| As expected, the Federal Open Market Committee (FOMC) ended its asset purchase program last month, after concluding there has been substantial improvement in the outlook for the labor market since the program began. The committee also decided to continue reinvesting principal payments from agency debt and mortgage-backed securities in order to help maintain accommodative financial conditions.
Some changes to the policy statement leaned in a hawkish direction. The committee noted “solid job gains and a lower unemployment rate,” and that “labor market indicators suggest that underutilization of labor resources is gradually diminishing,” suggesting growing confidence in the labor market. Surprisingly, the statement did not mention any increase in risks associated with the rising dollar or weaker external growth.
The FOMC reaffirmed that it is likely to maintain the current federal funds rate “for a considerable time.” The Fed emphasized balanced risks to this view by saying if economic data indicate faster progress toward the employment and inflation targets, then increases in the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.
At their September gathering, the FOMC upgraded their forecast of borrowing costs for next year, raising the median forecast for federal funds at the end of 2015 to 1.375 percent from June’s estimate of 1.125 percent. The committee projected a rate of 2.75 percent for 2016 and 3.75 percent for the end of 2017.
A wide range of indicators implies that the first increase in the target federal funds rate will occur during the second half of 2015. Based on trading in short-term interest rate futures, the Fed will raise rates in the fourth quarter of 2015. This forecast is three months later than a Bloomberg survey of 75 economists interviewed during the second week of October. The group of economists calls for the 10-year Treasury note to yield 2.70 percent by December 2014, and to reach 3.40 percent by the end of 2015.
Shorter-term Treasury yields rose to the highest in more than three years during September, as bond traders marked up their forecasts of Fed tightening. The “front-end” was under the most pressure, according to market participants. More recently, yields fell in response to weaker-than-expected growth in Europe, a steep decline in inflation expectations, and the perception that central banks are behind the curve.
Investing Now
Against this backdrop, investment officers face the dilemma of where to invest now; to reach out on the curve for additional current income or stay ultra-short in case rates creep higher. For those holding excess liquidity, the steep yield curve affords an opportunity to improve earnings without taking on undue interest rate risk.
Investors may wish to look for asset classes that are high in credit quality, such as municipal bonds of strong and stable issuers or securities with an agency guarantee. Intermediate-duration mortgage securities and well-structured CMOs should provide cash flow for reinvestment in most rate environments. Supplementing mortgage cash flow with “bullet” maturities where possible can complement the maturity ladder. Four to five years is the target maturity range.
The benefits of this strategy including the following:
- Price appreciation potential for stable or declining rates; price protection for rising rates
- High levels of marketability
- Call protection
- Stable and consistent cash flow
- Limited extension risk
- Reduced price volatility
Take the example of a five-year agency bullet currently yielding slightly under 2 percent. For the near-term, the security provides incremental income of almost 1.75 percent over federal funds. If interest rates in the five-year part of the yield curve rise 35 basis points (in a parallel shift) over the next year, then the agency security should remain priced at par, “protected” by the steepness of the curve. Conversely, the bond will increase in value by about 1.3 percent if rates remain unchanged over the time horizon. If interest rates unexpectedly decline, then the bond will appreciate further.
Next consider a “seasoned” 15-year agency MBS issued about 30 months ago. In a few years, the security will in effect, become a 10-year MBS. As this occurs, the monthly cash flows increase noticeably, regardless of the rate environment. In the base case, 40 percent of the security should be outstanding after five years. Even if market rates increase 200 basis points, the remaining balance is still likely to be under 50 percent, as the borrower’s principal payments accelerate. This cash flow provides funds for reinvestment or for granting new loans, while reducing the institution’s exposure to the asset.
Now that the investment environment has improved, we have the ability to acquire reasonably priced, well-structured assets that offset the optionality residing on most balance sheets. As always, portfolio managers should make sure their investment strategy complements the institution’s balance sheet and overall business plan. Asset-sensitive institutions may have the capacity to take on more duration, and vice versa. The ultimate goal is to enhance profitability within the overall asset/liability management objectives of the institution.
Robert B. Segal is president of Atlantic Capital Strategies Inc., an investment advisor located in Bedford. He can be reached at bob@atlanticcapitalstrategies.com.
