Download A-View-from-the-Desk

A View from the Desk
The following is a summary of the trading volume we experienced in July, 2013. In the first section, we break down our
trading volume by client purchases and sales, and categorize each trade by asset class, e.g. corporates, MBS, tax-exempt
municipals, etc. We will also show the duration breakdown of client purchases. In the next section, we provide a brief
overview of some strategies that are popular in the current environment. Finally, under the section titled “Looking
Forward”, we provide insight into how our clients can navigate this volatile market.
Trading Trends:
Below is a graph showing various fixed income asset classes and the percent of client purchases falling in each category.
Last month, MBS purchases accounted for over 67% of total purchases based on par value. This trend continued in July
as MBS accounted for almost 63% of total purchases. Although pricing stabilized throughout the month of July, 10-yr
and 15-yr MBS continued to be a popular trade amongst our clients. The two most popular MBS products purchased are
15-yr 2.50% and 10-yr 2.50% as pricing on these pools is down almost 5 points from May levels. These pools have littleto-no premium which will help mitigate yield-erosion from prepayments if rates fall but conversely, the extension risk is
smaller than 2.00% coupons if rates rise. In addition, the spreads versus Treasuries on these pools continue to look
attractive compared to other asset classes.
Almost 15% of client purchases were in the Agency space as clients looked to purchase clean callable agencies at large
discounts. This creates an opportunity to book a large total return if rates fall and these issues are subsequently called.
On the other hand, if rates remain near current levels, these discount callables should exhibit positive convexity and
perform similarly to Agency bullets as the call option is far out of the money. Tax-exempt municipals accounted for
10.28% of client purchases in July, which was down slightly from June. In last month’s “Looking Forward” section, we
referenced tax exempt municipals looking extremely attractive on a risk-return basis compared to other asset classes
and we saw this trend continue through the month of July.
Figure 1
Client Purchases: Sector Break Down
3.66%
0.00% 10.28%
0.00%
14.68%
8.79%
0.00%
62.60%
Agency
MBS
Tax Exempt Munis
Treasuries
Corporate
Taxable Munis
CMO
Brokered CD's
1605 North Cedar Crest Boulevard ∙ Suite 508 ∙ Allentown, Pennsylvania 18104 ∙ 610-351-1633 ∙ 866-240-3898 ∙ fax 484-274-6167
www.ambfg.com
Member FINRA/SIPC
In Figure 2, we have broken down sales by clients into various asset classes. After clients received their month end
portfolio pricing in June, many of our clients decided to reposition the portfolio. Most of these clients sold poorly
structured and esoteric step-ups and callable agencies that were vulnerable to unusually high extension risk. There was
also a large volume of clients selling out of corporates and MBS in order to harvest gains to offset the losses on callable
agencies.
Figure 2
Client Sales: Sector Break Down
0.00%
2.38%
0.00%
14.86%
0.00%
11.91%
0.00%
30.22%
Agency
MBS
Tax Exempt Munis
40.63%
Treasuries
Corporate
Taxable Munis
CMO
Brokered CD's
Non Agency MBS
Figure 3 below shows the duration mix of bonds clients have purchased through our trading desk. The 3-5 year duration
bucket was the most active part of the curve in July, accounting for almost 64% of purchases. The shortest duration
bucket, 0-2 years was very similar to the last couple months, coming in at 14.68% of purchases. Purchases of securities
with a duration of 6 years or longer accounted for 21.55% of purchases down from 45.23% last month. This duration mix
is consistent with clients looking to shorten the duration of the portfolio to protect against future interest rate moves.
Figure 3
Duration Mix
70.00%
63.76%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
14.68%
15.62%
4.39%
1.54%
0.00%
0-2 years 3-5 years 6-8 Years 9-11 Years 12+ Years
1605 North Cedar Crest Boulevard ∙ Suite 508 ∙ Allentown, Pennsylvania 18104 ∙ 610-351-1633 ∙ 866-240-3898 ∙ fax 484-274-6167
www.ambfg.com
Member FINRA/SIPC
Strategies:
As we mentioned in the trading trends section, many clients were eager to restructure the portfolio after recent interest
rate moves. Portfolios with large amounts of callable agencies with long final maturities were hit hard by rising rates.
These securities, while never a favorite of ours, understandably became vehicles to bolster portfolio yields. Now that
extension risk has manifested itself in degraded market values, portfolio managers have been looking to reduce
exposure to longer duration callable agencies to mitigate extension risk from future increases in interest rates. Other
portfolio managers looked to harvest gains in the portfolio, even at the expense of giving up income, as it has become
difficult to gauge where rates will be by year end.
As stated under the trading trends section, MBS seem to be the popular reinvestment vehicle for these portfolio
rebalancing strategies. Although these securities have some level of extension risk, the amount of the extension can be
minimized by focusing on 10 year and 15 year collateral. The new issue 10-yr 2.50% MBS pools have a base case
duration around 3.75 and duration of 4.20 in the +300 bps scenario. The 15-yr 2.50% pools have a similar profile with a
duration of 5.00 in the base case and a 5.70 in the +300 Bps scenario. The reason we like these pools is because of their
ability to perform a specific function in both a falling and rising rate environment. As we mentioned, prices on 10-yr and
15-yr collateral are down almost 5 points over the past two months. Therefore, if rates fall these pools should have
plenty of room for price appreciation, creating a nice total return play. Conversely, in a rising interest rate environment,
“cash-flow is king”. Although prices won’t appreciate under this scenario, the monthly cash-flow these securities
generate can be redeployed into higher yielding securities. Under current prepayment assumptions, 42% of a new 10-yr
2.50% pool is estimated to be paid off within the next three years. If we input a prepayment speed consistent with a
+300 bps increase in rates, 36% of a 10-yr 2.50% is estimated to be paid off within the next three years. If we take a look
at a 15-yr 2.50% pool, 31% is estimated to be paid down within the next three years under current prepayment
assumptions. Using the slower prepayment speed that is consistent with a +300 bps rise in rates, almost 26% of the
principal is estimated to be repaid in the next three years. Although, these securities would be underwater in a rising
rate environment, this amount of cash-flow could prove to be extremely beneficial. It is worth mentioning that in a +300
Bps environment, a 10-yr 2.50% is estimated to decline by 12%. This price seems to hang in nicely compared to other
securities we have looked at. Furthermore, one of the benefits to owning an amortizing security at a loss is, even if the
market price remained constant the total loss would fall each month as the principal pays down.
While many clients have been looking to shorten the portfolio’s duration, others have decided to take advantage of the
opportunities in the muni market. Tax-exempt muni spreads have been widening as Treasury yields moved higher over
the past two months. In addition, when Detroit filed for bankruptcy on July, 18, this sent some ripples through the
market. In our opinion, this has created a great buying opportunity. It is truly amazing that anyone is surprised by
Detroit’s decision to file for bankruptcy when they have been struggling for years to keep up with pension obligations
and debt problems. This bankruptcy should not be a cause for concern for other muni investors, especially since many of
our muni buyers focus on issues with strong underlying ratings. In addition, many of these issues have an added layer of
protection either from an insurer such as Assured Guaranty or Build America Mutual, or from a school enhancement
such as Pennsylvania’s St. Aid Withholding program. These enhancements may further help protect debt holders in case
of a default by the issuer.
We have attached a chart below to demonstrate how attractive munis have become. Historically, tax-exempt munis
were considered attractively priced when they traded at 90% to 95% of comparable treasuries, since the tax adjustment
would push the after tax-yields above treasuries. In light of the recent back up in treasury yields coupled with wider
muni spreads relative to treasuries, munis are now trading at historically wide spreads as a percentage of treasuries.
1605 North Cedar Crest Boulevard ∙ Suite 508 ∙ Allentown, Pennsylvania 18104 ∙ 610-351-1633 ∙ 866-240-3898 ∙ fax 484-274-6167
www.ambfg.com
Member FINRA/SIPC
Some of this is due to forced selling by leveraged muni players resulting in the baby being thrown out with the bath
water. Consequently we believe this represents an excellent buying opportunity as the spread relationship to treasuries
should eventually revert to the mean. Historically, the market tends to overreact given the dynamics that a falling
market creates, only to see a strong reversal in coming months. Even if you don’t want to invest assets on the long end
of the curve, the chart below paints a clear picture of the value that can be found on the short and intermediate parts of
the curve.
Bank Qualified Tax-Exempt Municipal Scale
Par Call:
5-10yr
Rating:
AA
TEFRA:
5 Bps
Tax-Rate:
34%
Maturity
8/1/2018
8/1/2019
8/1/2020
8/1/2021
8/1/2022
8/1/2023
8/1/2024
8/1/2025
8/1/2026
8/1/2027
8/1/2028
8/1/2029
8/1/2030
8/1/2031
8/1/2032
8/1/2033
Coupon
2.000
2.250
2.500
2.750
3.000
3.150
3.375
3.500
3.625
3.800
4.000
4.050
4.100
4.150
4.200
4.250
Yield
1.800
2.000
2.300
2.500
2.700
2.950
3.100
3.250
3.350
3.500
3.650
3.800
3.950
4.000
4.050
4.150
% of Treasury Tax Equivalent Yield
129%
2.652
143%
2.955
113%
3.409
123%
3.712
103%
4.015
113%
4.394
119%
4.621
124%
4.848
128%
5.000
134%
5.227
140%
5.455
103%
5.682
108%
5.909
109%
5.985
110%
6.061
113%
6.212
Tax Equivalent Yield
% of Treasury
189%
211%
168%
183%
154%
168%
177%
186%
191%
200%
209%
155%
161%
163%
165%
169%
Tax-Exempt Yield
Spread to Treasury
40/ 5 Year
60/ 5 Year
27/ 7 Year
47/ 7 Year
9/ 10 Year
34/ 10 Year
49/ 10 Year
64/ 10 Year
74/ 10 Year
89/ 10 Year
104/ 10 Year
13/ 30 Year
28/ 30 Year
33/ 30 Year
38/ 30 Year
48/ 30 Year
Tax Equivalent Yield
Spread to Treasury
125/ 5 Year
156/ 5 Year
138/ 7 Year
168/ 7 Year
140/ 10 Year
178/ 10 Year
201/ 10 Year
224/ 10 Year
239/ 10 Year
262/ 10 Year
284/ 10 Year
201/ 30 Year
224/ 30 Year
231/ 30 Year
239/ 30 Year
254/ 30 Year
Looking Forward:
Throughout the month of July the yield on the 10-yr Treasury rose 9 Bps to end at 2.577%. The 10-yr has now moved 95
bps higher from its 2013 low of 1.626%. This has been a fast and furious move and it has left many portfolio managers
scratching their heads. Many investors still believe the U.S. economy isn’t strong enough to warrant higher rates, but
unfortunately we have to play the hand we are dealt. Although we are in the camp that believes rates should remain low
for quite some time, we have been helping our clients reposition their portfolios to prepare for rising rates. We think it
makes a lot of sense to be proactive and if you have the ability to reduce extension risk and improve monthly cash-flows
this could be very beneficial in the future. Please contact a member of the Ambassador team if you are interested in
repositioning your portfolio.
-Joshua A. Albright, CFA
Senior Vice President, Fixed Income Trading
-Ryan G. Epler
Senior Vice President, Fixed Income Trading
1605 North Cedar Crest Boulevard ∙ Suite 508 ∙ Allentown, Pennsylvania 18104 ∙ 610-351-1633 ∙ 866-240-3898 ∙ fax 484-274-6167
www.ambfg.com
Member FINRA/SIPC
-Mark Trinkle
Senior Vice President, Fixed Income Trading
1605 North Cedar Crest Boulevard ∙ Suite 508 ∙ Allentown, Pennsylvania 18104 ∙ 610-351-1633 ∙ 866-240-3898 ∙ fax 484-274-6167
www.ambfg.com
Member FINRA/SIPC