changed, the market for one-year
agencies is at 5 percent. The one-year
6 perc ent agency can, therefore, be
sold for a 1 percent gain and the proce e ds rein ves te d i n a br a nd n ew 2
year, 6 percent Agency.
Th e t o ta l re tu r n f o r t he n e x t 12
months will be the 1 percent gain plus
1 2 3
4 5 6 7 8
Time in Quarters
Source: ICBA Securities
the 6 percent reinvestment, or a total of
7 percent. This is a net gain of 1 percent
over the 6 perce nt yield that would
have been earned had the original twoyear, 6 percent agency been held for the
additional year to maturity.
What if rates rise as shown in Column B? At the end of the first year,
one- and two-year rates will be at 7
percent and 8 percent, respectively.
The two-year agency originally purchased at 6 perc2nt will sell at a loss
of 1 percent since one-year market
rates will be at 7 percent. The proceeds will be reinvested in a brand
new two-year, 8 percent agency for a
total return of 7 percent for the next
IndependentB a n k e r
DEPT Bank Invest.8e 5/9/02 2:21 PM Page 2
Table II
RTYC Ladder Evaluation
Total Return under Various Rate Scenarios
Column A
Level Rates
1 Yr
2 Yr
Column B
Rates Rise
1 Yr
2Yr
Column C
Rates Fall
1 Yr
2Yr
Initial Rates (year 0)
5%
6%
5%
6%
5%
6%
Conditions 1 Year later
New Rates
5%
6%
7%
8%
3%
4%
Sale Gain/Loss
Reinvestment Yield
1%
6%
<1%>
8%
3%
4%
Total Return
7%
7%
7%
Yield if Original Bond is
Held for an Additional Year
6%
6%
6%
RTYC Net Gain
1%
1%
1%
Source: ICBA Securities
IndependentB a n k e r
12 months (a loss of 1 percent, plus a
new investment rate of 8 percent).
This is, again, a net gain of 1 percent over the 6 percent yield that
would have been earned had the
original two-year, 6 percent agency
been held for the additional one year
to maturity.
If rates fall during the year as
shown in Column C, one- and twoyear rates will be at 3 percent and 4
percent, respectively. The two-year
agency is now one year from maturity
and will sell at a 3 percent premium,
since the current market for one-year
agencies will be at 3 percent.
The proceeds will be reinvested at 4
percent for a net return of 7 percent
versus the 6 percent return if the original agency purchased is held for an
additional year.
In each case, with rates level, rising
or falling, Riding the Yield Curve
adds 1 percent to the total return.
January 2002 65
DEPT Bank Invest.8e 5/9/02 2:21 PM Page 3
Ban k In vestm en ts
RTYC will always add whatever the
spread is between the one-year and
two-year agencies.
Earning Power To d a y
Table III shows the additional earnings that were available when this
article was written. An RTYC twoyear Treasury ladder would yield 3.22
percent, or 0.33 percent more than a
traditional Treasury ladder. An
RTYC two-year agency ladder would
yield 3.76 percent, or 0.60 percent
more than a traditional agency ladder
and 0.87 percent more than a traditional Treasury ladder.
The RTYC three-year agency ladder
results are even more impressive at
this time because the agency yield
curve steepens dramatically between
two and three years. However, all
other security yields steepen dramatically as well. This means that a
decision to move from a two-year ladder to a three-year ladder should be
compared with the results of using the
three-year funds for other alternatives—such
as
corporates,
mortgage-backeds, callables and taxfrees, among others.
One of the most important features
of RTYC is that all the salient facts
are known before your decision is
made to sell and repurchase or to
hold the original security. At decision
time, you know the gain or loss on
the sale of the security you are thinking about selling. You know the yield
of the new two-year agency to be purchased, and you know the yield you
will get if you hold the original security for an additional year.
Remember that additional earnings
using RTYC equal the spread between one-year and two-year
agencies. This means that the steeper
the yield curve, the more profitable
the RTYC strategy. IB
C.J. Pickering is president of ICBA
Securities, a member of NASD and
SIPC located at 775 Ridge Lake Blvd.
in Memphis, Tenn. Reach him at
cj_pickering@icba.org.
Table III
Annualized Total Returns*
Treasury Agency
Ladder Ladder
Two-Year Ladder
Traditional
RTYC
Added Income
2.89%
3.22%
0.33%
3.16%
3.76%
0.60%
Three-Year Ladder
Traditional
RTYC
Added Income
3.24%
3.62%
0.38%
4.15%
4.95%
0.80%
* Changes in market rates will change
total returns but added income will
stay the same as long as yield curve
shape remains the same.
Source: ICBA Securities
66 J a n u a r y 2002
IndependentB a n k e r