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As we head into March, many portfolio managers are taking stock of how the balance sheet will look at the end of the first quarter. We continue to have conversations with financial institutions struggling to balance current earnings and long-term cash flow needs. Rates have continued to trend lower over the past year. Consequently, the volume of calls and prepayments has heavily increased in the portfolio (Graph 1). Most managers will agree that their portfolios are more liquid than they would probably like.
While this cash flow graph is an example from one institution, it is indicative of what we routinely see across the landscape. With the high amount of near-term liquidity, portfolio managers are understandably concerned about near-term reinvestment risk. What do I reinvest the cash flow in? Staying invested too short offers very little yield and can even become a negative arbitrage. Therefore, many investors are extending out along the curve. Tactically extending out the curve can help increase yield, all the while limiting near term cash flow, and without significantly increasing the risk profile of the portfolio.
6750 POPLAR AVENUE, SUITE 300 - MEMPHIS, TN 38138 | 800.827.0827 WWW.DUNCANWILLIAMS.COM | MEMBER FINRA, SIPC, BDA, WBENC
For those investors that are comfortable adding on limited duration, there are a variety of options available. One option is a Last Cash Flow CMO (LCF CMO). A LCF CMO is a slightly longer average life investment (between 7 and 10 years in the base case for 15 year collateral) where the principal cash flow window starts towards the end of the investments duration (Table 1).
While
a
longer
average
life
LCF
CMO
is
not
a
fit
for
every
investment
portfolio,
it
can
be
a
strategic
addition
for
investors
that
have
too
much
near-term
liquidity.
The
bond
highlighted
above
has
an
attractive
yield
(2.44%)
and
spread
to
the
treasury
curve
(100
bps).
This
can
incrementally
add
income
to
the
institution
today.
There
is
some
extension
risk
in
a
rising
rate
environment
(+300,
11.2
years
average
life),
but
Table
1
above
shows
an
instantaneous
rate
shock
of
300
bps
today,
which
is
highly
unlikely
given
the
Feds
recent
rate
outlook.
Also,
the
bond
maintains
a
positive
spread
under
all
rate
scenarios
(keeping
in
mind
this
is
an
instantaneous
300
bps
rate
shock).
If
the
Fed
keeps
rates
at
current
levels
through
2014,
capacity
constraints
amongst
servicers
will
start
to
ease
as
they
add
more
employees
and
resources
to
take
advantage
of
mortgage
refinancing.
There
is
a
distinct
possibility
of
prepayments
picking
up
outside
of
HARP
2.0,
if
the
current
rate
environment
persists
over
the
next
couple
of
years.
In
this
case,
it
is
not
only
important
that
an
investment
hold
up
well
in
a
rising
rate
scenario,
but
that
it
also
continues
to
perform
in
a
falling/lower
rates
scenario.
6750 POPLAR AVENUE, SUITE 300 - MEMPHIS, TN 38138 | 800.827.0827 WWW.DUNCANWILLIAMS.COM | MEMBER FINRA, SIPC, BDA, WBENC
Graph 2 below also highlights the principal cash flows from this bond. As previously mentioned, this investment product is not necessarily ideal for every institution, but it makes a strategic addition for those investors that are already either sitting on too much cash or have too much principal coming due. As the refinancing risk of HARP 2.0 gets more pronounced over the coming months, and with the possibility of other government interventions to help homeowners stay in and keep their homes, a LCF CMO offers protection against reinvestment risk while positively impacting the bottom line now.
Banks typically add longer duration exposure to the investment portfolio in the form of Municipal securities. For those financial institutions that are already full on their allocation to Municipals, a LCF CMO offers an alternative longer dated investment with both principal and interest over the last years of the investment. A LCF CMO is also a good alternative to longer callable agencies with shorter lockouts of only 1 to 2 years. The investor runs the risk of holding a fixed rate, below market coupon in a rising rate environment with long callables. While the LCF CMO also poses extension risk, the bond will continue to pay interest and principal due to the self-amortizing nature of the security. To discuss if a LCF CMO makes sense for your investment portfolio, call your Duncan-Williams representative today, or please let us know if we can help. Geetika Bansal Senior Market Analyst Fixed Income Strategies & Services.
6750 POPLAR AVENUE, SUITE 300 - MEMPHIS, TN 38138 | 800.827.0827 WWW.DUNCANWILLIAMS.COM | MEMBER FINRA, SIPC, BDA, WBENC
Chad McKeithen Managing Director 901.260.6887 chad.mckeithen@duncanw.com Chris Klass Senior Market Analyst 901.260.6810 cklass@duncanw.com OFFICES Akron Atlanta Birmingham Charlotte Cleveland Chicago Gainesville
Geetika Bansal Senior Market Analyst 901.435.4016 gbansal@duncanw.com Catherine Folk Market Analyst 901.435.4162 Catherine.folk@duncanw.com Houston Jackson Memphis New York Philadelphia Tampa
Disclaimer: This material has been prepared by Duncan-Williams, Inc., member FINRA/SIPC (Duncan- Williams"), from information sources believed to be reliable. Duncan-Williams expressly disclaims any and all liability which may be based on such information, errors therein or omissions there from, or in any other written or oral communication related thereto. This material is for your information only and should not be construed as investment advice or as any recommendation of a transaction. Neither Duncan-Williams nor any of its representatives is soliciting any action based upon this material. Specifically, this material is not, and is not to be construed as, an offer to buy or sell any security or other financial instrument referred to herein.
6750 POPLAR AVENUE, SUITE 300 - MEMPHIS, TN 38138 | 800.827.0827 WWW.DUNCANWILLIAMS.COM | MEMBER FINRA, SIPC, BDA, WBENC