Q4 2012 Investment Strategy
Sample Bank
Anywhere, US
Economic and Fed Overview
US economic growth in the third quarter continued to come in fits and starts,
taking two steps forward, then one step back. The most notable area of
sluggishness is clearly the jobs market where the unemployment rate remains
stuck above 8%. The persistent joblessness has curbed wage gains and limited
consumer spending, further impeding an economy facing a slowdown in
manufacturing as global demand cools and businesses curtail investments. Bright
spots in the economy include the housing and auto sectors which are now
showing signs of sustainable improvement. Still, the rate of growth is barely
expected to be 2% for calendar year 2012. This weak performance was
underscored by the recent downward revision of 2nd quarter growth to just 1.3%.
In addition to generally weak growth, financial markets must also cope with
dangerous uncertainties in US fiscal policy and ongoing problems in the Eurozone.
Portfolio
Book Value
Portfolio/TA
$ Gain/(Loss)
% Gain/(Loss)
Tax Equiv. Yield
Sept 30, 2012
$54,000,000
54%
$1,587,600
2.9%
3.01%
Proj Avg. Life
3.64yrs
Eff. Dur/Conv
1.98/(0.6)
+300bp Risk
(8.8%)
As for Fed policy, the big news during the quarter was of course the
announcement by the FOMC that it would hold its target interest rate near zero
until at least mid-2015 as it began a third round of stimulus, buying $40 billion in
mortgage bonds a month. Chairman Bernanke cited a lack of “ongoing, sustained
improvement in the labor market” as justification for the open-ended Quantitative
Ease (QE) program. Not all FOMC members agreed with this point as some
worried that the positive effect will be quite small and transitory, and that it could
risk higher inflation and harm to the Fed’s credibility when the time comes to
unwind the stimulus.” Nonetheless, the voting members counted only one dissent
(Jeffrey Lacker from Richmond) among them.
The average yield on the 10yr T-Note during the third quarter was 1.62%, twenty
basis points lower than the average of the second quarter, and sharply below the
high for the year of 2.38%. In light of the prospects for continued weak growth,
the weakness in inflation measures, and the Fed’s aggressive monetary policy
stance, we anticipate continued low and range-bound behavior for US Treasury
yields. Spreads of other bond market sectors, however, are behaving quite
differently, and for good reason. Without the Fed’s various QE programs, some
estimates suggest that the 10yr yield would now be in a 2.5% to 3% range. But we
know that without QE the economy would be somewhat weaker and therefore
bond yields would naturally be lower as well. One thing that is clearly distorted is
the spread relationships between and among certain bond market sectors. The
unusual circumstances created by market yields in a world of QE mean that
scrutinizing relative value among security sectors and types is perhaps more
important than ever before.
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Member: FINRA & SIPC
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Q4 2012 Investment Strategy
March 2016
Fed Funds Futures – Current Market Expectations for FUTURE levels (as of 9/30/12):
0.15%
0.14%
0.14%
0.14%
0.14%
0.13%
0.13%
0.13%
0.13%
0.12%
0.11%
Oct '12
Nov '12 Dec '12
Jan '13
0.12%
0.12%
0.13%
Feb '13 Mar '13 Apr '13 May '13 Jun '13
0.13%
0.13%
0.13%
Jul '12
Aug '13 Sep '13
Current Portfolio Position and Strategy
Despite the unprecedented steps taken by the Federal Reserve in the 3rd quarter,
US Treasury yields on the short and long ends of the curve finished the quarter
relatively unchanged while the “belly” of the curve fell about 10bp. The Fed’s
commitment to keep rates at zero through mid-2015 continues to depress bond
market yields and has contributed to another 10bp drop in portfolio yield to a
cycle low of 3.01% and an unrealized gain on the portfolio near records highs at
around 3%. The Bank has continued to resist the urge to “chase yield” in higher
risk securities and this strategy has led to a drop in our +300bp price risk to less
than 9%. Portfolio average life and duration have also fallen as MBS/CMO
prepayments have risen with record low mortgage rates. The Bank may need to
work hard to maintain duration in the face of faster prepayments and the rising
numbers of Agency bonds being called. With continued strength in deposit
growth and relatively tepid loan demand, a top priority will be to fully deploy
excess liquidity, while building a diversified portfolio that fits within the Bank’s
overall balance sheet risk.
Sector Distribution
Other,
CMO, 3%
12%
Agency
16%
Muni,
27%
MBS,
41%
Tax
Muni,
3%
Yield spreads on Agency and Municipal bonds remained relatively flat during the
quarter while MBS spreads fell to record lows. The Fed’s announcement that they
will be buying $40 billion a month of Agency MBS indefinitely has put
unprecedented upward pressure on prices and led to a 50bp drop in spreads
during the quarter. Market yields on certain Fixed Rate MBS have now fallen to a
point where some Hybrid ARMs may provide better relative value and the Bank
will consider building that sector. Municipal bonds will continue to be the favored
sector for increasing portfolio yield and purchases will be focused on the long-end,
assuming risk and tax positions warrant.
With an understanding that the worst bonds are normally purchased at peaks and
troughs in interest rates, security selection has never been more critical and the
Bank will avoid high risk securities. Purchase decisions will be focused on
structure, credit, loan attributes, cashflow volatility, price risk and optimal relative
value between and among sectors.
The Bank will seek to build a cash flow barbell with a short-to-intermediate range
ladder of taxable combined with longer maturity tax-exempt municipals. The
liquidity ladder should be anchored with well-structured MBS pass-throughs,
Austin, TX | Birmingham, AL | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
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Q4 2012 Investment Strategy
March 2016
short-to intermediate maturity agencies, and clean CMO tranches. Portfolio
allocations will be managed based on anticipated needs for liquidity, cashflow and
earnings. Overall portfolio yield will likely continue to fall in the coming weeks as
older bonds pay off or mature. Current re-investment rates remain at historic lows
making it difficult to maintain earning asset yield targets. This simply underscores
the necessity of keeping excess liquidity deployed. The cost of sitting in fed funds
becomes greater the longer we remain locked in the low rate environment.
Historical U.S. Treasury Yield Curves
3.5%
3.0%
2.5%
2.0%
12/31/2011
1.5%
3/31/2012
1.0%
6/30/2012
0.5%
9/30/2012
0.0%
Sector Strategies
Agencies
Agency spreads to Treasuries remained tight in Q2 as the treasury curve
steepened; 2-year bullet agencies are +5 basis points to treasuries and 5-years are
+15 basis points. The Bank will continue to moderate sector duration by
primarily purchasing securities with 3- to 7-year maturities. Favored structures
will continue to be premium one-time callable securities with at least one year of
call protection. Step-ups with 1x-call, 1x-step structures will also be utilized when
the step coupon provides sufficient probability of call. The Bank will also look to
add multi-step structures with mid-term maturities when the step coupon
schedule provides ample cushion and the yield pickups warrant. Step-up issuance
remains high and with a varying range of structures. The Bank will avoid chasing
yield and refrain from buying longer maturity bonds in favor of shorter maturity
1x-step, and 1x-callable 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
when rates rise, and focusing on premium 1x-calls in the lower part of the trading
range.
Agency %
Curr/Last
Target
15%/16%
15-25%
Eff. Duration / Convexity
Curr/Last
Target
1.9/(0.9)
2.0/(0.8)
1.52.5/(0.5)(1.0)
Austin, TX | Birmingham, AL | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
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Q4 2012 Investment Strategy
March 2016
CDs
The bank’s CD sector remains quite small. However, with Agency yields and
spreads near all-time lows, the Bank will add to the sector as appropriate
securities become available. The Bank will focus on buying short-to-mid-term
marketable FDIC-insured CDs, where it can expect to pick up 10-25 bps vs. 2-year
maturity and 15-50 bps vs. 5-year maturity bullet agencies. Like agencies, the
Bank will avoid longer-maturity, option-heavy structures. FDIC insurance covers
up to $250,000 per issuer, including accrued interest. The bank will limit holdings
of CDs under these constraints per issuer. The supply of unique issuers remains
limited, so the Bank will look to take advantage quickly when new opportunities
arise.
CD %
Curr/Last
Target
1%/0%
0-5%
Eff. Duration / Convexity
Curr/Last
Target
1.1/(0.3)
1.2/(0.3)
1.52.5/(0.5)(1.0)
Municipals
Municipals continued with solid returns in the third quarter as demand outpaced
issuance and this trend should continue in the future. The percentage ratio
between 10 year municipals and treasuries is 100%. The historical ratio is 80%
and the Bank will purchase municipals when the ratio is above 80%. The Bank has
made an extensive effort to analyze and monitor the credit metrics of all municipal
holdings and will be very diligent in reviewing the creditworthiness of all future
purchases. Given prudent credit analysis, the environment continues to offer
excellent opportunities to add to the Municipal sector. As the Bank continues to
employ a barbell strategy, the Bank will maximize longer municipal holdings and
explore opportunities to swap out of shorter maturities and deploy the proceeds
out on the preferred range of the curve.
The Bank will continue to buy general obligation municipals and will purchase
essential-purpose revenue municipals with a minimum of 1.25x coverage and
preferring a 1.50x or higher coverage. The Bank will also purchase taxables 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 buy taxables
with make whole calls tied to the treasury market or redemption provisions that
are not affected by Sequestration Transparency Act of 2012. The Bank will
carefully review the creditworthiness of all municipal issuers in addition to
assessing the strength of the bond insurer. Preferred insurers of municipal
holdings will be the Texas PSF, State Aid Withholding and Qualified School Bond
Funds, and issues rated A or better on their own. The Bank will purchase
municipals with AGM or Assured Guaranty insurance that have an A or better
underlying rating.
Municipal %
Curr/Last
Target
26%/25%
20-30%
Eff. Duration / Convexity
Curr/Last
Target
3.4/(0.4)
3.4/(0.4)
3.5-4.0/0-(0.5)
Taxable Municipal %
Curr/Last
Target
3%/3%
5-10%
Eff. Duration / Convexity
Curr/Last
Target
5.6/0.2
5.8/0.1
5.0-7.0/0.3-(0.3)
Austin, TX | Birmingham, AL | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
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Q4 2012 Investment Strategy
March 2016
MBS
On September 13th, The Federal Reserve announced another round of
quantitative easing measures (QE3) by saying they will invest $40 Billion per
month in the MBS market while continuing to reinvest portfolio cash flows into
Agency MBS securities This program has been extended until the FOMC believes
the unemployment rate has fallen to acceptable levels. The role of the MBS
portfolio continues to be to provide steady front-end cash flow while maximizing
risk/reward benefits. Over the third quarter, MBS holdings declined another 1%,
and sits at the low end of the target, while sector duration contracted from 1.6 to
1.2 as mortgage rates reached new record lows below 3.50%. This further drop in
rates reinforces our strategy to balance both contraction and extension risk in all
mortgage related investments. On one hand, the White House continues to push
stimulative packages to allow more homeowners to refinance. At the same time
private mortgage lending remains non-existent and the FHFA continues to raise
fees for government mortgage insurance. They recently announced guarantee
fees will increase another 10bp before the end of the year nationally, while certain
states face the prospect of additional increases. The Home Affordable Refinance
Program (HARP 2) has continued to gain traction and has elevated prepayments
for certain securities. HARP eligible homeowners continue to take advantage of a
tremendous opportunity to obtain an artificially low cost mortgage. Specifically,
borrowers with no delinquencies over the past 12 months and an underwater
loan (>80LTV) originated before June 1, 2009, have the opportunity to streamline
refinance, with limited LLPA fees, through Dec 31, 2013. Currently, over 30% of
all mortgage refinancing is under the HARP 2 program. It is expected these speeds
will remain elevated for at least the remainder of 2012 before we may see some
burnout.
MBS %
Curr/Prev
Target
35%/36%
35-45%
Eff. Duration / Convexity
Curr/Prev
Target
1.2/(0.8)
1.6/(0.7)
1.5-2.0/
(0.7)-(1.3)
During the first 9 months of the year, the Bank reviewed all holdings in the MBS
portfolio and liquidated all securities deemed to be negatively impacted by these
changes. Specifically, the portfolio was filtered to find loans originated after 2003
(+ before June 1, 2009) with >80% estimated current LTV. Of those securities,
pools with longer terms (e.g. 30yr), higher loan balances (>$150k), higher FICO
scores (>700) were liquidated as deemed necessary.
More recently, the FHA has initiated a similar refinancing program, commencing
June 11, 2012, to provide incentives to refinance borrowers with loans also
originated prior to June 1, 2009. These specific FHA loans are grandfathered from
having to pay a 70 basis points increase in annual Mortgage Insurance Premiums
(MIPs) and the upfront premium is only 1 basis point (vs. 1.75% for nongrandfathered loans). The Bank has performed a similar review of all GNMA
holdings to determine if any items should be liquidated prior to any accelerated
prepayments resulting from the new program. Prepayments on FHA HARP
eligible loans have accelerated at a very fast pace (starting with August payments),
however, it is believed the very fast prepayments should be somewhat short-lived.
Austin, TX | Birmingham, AL | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
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Q4 2012 Investment Strategy
March 2016
MBS Con’t
Over the past few years of elevated refinance activity, the Bank has strived to hold
securities that provide consistent prepay protection while offering more defensive
price volatility characteristics. 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 shorter-term (<=20yr) and higher coupon
(>=4.0%) specified agency MBS pools. With current production coupons now
falling to 3.5% and below, this is becoming more difficult to do. Pools will be
selected with one or more of the following loan characteristics that should provide
prepay protection: 1) low loan balance, 2) investor and vacation properties, 3) NY,
TX, NJ, FL geographic concentrations, 4) Higher LTV (>85%), and 5) FHA Loans
(GNMAs) originated after June 1, 2009 and prior to April 2011.
MBS ARM
As fixed rate MBS yields continue to fall, the Bank has increased emphasis on the
MBS ARM sector. The yield differential between fixed and floating rate
instruments has continued to narrow significantly, leading to potential
opportunities to enhance future rate sensitivity with minimal yield give up.
Specifically, the Bank has added newer GNMA 3x1 and 5x1 Hybrid ARMs. GNMA
hybrids are the primary focus of the ARM strategy as the underlying FHA loans
have shown to provide similar prepayment protection offered by GNMA 30yr fixed
mortgages (Post June1, 2009). Longer first resets provided by these structures,
24-60 months, could coincide well with the FOMC stated bias toward keeping
short term rates into 2015. Additionally, the Bank will evaluate 7x1 and 10x1, low
coupon, FNMA and FHLMC Hybrid ARMS. Newer production loans should provide
some prepayment protection in the near-term, while escalating cash flows
towards future reset dates could provide liquidity in harmony with forward rates.
MBS ARM %
Curr / Prev
Target
5%/5%
10-20%
Eff. Duration / Convexity
Current / Prev
Target
0.77/(0.5)
1.0-1.5/
(0.3)-(0.8)
0.9 / (0.3)
CMO
After peaking at 15% allocation in Q3 2011, the CMO sector has declined 3% to
stand at 12% of the total portfolio. With the continued decline in mortgage rates,
the effective duration of the CMO portfolio has contracted to 1.2 from 1.7 at the
end of Q1, 2012. Given the growing impact of HARP 2 and the FHA HARP
program, CMO structures must continue to be evaluated with heightened scrutiny
towards faster prepayment rates over the near term. The Bank will continue to
pursue CMO structures that have 3-5 year projected average lives with limited
extension risk. Additionally, very short average life CMOs (1-2yrs) will be utilized
to provide a spread to cash alternatives over the next 24-30 months while the Fed
keeps short-term rates anchored. To diversify mortgage prepayment exposure
and take advantage of the more stable prepayment characteristics, GNMA MBS,
post June1, 2009 origination, will be the preferred CMO collateral. Foremost, FHA
loans originated after June 1, 2009 are not eligible to refinance under the FHA
HARP program.
CMO %
Curr/Prev
Target
12%/14%
10-20%
Eff. Duration / Convexity
Current/Prev
Target
1.3/(0.6)
1.3/(0.7)
1.2-1.7/
(0.5)-(1.2)
Austin, TX | Birmingham, AL | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
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Q4 2012 Investment Strategy
March 2016
CMO Con’t
Additionally, FHA loans originated prior to April 2011 have provided excellent
prepayment protection as the FHA has increased the annual Mortgage Insurance
Premium by 70bps since October1, 2010. The increased premium results in an
additional 40-70bp rate incentive needed for an FHA borrower to achieve the
required 5% Net Tangible Benefit to refinance. Furthermore, GNMA collateral can
offer superior extension protection as base case turnover should remain brisk due
to ongoing buyouts of lesser credit FHA borrowers. Alternatively, preferred
FNMA/FHLMC collateral will have underlying loan attributes that should provide
prepay protection (low loan balance, investor and vacation properties, NY, TX, NJ,
FL geographic concentrations, higher LTV MHA loans, etc.). A new strategy for the
CMO sector this quarter will be to search for securities being liquidated at
depressed levels because they have been adversely impacted by the
FNMA/FHLMC HARP II or the FHA HARP programs. All CMO’s will be prudently
analyzed and continually monitored for both extension and call risks and will
managed to maximize risk/reward benefits.
Austin, TX | Birmingham, AL | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
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