Q2 2013 Investment Strategy
Economic and Fed Overview
Portfolio / Mar 31, 2013Book Value / $54,000,000
Portfolio/TA / 54%
$ Gain/(Loss) / $934,447
% Gain/(Loss) / 1.49%
Tax Equiv. Yield / 2.79%
Proj Avg. Life / 4.16yrs
Eff. Dur/Conv / 2.28/(0.71)
+300bp Risk / (10.0%)
The US economy continued to improve gradually in the first quarter of 2013 with particular strength in housing and autos, plus surprising resilience in consumer spending. This, despite tax rate increases at year-end for upper income households and wage earners alike. The cyclical outlook for the US is sound as progress continues in deleveraging household balance sheets and shoring up state and local finances. Still, the recovery’s growth remains tepid when compared to historic averages. Substantial fiscal policy contraction will keep growth lower than it would otherwise be this year, with the bulk of the impact occurring in the 2nd and 3rd quarters. CBO estimates 750K fewer jobs due to sequester cuts. The Federal Reserve estimates a 2.55% GDP growth rate for all of 2013.
Inflation remains modest with the exception of prices for certain raw materials. There is no sign of higher input prices being passed along to consumers in broad-based fashion. The Fed anticipates consumer price inflation will run at or below their long-run objective of 2%. Although Fed purchases of Treasuries and MBS have expanded the reserves of the banking system, banks have held most of those reserves as excess reserves, thus blocking or sterilizing the multiple expansion of money. Reserves sitting on deposit at the Fed are not inflationary unless or until they filter out into the “real” economy. That simply isn’t happening. Inflation will not be a problem as long as the economy continues to experience a large, negative output gap.
Eventually the Fed will change its policy focus from stimulating growth to containing inflation, but not in 2013. One thing that may happen later this year is the tapering off of, or adjustment to, the size or composition of the Fed’s purchase program, currently $85billion per month consisting of Agency MBS and Treasuries. Any adjustment to the buy program, however, would not constitute a policy change toward tightening, but rather a decision to hold current levels of accommodation.
Interest rates and bond yields changed little during the first quarter as bond market volatility remain at extremely low levels. The 10yr US Treasury note only saw a 30 basis point yield range for the first three months of the year. The high yield was 2.06%, the low was 1.76%, and the quarter-end yield was 1.87%. Foreign demand at US Treasury auctions continues to impress, partly as a result of safe haven flows. The Cypriot banking crisis serves as a reminder that the Euro-zone is still dealing with problems that produce flights-to-quality into US Treasuries. All-in-all, we anticipate little change in the general behavior or level of bond yields until next year at the earliest.
Fed Funds Futures – Current Market Expectations for FUTURE levels (as of 3/31/13):
Current Portfolio Position and Strategy
The decline in portfolio yield slowed slightly during the 1st quarter as market yields moved up to the middle of the 18 month trading range (1.5-2.5% on the 10yr Treasury) and provided marginally better reinvestment opportunities. The Bank’s overall yield fell 9bp to another cycle low of 2.79% after falling 13bp in the 4th quarter. The recent rise in market yields caused the average life of the portfolio to extend about 1/3rd of a year to just over 4 years. Despite the moderate extension of the portfolio caused by rising rates, the Bank has continued to resist the urge to “chase yield” in higher risk securities and this strategy has maintained a +300bp price risk of less than 10%. The Bank will continue to monitor the changing duration of the portfolio to ensure extension risk and depreciation potential remain within acceptable. 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.
Yield spreads on Agency bonds and MBS/CMO finished the quarter close to where they began as the Federal Reserve continued to purchase $85 billion a month of securities. The market is uncertain as to when the Fed will end its purchase program, but it seems clear that yields and spreads in the mortgage market will remain low and tight as long as they are buying. The one sector that continues to provide excellent value and opportunity for portfolio income is in Municipal bonds which sold off yet again in the 1st quarter. Tax-equivalent muni spreads widened another 20bp during the quarter and 10yr munis now provide more than 2.5x as much spread over Treasuries as 15yr MBS. In addition to the rising relative value of municipal bonds, the increase in the top marginal tax rate to as high as 43.4% at the beginning of the year has significantly increased the benefit of munis to holders in that tax bracket. Needless to say, high-credit municipal bonds continue to offer the best relative value to maintain yield and duration in the bond portfolio. Municipal purchases will continue to 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, 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 months 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
Sector Strategies
Agencies
Agency %Curr/Last / Target
13%/14% / 10-25%
Eff. Duration / Convexity
Curr/Last / Target
2.2/(1.1)2.0/(1.0) / 1.5-2.5/(0.5)-(1.0)
Agency spreads to Treasuries remained tight in Q1 as treasury yields increased slightly; 2-year bullet agencies are +4 basis points to treasuries and 5-years are +12 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.
CD %Curr/Last / Target
2%/2% / 0-5%
Eff. Duration / Convexity
Curr/Last / Target
1.2/(0.4)1.2/(0.3) / 1.5-2.5/(0.5)-(1.0)
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 15-40 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.
Municipals
Municipal %Curr/Last / Target
28%/28% / 20-30%
Eff. Duration / Convexity
Curr/Last / Target
3.4/(0.5)3.4/(0.5) / 3.5-4.0/0-(0.5)
Municipals continued to be attractive to investors in the first quarter as demand outpaced issuance and this trend should continue in the future. The threat of Sequestration dominated the news as investors sold off Build America Bonds with par calls dragging down the taxable municipal market. As a percentage of treasuries, municipals continue to be 90 to 120% along the curve. The historical percentage has been around 75 to 80%. The Bank has made an extensive effort to analyze and monitor the credit metrics of all municipal holdings and will be very diligent in reviewing the creditworthiness of all future purchases. Given prudent credit analysis, the environment continues to offer excellent opportunities to add to the Municipal sector. As the Bank continues to employ a barbell strategy, the Bank will maximize longer municipal holdings and explore opportunities to swap out of shorter maturities and deploy the proceeds out on the preferred range of the curve.
Taxable Municipal %Curr/Last / Target
3%/3% / 5-10%
Eff. Duration / Convexity
Curr/Last / Target
5.3/0.35.4/0.2 / 5.0-7.0/0.3-(0.3)
Taxable Municipals
The Bank will continue to buy general obligation municipals and will purchase essential-purpose revenue municipals with a minimum of 1.25x coverage and preferring a 1.5x or higher coverage. The Bank will also purchase taxables with 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, State Aid Withholding, Qualified School Bond Funds, and issues rated A or better on their own. The Bank will purchase municipals with AGM, Assured Guaranty or Build America Mutual insurance that have an A or better underlying rating.
MBS
MBS %Curr/Prev / Target
358he bank will continue to maintain its current target duration for the portfolio.111111111111111111111111111111111111111111111%/34% / 35-45%
Eff. Duration / Convexity
Curr/Prev / Target
1.6/(0.9)1.4/(0.8) / 1.5-2.0/ (0.7)-(1.3)
Chairman Bernanke let the nation know The Federal Reserve will continue to execute open-ended quantitative easing measures (QE3) by investing $40 Billion per month in agency MBS securities, while also continuing to reinvest portfolio cash flows into the sector. Chairman Bernanke reiterated the program will be extended until the FOMC believes the unemployment rate has fallen to an acceptable level. Most market participants believe the purchases will continue throughout 2013, meaning the Fed remains on track to purchase approximately $500 Billion Agency MBS this year. The HARP 2 program has continued to be very successful in allowing eligible homeowners 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 very low costs, through Dec 31, 2013. Currently, almost 40% of all mortgage refinancing is through the HARP 2 program. The program has not shown signs of burning out and the FHFA Director DiMarco testified to Congress that a new national marketing campaign would be underway soon. Additionally, the FHA has had much success with a similar refinancing program, launched June 11, 2012. The FHA streamline program provides incentives to refinance for borrowers with loans also originated prior to June 1, 2009. These pre-June 2009 FHA loans are grandfathered from having to pay the higher current annual Mortgage Insurance Premiums (Grandfathered MIP = 55pb vs. 120-135bp) and the upfront premium is only 1 basis point (vs. 1.75% for non-grandfathered loans).
While these government programs have been very beneficial to a certain segment of borrowers (basically Pre June 2009 loan origination), the cost and ability of getting a non-HARP/FHA Streamline residential loan continues to be very credit sensitive and is getting more expensive as the FHFA and FHA continue to raise costs for guarantee fees and government mortgage insurance premiums (MIP). In 2012, the FHFA raised the Guarantee fee by 20 basis points and appear to be on a path to raise it another 10-20bp in 2013. The FHA, in an effort to shore up its reserve fund, has more than doubled mortgage insurance premiums, from 50/55 basis points to 120/125 basis points since 2011. Additionally, the FHA implemented another 10 basis points increase in the annual MIP (upto 130/135bp) April 1st.
The role of the MBS portfolio continues to provide steady front-end cash flow while maximizing risk/reward benefits. Record low mortgage rates and sustained Fed buying of MBS rates reinforces our strategy to balance both contraction and extension risk in all mortgage related investments. Over the 1st quarter, the sector held steady with a 35% allocation and the effective duration extended from 1.4 to 1.6. The Bank continues to review all holdings in the MBS portfolio and will continue to evaluate the benefits of liquidating securities negatively impacted by Government refinance programs.
In the environment of sustained elevated refinance activity, the Bank will be diligent in striving 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 relatively higher coupon (>=3.5%) specified agency MBS pools. With current production coupons now falling to 2.5% to 3.5%, 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 (>90%), and 5) FHA Loans (GNMAs) originated after June 1, 2009 and prior to April 2011.
MBS ARM
MBS ARM %Curr / Prev / Target
7%/7% / 10-20%
Eff. Duration / Convexity
Current / Prev / Target
0.8/(0.6)
0.8 / (0.5) / 1.0-1.5/(0.3)-(0.8)
As fixed rate MBS yields and spreads continue to fall, the Bank has increased emphasis on the MBS ARM sector. The yield differential between fixed and floating rate instruments has become much narrower as the low rate environment persists. The Bank will continue to search for opportunities to enhance future rate sensitivity with minimal yield give up. Throughout 2012, the Bank added newer GNMA 3x1 and 5x1 Hybrid ARMs. These GNMA hybrid ARMs have been 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 origination). Longer first resets provided by these structures, 24-60 months, may also coincide well with the FOMC stated bias toward keeping short term rates low into 2015. More recently, GNMA Hybrid supply has become somewhat scarce and the Bank will more aggressively search for opportunities in lower coupon FNMA and FHLMC 5x1, 7x1 and 10x1 hybrid ARMS. With a focus on newer production loans, these instruments could provide some prepayment protection in the near-term, while escalating cash flows towards future reset dates could provide liquidity in harmony with forward rates. As opportunities present, an additional focus for the sector will be seasoned post-reset ARMS. These loans will have originations ranging from ‘03-‘05 and currently have annual resets of less than 12 months.
CMO
Austin, TX | Birmingham, AL | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL
Member: FINRA & SIPC
Q2 2013 Investment Strategy
CMO %Curr/Prev / Target
10%/11% / 10-20%
Eff. Duration / Convexity
Current/Prev / Target
1.6/(0.7)1.3/(0.7) / 1.2-1.7/(0.5)-(1.2)
After peaking at 15% of portfolio allocation in Q3 2011, the CMO sector allocation has continued to decline and now stands at 9% of the total portfolio. With sustained low mortgage rates and government refinancing programs driving prepayments higher, the CMO portfolio continues to spin off measurable cash flow. Given the sustained impact of HARP 2 and the FHA Streamline program, CMO structures must continue to be evaluated with heightened scrutiny towards fast 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, 30 year GNMA MBS (post June1, 2009 origination) will be the preferred CMO collateral. Foremost, FHA loans originated after June 1, 2009 are not eligible to refinance under the FHA HARP program. FHA loans originated prior to April 2011 (and after June 1, 2009) have provided excellent prepayment protection as the FHA has increased the annual Mortgage Insurance Premium by 80bps. The increased premium results in an additional rate incentive needed for an FHA borrower to achieve the required 5% Net Tangible Benefit to refinance. Furthermore, GNMA collateral can offer superior extension protection as base case turnover should remain brisk due to ongoing buyouts of lesser credit FHA borrowers. Preferred FNMA/FHLMC collateral will have underlying loan attributes as stressed in the MBS sector (low loan balance, investor and vacation properties, NY, TX, NJ, FL geographic concentrations, higher LTV MHA loans, etc.) that should provide prepay protection. We continue to see a significant number of CMO securities being liquidated at depressed levels because they have experience a large increase in prepayments as a result of the FNMA/FHLMC HARP II or the FHA Streamline programs. The Bank will evaluate and consider those CMO structures that may have elevated cash flows, but are now trading and much lower premiums. All CMO’s will be prudently analyzed and continually monitored for both extension and call risks and will be managed to maximize risk/reward benefits.