Q4 2011 Investment Strategy
Sample Bank
Anywhere, US
Economic and Fed Overview
US economic growth remained weak but positive in the third quarter as the private
sector struggled with some now-familiar challenges. The unemployment rate remained
stuck at 9.1% with non-farm payrolls growth completely stalling in August. Wage
growth fell back below 2% for only the third time in 25 years. Second quarter GDP
advanced at a 1.3% rate which was faster than first reported but a poor performance
nonetheless. The manufacturing sector as measured by the ISM Index stabilized just
above the 50% level, indicating a bare minimum of expansion. Stock markets produced
dismal results as the Dow Jones Average ended down 12% for the quarter, the worst
performance since Q1 2009. Markets also assessed the Fed's newest attempt at policy
stimulus and warily watched developments in Europe.
The weak economic performance was not lost on Fed Chairman Bernanke or
the FOMC, who acknowledged "significant" downside risks to the economy. In
response, the FOMC announced its new policy initiative, "Operation Twist", the
essence of which is a duration extension of the Fed's Treasury holdings. The Fed also
announced the re-investment of MBS principal pay downs into additional MBS, rather
than Treasuries. The net effect of the Fed's policy announcement was, as expected, a
slight flattening of the Treasury curve and a modest tightening of MBS spreads. All of
this follows the Fed’s unprecedented August statement that the Fed Funds target rate
should remain near zero until “at least mid-2013”.
Portfolio
Sep 30, 2011
Book Value
$54,000,000
Portfolio/TA
54%
$ Gain/(Loss)
$1,500,000
% Gain/(Loss)
Tax Equiv. Yield
2.8%
3.46%
Proj Avg. Life
3.45yrs
Eff. Dur/Conv
2.0/(.7)
+300bp Risk
(9.0%)
The European banking crisis continues to put increased stress on financial markets as
policymakers struggle to find a lasting solution. The idea of a "Euro-TARP" program
has been rumored, but the politics are difficult and many questions remain
unanswered. As long as the sovereign debt problem remains unresolved, markets will
be nervous and skittish capital will likely support US Treasuries in safe haven trades.
Through the quarter, the yield on the 10yr T-Note fell roughly 124bps from 3.16% to
1.91%. The 2yr dropped in yield by just 21bps, from .45 to .24%. This produced a
flatter yield curve as the 2s / 10s spread fell from 270bps to 167bps through the quarter.
Due to continued economic weakness along with the flight to quality bid from Europe
and the Fed’s intention to keep the rate structure low, we can expect to see bond yields
remain low and range-bound for quite some time.
Fed Funds Futures – Current Market Expectations for FUTURE levels (as of 9/30/11):
0.15%
0.10%
0.09%
0.09%
0.09%
Oct '11
Nov '11
Dec '11
0.10%
0.11%
0.12%
0.12%
0.12%
0.12%
0.12%
Mar '12
Apr '12
May '12
Jun '12
Jul '12
0.13%
0.13%
Aug '12
Sep '12
0.05%
0.00%
Jan '12
Feb '12
Austin, TX | Birmingham, AL | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
Page 1 of 5
Q4 2011 Investment Strategy
March 2016
Current Portfolio Position and Strategy
Lower market yields throughout the 3rd Quarter resulted in a 9bp decline in
Portfolio Yield (now 3.46%) and almost ¼% drop in Effective Duration (from 2.23
to 2.0). Additionally, the Unrealized Gain in the portfolio grew from 2.04% to
2.78% over the period. The decline in Effective Duration over the quarter is not
only due to a decline in market yields, but also a direct effect of the Bank’s strategy
to selectively reduce extension risk. Specifically, the Bank has continued to
eliminate longer maturity callable Agency bonds and replacing them will more
defensive Municipals and Mortgages. As a result, the +300bp price risk has fallen
from almost 10% to just below 9%, while the portfolio mix has shifted out of the
Agency sector (down to 18%) and into MBS (up to 38%). As the current rate
environment dictates, the Bank will continue to maintain a cash flow barbell
using short-end MBS/CMO products, along with longer tax-free Municipal bonds
that will supply the Bank with necessary liquidity without sacrificing too much
yield. As markets continue to anticipate the Fed Funds rate will remain
“exceptionally low for an extended period”, the Bank will work hard to fully
deploy idle funds in an effort to fight margin erosion. The Bank expects to
maintain duration and not be tempted to chase yield in the wrong sectors,
especially as the yield curve has flattened. As it appears, market yields could be
somewhat range bound, given the Feds participation in the markets, the Bank will
look for ways to take advantage of yields moving higher and lower within that
range by slightly adjusting duration in an attempt to increase performance. This
could be accomplished by focusing on higher coupon, more defensive securities
near the bottom of the range and lower coupon, intermediate securities near the
upper-end of the range.
Sector Distribution
Other,
CMO, 2% Agency
18%
15%
MBS,
38%
Tax
Muni,
3%
Muni,
24%
Historical U.S. Treasury Yield Curves
5.0%
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
12/31/2010
3/31/2011
6/30/2011
9/30/2011
0.5%
0.0%
Austin, TX | Birmingham, AL | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
Page 2 of 5
Q4 2011 Investment Strategy
March 2016
Sector Strategies
Agencies
Treasury yields continued to fall during the 3rd Quarter, falling 20-40bps on the
short- and over 100bp on the long-end, giving as a 100bp flatter yield curve (2s vs.
10s). Agency spreads widened to Treasuries over the quarter, ending 10-20bp
cheaper across the curve. The Bank will moderate sector duration by primarily
purchasing securities with 3- to 7-year maturities. Favored structures will
continue to be premium one-time callable securities with at least one year, if not
more, of call protection. Step-ups with 1x-call, 1x-step structures will also be
utilized when the step coupon provides sufficient probability of call. Step-up
issuance remains high and with a varying range of structures. The Bank will resist
the temptation to chase yield and avoid longer maturity, multi-step bonds in favor
the shorter 1x-step, and 1 x-call bonds with higher back-end coupons. The Bank
will continue to look for opportunities to sell short maturities and deploy the
proceeds on the intermediate portion of the curve. In general, the Bank will look
to take advantage of market fluctuations by adding slightly longer duration
instruments if rates rise, and focusing on premium 1x-calls in the lower part of the
trading range.
Agency %
Curr/Last
Target
18% /
20%
15-25%
Eff. Duration / Convexity
Curr/Last
Target
1.8/(.8)
2.0/(.8)
1.5-2.5/(.5)(1.0)
Municipals
Municipals rallied in the third quarter as demand outpaced issuance and this
trend should continue in the future. The Bank has made an extensive effort to
analyze and monitor the credit metrics of all municipal holdings and will be very
diligent in reviewing the creditworthiness of all future purchases. Given prudent
credit analysis, the environment continues to offer excellent opportunities to add
to the Municipal sector. As the Bank continues to employ a barbell strategy, the
Bank will maximize longer municipal holdings and explore opportunities to swap
out of shorter maturities and deploy the proceeds out on the preferred range of
the curve. The Bank will continue to buy general obligation municipals and will
purchase essential-purpose revenue municipals with a minimum of 1.25x
coverage and preferring a 1.50x or higher coverage. The Bank will also purchase
BABs with 5-10 year maturities, preferring shorter maturities because they do not
have the same reduced duration benefit as the tax-free issues. The Bank will
carefully review the creditworthiness of all municipal issuers in addition to
assessing the strength of the bond insurer. Preferred insurers of municipal
holdings will be the Texas PSF, Nevada PSF, AGM, Assured Guarantee as well as
State Aid Withholding , Qualified School Bond Funds, and issues rated A or better
on their own.
Municipal %
Curr/Last
Target
24%/24%
20-30%
Eff. Duration / Convexity
Curr/Last
Target
3.4/(.4)
3.5/(.3)
3.5-4.0/0-(.5)
Taxable Municipal %
Curr/Last
Target
3%/3%
5-10%
Eff. Duration / Convexity
Curr/Last
Target
5.9/.1
6.0/.2
5.0-7.0/0.3(.3)
Austin, TX | Birmingham, AL | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
Page 3 of 5
Q4 2011 Investment Strategy
March 2016
MBS
The Federal Reserve provided a boost to the MBS market when it announced, on
September 21st, it would reinvest monthly portfolio pay downs and Agency
debenture maturities back into Agency MBS as part of “Operation Twist”. In the
short –term, 30yr lower coupon FN/FH MBS stand to benefit the most, as these
products are sure to be the target of Fed purchases. This Fed strategy , combined
with the announced intention to buy longer-term Treasury securities over the
next several quarters, pushed the 30yr fixed mortgage rates to record lows around
4%. While rates have reached record lows, the mortgage market remains stuck.
The mortgage market remains very difficult to enter as only those with 750+ FICO
scores and <70% LTV ratios seem to be able to access refinancing options. Even
with record low mortgage rates, the Mortgage Bankers Association Refinance
Index has only risen to just over 4,000 after reaching 5,000+ in Dec 2010, when
mortgage rates were 4.25% and over 10,000 in 2003.
MBS %
Curr/Last
Target
38%/36%
35-45%
Eff. Duration / Convexity
Curr/Last
Target
1.5/(.8)
1.8/(.9)
1.5-2.0/(.7)(1.3)
Prepayments continue to be a tale of the “Haves” versus the “Have Not’s”. As a
result, voluntary prepayment speeds for lesser credit MBS pools continue to come
in far below historic norms, as extremely tight underwriting standards, declining
home prices, and increasing refinancing costs more than offset the impact of the
historically low 30-year mortgage rates experienced last year. However, cuspy
coupon MBS (15yr 4 + 4.5, 30yr 4.5 +5) comprised of borrowers fitting the
“Haves” profile proved to be very responsive to lower rates and thus should prove
to get fast once again. We will avoid these instruments and review the portfolio to
determine if any securities could be at risk to prepays from the lower rates. As
the housing market remains in the tank, we are keeping a watchful eye for any
impactful Government program to free up the credit markets. It is believed
possible changes to the current HARP program could be the program of choice to
reduce refi friction. These adjustments likely would have a very small effect on
prepayment speeds depending on the direction that the policymakers will take
(e.g. increase LTV limit, eliminate June ’09 cutoff date, adjust LLPA, etc.)It is
imperative to manage the MBS portfolio with a balance of protecting against both
extension and prepayment risks. The #1 loan attribute to curtail fast
prepayments, and also provide higher base case turnover rates, continues to be
pools comprised of lower loan balance mortgages. These loan holders have less
economic incentive to refinance into lower rates when they are low but have
increased mobility due to smaller loan sizes when rates are higher. To balance
extension and prepayment risks, the Bank will continue to focus on higher coupon
(>=4.5%) specified agency MBS pools with one or more of the following loan
characteristics: 1) pools with particular loan attributes that should provide
prepay protection( low loan balance, investor and vacation properties, NY, TX, NJ,
FL geographic concentrations, etc.), 2) FHA Loans (GNMAs), 3) seasoned
underlying mortgages (e.g. 2005 and earlier origination), or 4) short weighted
average maturities (e.g. WAM <120 months).
Austin, TX | Birmingham, AL | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
Page 4 of 5
Q4 2011 Investment Strategy
March 2016
CMO
The Bank has continued to reinvest cash flows in the Agency CMO sector to
maintain a 15% allocation. To diversify mortgage prepayment exposure and take
advantage of the more stable prepayment characteristics of FHA loans, GNMA MBS
will be the preferred CMO collateral. FHA loans currently offer superior extension
protection as base case turnover should remain brisk due to ongoing buyouts of
lesser credit FHA borrowers, while faster prepayments should be curtailed by the
60bp increase in annual Mortgage Insurance Premium (now 115bp) since October
2010. Preferred FNMA/FHLMC collateral will preferably have underlying loan
attributes that should provide prepay protection (low loan balance, investor and
vacation properties, NY, TX, NJ, FL geographic concentrations, etc.). Additionally,
very short average life CMOs (1-2yrs) will be utilized to provide a spread to cash
alternatives over the next 18 months while the Fed keeps the Funds rate
anchored. All CMO’s will be prudently analyzed for both extension and call risks
and will pass all FFIEC stress tests.
CMO %
Curr/Last
Target
15%/15%
10-20%
Eff. Duration / Convexity
Current/Last
Target
.9/(.8)
1.3/(1.1)
1.0-1.5/(.75)(1.25)
Austin, TX | Birmingham, AL | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
Page 5 of 5