February 08, 2013Daily Rates & Viewpoints From the Officers & Staff of TIB.

It's Not As Clear-Cut As You May Think...

We’re now into the second month of 2013 – we’re now getting comfortable with writing a “3” when we write a date, instead of doing our best to fashion a “2” into a “3” after we’ve mis-written the year. We’re facing some new challenges as well. We’ve watched the 10 year Treasury bounce around the 2% range as uncertainty begins to fade a little bit in relation to the (potential growth of the) economy. Is this a harbinger of rising rates and a “great rotation” from bonds to equities, or is it a temporary outlier based on short-term, overwrought confidence?

With that in mind, I thought I’d share a simulation that we do with attendees at our investment and ALM Seminars (next one coming up March 28-29 at the Omni Mandalay in Irving, TX! ). The simulation is simple… Your choices are a 1, 2, 3, 4, and 5 year Treasury. You must be fully invested at all times, but you can buy any combination of those securities (a 1 year followed by a 4 year, or a 3 year followed by two consecutive 1 years, etc.), as long as your final maturity is at the horizon date in five years. As a bonus, I will tell you exactly what rates will do for the next five years. Sounds easy, right?
For simplification purposes, we’ll just use 4 of the 16 possible investment scenarios.
We’ll use             1) five consecutive one year Treasuries
                                2) a 2 year Treasury, followed by another 2 year, followed by a 1 year
                                3) a 3 year followed by a 2 year
                                4) the 5 year bond
The yield curve is as follows:     

1 year:
2 year:
3 year:
4 year:
5 year:

Scenario #1: We’ll see a parallel 50 bps rise in year 2 and a 50 bps rise in year 4. Which is the best investment strategy? Before reading ahead, which of these scenarios appears most appealing? Most people reflexively vote for Investment #2, which is to invest in the two year, which takes advantage of the first rate increase, and then buy another two year which will mature at the second rate increase, and then buy the one year, which is now 100 bps higher. So what did you decide?
Investment #1, five consecutive one years: Weighted average yield will be 0.54%
Investment #2, the 2 year, 2 year, and 1 year: Weighted average yield will be 0.63%
Investment #3, the 3 year, and the 2 year: Weighted average yield will be 0.52%
Investment #4, the 5 year: Weighted average yield will be 0.84%
In our scenario where rates rise 100 bps over a four year period, the longer bond outperformed every combination of the shorter bonds by a wide margin.
Scenario #2: Rates rise 100 bps in year two and 100 bps in year four. Again, what’s your vote?
Investment #1, the 1/1/1/1/1, had a net yield of 0.94%
Investment #2, the 2/2/1, had a net yield of 1.03%
Investment #3, the 3/2, had a net yield of 0.92%
Investment #4, the 5 year, had a net yield of 0.84%.
When rates rose 100 bps instead of 50 bps in each shift, the results turned upside down. The long bond went from being the winner to last place. Surprising?
Scenario #3: A bear flattening curve to 1.5%. Over the next four years, all rates will rise to 1.5%. The one year will rise 0.34% per year, the 2 year will rise 0.31% per year, etc. This example is a particularly valuable example because, historically, when rates rise after periods of exceptionally low rates, we see bear flattening curves develop. So how do you vote?
Investment #1, the 1/1/1/1/1, had a net yield of 0.82%
Investment #2, the 2/2/1, had a net yield of 0.75%
Investment #3, the 3/2, had a net yield of 0.70%
Investment #4, the 5 year, had a net yield of 0.84%.
In a bear flattening curve to 2%, however, the 1/1/1/1/1 is the best option, and the 5 year is the worst.
In rates-unchanged and rates-down environments, the 5 year is the best option.
Be honest – even when you knew what rates were going to do, did you always invest correctly?
In the real world, we invest in more than Treasuries and we don’t have investment horizons where we have to be fully matured at a certain date. Also, in the real world, of course, we don’t know what rates are going to do. And we don’t know when. Those of us who designed our portfolios around what we “thought rates were going to do” haven’t done very well in the past few years. But if there’s one lesson to be learned from our simulation, it’s that there’s a great deal of value in being short, and there’s a great deal of value in taking on some duration, depending on how rates eventually move. 
For most banks, the best investment option is some combination of cash-flowing mortgage-backed securities (to capture the value of being “short”) and 8-15 municipals (with limited call risk) to take advantage of the duration aspect. What’s the perfect combination for you? Let your asset/liability model be your guide. 
Your TIB Capital Markets officer is standing by to discuss this or anything else you may have on your mind. We look forward to hearing from you!

Blake Scharlach Blake Scharlach
Vice President/TIB Capital Markets

Market Levels @ 7:54 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 13944.05
3 - Month LIBOR 0.29% NASDAQ 100 3165.13
1-Yr LIBOR 0.76% S&P 500 1506.20
1-Yr CMT 0.15% Spot Gold 1669.00
Prime 3.25% Spot Silver 31.40
3-yr LIBOR Swap/Offer 0.53% Spot Crude Oil 96.13
5-yr LIBOR Swap/Offer 0.97% CRB Index 301.53
3 Mo - Fed Fund Futures 0.13% 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    
0.20% 2 - Year 0.28% 8bp
0.33% 3 - Year 0.37% 4bp
0.79% 5 - Year 0.93% 14bp
1.91% 10 - Year 2.24% 33bp
3.13% 30 - Year    
171 BPs Yield Curve(2's-10's)
Sample 1x Callable Agency Issues
Description Call Date YTC YTM
FNMA .75 2/27/2017 2/17 0.75% 0.75%
Select MBS Levels
Description Coupon Yield Spread/Duration*
15-Yr FNMA 3.00% 1.34% 84 / 3.34
30-Yr GNMA 3.50% 2.09% 95 / 5.51
*Duration @ 12 month Historical CPR
Morning Commentary: Reed Bateman

The U.S. trade deficit narrowed more than expected in December from a revised -$48.6B the prior month to -$38.5B.  Treasury prices have declined on the news with the 10-year losing an eighth of a point in value, sending its yield higher to 1.98%.  Wholesale inventories declined by 0.1% in December after forecasts were for inventories to increase by 0.4%.  Winter Storm Nemo is causing havoc in the northeast today, with many firms only requiring the most crucial employees to come in.  With that said, trading should be light, even for a Friday.  Equities are higher with the Dow up 50 points on the day and sitting just below 14,000 at the moment, after crossing the threshold briefly earlier. 

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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