January 24, 2013Daily Rates & Viewpoints From the Officers & Staff of TIB.

Einstein and Relativity

 “If you can’t explain it to a six year old, you don’t understand it yourself.” Albert Einstein

In the spirit of the famous physicist quoted above, this Ticker will not be about debt ceiling limits and/or mind-numbing “kicking the can down the road” strategies, the faltering economics of China, or the British Empire seceding from the European Union. I would obviously fail miserably when benchmarked against Mr. Einstein’s litmus test. What this Ticker will be about is implications of the current yield environment with an illustration of TIB’s portfolio strategy given that relativity.
Let’s start with examining a couple of yield curves and defining the slope of those curves.  
Graph (click to enlarge) The yield curve at the top is from June 29th, 1990, with the bottom yield curve the current “on the run” curve from today. The “slope of the curve” is calculated by subtracting the current 2 year treasury yield from the current benchmark 10 year treasury yield. Note that even though the yields are substantially different, the slope of the 1990 illustration is only 19 Basis Points (10 year treasury @ 8.41% versus 2 year treasury @ 8.22%) versus the slope of today’s yield curve is 157 Basis Points (1.81% minus 0.23%). There was obviously very little reward for extension / duration risk given the flat yield curve environment in 1990 – for the moment, we will ignore interest rate expectations and forecasts. (Relativity side note – for those of us actually investing back in 1990 if we’d had bought the 30 year treasury note, we could still have a “full faith and credit” item on the books at 8.40% which didn’t mature until 2020 – hindsight’s 20/20.)
Given the current environment and our fixed income portfolio’s profile, one of TIB’s strategic decisions for the New Year was to sell fourteen of our MBS pools with current balances of $82 million. Numerous factors went into that decision matrix including loan portfolio expectations, current coupon environment, premium pricing, aging of securities, prepayment expectations, and the slope of the curve.   The yield table below details the price and yield of one pool of TIB’s portfolio sold:
Graph (click to enlarge) 
Note that given our December 31 Book Price of 99.820802 our book yields are north of 4%, regardless of the prepayments that occur for the underlying mortgages of 4.5%. Note also that the duration of the security is 1.56 to 1.90 years across the spectrum of prepayment assumptions.  Given the all-time historically low interest rate environment, why would you ever give up that kind of yield? The answer is simple with all credit and recognition to Albert – mathematics and relativity. Whether I am investing in an 8% environment, or a 1.8% environment the mathematical calculations are the same. The relativity that is important is the “breakeven date” (horizon date) that is a direct function of the slope of the curve. Plain English for the 6 year old in me: the greater the slope of the curve, the greater the impact to the math involved. To illustrate that concept, the following table is the “take out” yield on that same MBS pool given the 107.625 selling price.
Graph (click to enlarge)
Note that in the premium world fixed income securities are currently trading, the selling price of the bond gives a negative or flat yield across the current historical prepayment speeds for that specific pool.    The break-even date (horizon date) calculation is a mathematical quantification of time given my realization of current income (gain of $165k on bond) versus my future earnings potential at a 4.45% rate (the paradox of forsaking future earnings for current income). 
At its most basic level, the duration of a bond is a mathematical calculation of cash flow. For illustration of that concept, consider that the duration of a zero-coupon bond always equals the exact maturity date of that bond as there are no payments received until the exact maturity date. (I.E. The duration of a three year zero- coupon bond is exactly three years.) To calculate the break-even date of a Mortgage Backed Security, the mathematics requires a reinvestment assumption, as well as a prepayment speed expectation. Given the current speeds of the highlighted bond sold and using a reinvestment assumption scenario of 1% and 2% give mathematical breakeven dates of 2.26 years and 3.18 years, respectively. Given the current duration of the bond at 1.56-1.90 years illustrated in the first yield table (Because inquiring minds want to know, why would the duration calculation be slightly longer in the second yield table given the exact same prepayment speeds?), the difference in time of the breakeven date (horizon date) is a mathematical quantification of if my future earnings potential is greater or lesser than the current income potential. To illustrate, if the break-even date equals the current duration, then I should be neutral in the decision matrix as there is no financial incentive. If the break-even date is greater than the current duration, then that translates to receiving more current income than future earnings would generate. If the breakeven date is shorter than the current duration of the bond, then future earnings definitely outweigh current income options. 
Note that this entire conversation has been based on no interest rate considerations. With the clarity of 20/20 hindsight, the single best investment decision for a fixed-income portfolio manager on June 29th, 1990 would have been to accept the “no reward” extension risk quantification of the flat yield curve, and bought the 30 year treasury note locking in a 8.40% yield (excluding regulatory concerns and the price volatility exposure – and no, I didn’t buy any back then either!). TIB’s decision to sell several of our short duration pools was also based upon an interest rate forecast of a continued low interest rate environment – never forget the decision to stay in cash is an interest rate forecast. The quantification of “opportunity cost” for the 14 pools sold resulted in substantial breakeven dates well beyond the duration of the current holdings. (Side-note / Shocking TIB’s portfolio for an extreme 400 Basis Points increase in rates pre and post sales varied the duration only slightly due to the prepay speeds and high coupons of bonds sold.) In 6 year old parlance, we took more off the table than we gave up.
For further discussions to your bank’s portfolio specifics and given your interest rate expectations, please contact me or your TIB Investment Officer. One final thought from Mr. Einstein,
“The hardest thing in the world to understand is the income tax.”     
We appreciate your continued trust and support at TIB!

Bruce Taylor Bruce Taylor
Sr. Vice President

Market Levels @ 7:09 AM CST

TIB Fed Funds & MMDA Rates - Previous Day
Agent 0.20% Prin 0.05% MMDA 0.30%
STAR Prin 0.10% STAR MMDA 0.35%
Key Indices/Commodities
1 - Month LIBOR 0.20% Dow Jones 13779.33
3 - Month LIBOR 0.30% NASDAQ 100 3153.67
1-Yr LIBOR 0.79% S&P 500 1487.00
1-Yr CMT 0.15% Spot Gold 1677.30
Prime 3.25% Spot Silver 31.74
3-yr LIBOR Swap/Offer 0.49% Spot Crude Oil 95.54
5-yr LIBOR Swap/Offer 0.87% CRB Index 300.60
3 Mo - Fed Fund Futures 0.12% 6 Mo - Fed Fund Futures 0.13%
US Treasury Yields US Non-Callable Agency Yields
Yield Maturity Yield Spread
0.00% 90 - Days    
0.00% 180 - Days    
0.18% 2 - Year 0.26% 8bp
0.31% 3 - Year 0.34% 3bp
0.70% 5 - Year 0.87% 17bp
1.78% 10 - Year 1.98% 20bp
2.98% 30 - Year    
160 BPs Yield Curve(2's-10's)
Sample 1x Callable Agency Issues
Description Call Date YTC YTM
FNMA 1 07/30/18 1/14 1.03% 1.03%
Select MBS Levels
Description Coupon Yield Spread/Duration*
15-Yr FNMA 3.00% 1.31% 84 / 3.46
30-Yr GNMA 3.50% 2.1% 90 / 6.02
*Duration @ 12 month Historical CPR
Morning Commentary: Blake Scharlach

The feeling this morning in the markets is “risk-on”.  First-time jobless claims came in far below expectations at 330K.  Markets were expecting 355K.  For the second week in a row, low initial claims are being attributed to the Labor Department’s calculation of seasonal adjustments instead of an improving labor market.  The big conversation this week in fixed-income markets has to do with whether the Fed will end its stimulus anytime soon.  It’s important to remember that six of the voting members of the FOMC have all said this week that stimulus must continue.  Also, the two new voting members to the FOMC this year are big-time supporters of stimulus.   Lastly, just last week, Bernanke said that the current labor market is “an unacceptable situation”.  The general consensus is that the Fed might begin reducing its purchases this summer at the earliest, but it probably will not consider taking any action until we see 7% unemployment.    The Bloomberg Consumer Comfort Index fell this week to -36.4 from -35.5 last week.  Also, The US Index of Leading Economic Indicators came in at 0.5% versus a projected 0.4%.  December’s revised number was 0.0%.  The Dow is up 80 in the first 30 minutes of trading and the 10 year yield has climbed from 1.81% to 1.86% this morning.

Information contained herein is based on sources we believe to be reliable but its accuracy is not guaranteed. Customers should rely on their own outside counsel or accounting firm for specific circumstances. The securities, yields or levels discussed herein are for illustration purposes and are not guaranteed, not obligations of any bank, thrift or other entity and are not insured by the FDIC.

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