The Federal Reserve will likely hold short-term interest rates steady until late 2015. U. S. Economic Projections 2014 2015 2014 2015 2014 2015 Stifel FI Strategy Group Forecast 2.5% 3.1% 1.4% 1.7% 6.4% 5.9% Bloomberg Economists' Survey 2.7% 3.0% 1.4% 1.8% 6.4% 6.0% Fed Forecast - Central Tendency Mid- Point 3.0% 3.2% 1.5% 1.8% 6.5% 6.0% Updated as of 03/17/2014. GDP Core PCE Price Index Unemployment Rate (YE) In 2014, we expect the economy to take another incremental step toward pre-crisis conditions, with slightly stronger growth compared to the past four years. For the first time in a decade, GDP growth should exceed 3.0% for a full calendar year in 2015. As excess capacity is absorbed in the labor market and throughout the economy, core inflation should gradually move toward the Fed s 2.0% target rate over the next two years. Taking into account the structural changes in the labor force due to demographics, technology, and globalization, the economy should make significant progress toward sustainable full employment by late 2015. certifications. 1
Treasury yields should remain range bound for many months to come. Over the past 20 years, the five-year Treasury yield has increased by 100bps or more over a 24-month period on three separate occasions. In all three cases, the Fed was lifting short-term interest rates during these periods of rising Treasury yields. In every other instance, the Treasury rate spikes were temporary. Core inflation appears to be bottoming but remains near the low end of its six-year range. We expect core inflation to gradually move toward the Fed s 2.0% target rate over the next few years as excess capacity is absorbed, but the FOMC could take delay tapering or increase QE in response to persistently low inflation or a deflationary shock. (%) 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 5- Year Treasury *Source: Bloomberg L.P. as of 03/14/2014. (%) 2.5 2.3 2.1 1.9 1.7 1.5 1.3 1.1 0.9 certifications. 2 May- 93 Feb- 94 Dec- 07 Nov- 94 Apr- 08 Aug- 95 Policy Measures vs. Core PCE Inflation QE1 Announced 12/16/08 Aug- 08 Fed Policy vs. 5- Year Treasury Yield May- 96 Feb- 97 Fed's 2.0% Inflation Target Dec- 08 Nov- 97 Apr- 09 Aug- 98 May- 99 Aug- 09 Feb- 00 QE1 Ends 03/21/101 Dec- 09 Nov- 00 Apr- 10 Aug- 01 May- 02 Feb- 03 QE2 Ends 6/28/11 QE2 Ends 11/30/10 Aug- 10 Dec- 10 Nov- 03 Apr- 11 Aug- 04 May- 05 Feb- 06 Operation Operation Twist Twist Extended Announced 6/20/12 9/2/11 Aug- 11 *Source: U.S. Bureau of Economic Analysis as of 01/31/2014. Dec- 11 Nov- 06 Aug- 07 Fed Funds Target Rate Apr- 12 May- 08 Feb- 09 QE3 Announced 9/13/12 Aug- 12 Dec- 12 Nov- 09 Aug- 10 May- 11 Apr- 13 Aug- 13 Feb- 12 Nov- 12 Dec- 13 Aug- 13
More predictable monetary policy should lead to less interest rate volatility in 2014. The large upward adjustment in real interest rates during 2013 restored yields to pre-qe levels. Treasuries appear to have largely priced-in stronger economic growth and the end of Fed purchases. A source of significant uncertainty last year, the outlook for monetary policy appears much clearer in 2014. Relative to economic fundamentals, the Fed s forward rate guidance, and the size of the central bank s balance sheet, we believe that current Treasury yields are very near fair value, equilibrium levels across the curve. Our interest rate forecast assumes that yields will converge with our fair value estimates by the end of the first quarter then modestly increase over the balance of the year. Projected Fed Timeline: Tapering: Jan October 2014 New Forward Guidance: March 2014 First Rate Hike: 4Q 2015 (%) 3.0 2.5 2.0 1.5 1.0 0.5 0.0-0.5-1.0 Dec- 07 Apr- 08 Aug- 08 Dec- 08 Yield Curve Projections 1Q14 2Q14 3Q14 4Q14 Fed Funds 0.25% 0.25% 0.25% 0.25% 2-year 0.35% 0.45% 0.55% 0.65% 5-year 1.50% 1.70% 1.80% 1.90% 10-year 2.75% 3.00% 3.15% 3.25% 30-year 3.75% 4.00% 4.15% 4.20% 2s to 10s +240 bps +255 bps +260 bps +260 bps *Updated as of January 14, 2014 Real 10- Year Treasury Yield (Nominal 10Y - Core PCE Price Index) Apr- 09 Aug- 09 Dec- 09 Apr- 10 Aug- 10 Dec- 10 Apr- 11 Aug- 11 Real 10- Year Yield **February's PCE reading is a Stifel estimate. *Source: Bloomberg L.P. as of 02/28/2014. Dec- 11 Apr- 12 Source: Stifel Fixed Income Research and Strategy Group Aug- 12 Dec- 12 Apr- 13 Aug- 13 Dec- 13 certifications. 3
The Treasury curve has steepened significantly since the end of 2012. The Treasury curve has steepened significantly since the end of 2012 led by higher yields at the 5-year maturity point. The spread between the 5-year Treasury and the 2-year Treasury widened by 73 basis points, while the spread between the 10-year and the 5-year only steepened by 9 basis points. The steepening move in the Treasury market reflects investors perceptions that the bulk of the Fed s tightening cycle will occur in the 2016 to 2018 time frame. certifications. 4
Portfolio Management Considerations for Rising Rate Scenarios Shortening duration by holding excess cash, selling longer-term bonds, or buying floating rate securities may not produce an optimal outcome. Callable bonds and step-ups can help manage duration and income in moderately rising rate environments. Callable capped floaters represent a higher yielding alternative to traditional floating rate securities. A steep yield curve provides a built-in cushion against rising interest rates. A simple bond ladder offers a reasonable balance between current income and the risk of future price depreciation. During previous periods of rising rates over the past 30 years, 2-year duration government bonds have generated positive total returns in most instances. certifications. 5
Rising Rate Strategy: Reduce price sensitivity by swapping longer duration bonds for shorter duration bonds. In general, shorter duration bonds are less sensitive to changes in interest rates and exhibit less price depreciation in a rising rate environment. However, given the steepness of the yield curve, shortening duration requires a significant yield give-up as shown in the table below. Interest rates must increase significantly in a relatively short period of time for the break-even reinvestment yields to be realized. Example Duration Shortening Bond Swap Transaction Cpn Mkt Book Avg Eff Price Δ CUSIP Description Cpn Type Maturity Price Yield Life Dur +50 912828SH4 5- Year Treasury 1.375 FIXED 2/28/2019 99.10 1.56 5.0 4.8-2.41 Total Sells 99.10 1.56 5.0 4.8-2.41 Cpn Mkt Book Avg Eff Price Δ CUSIP Description Cpn Type Maturity Price Yield Life Dur +50 912828UM0 2- Year Treasury 0.375 FIXED 2/15/2016 99.81 0.35 1.9 1.9-0.99 Total Buys 99.81 0.35 1.9 1.9-0.99 Difference 0.71 (1.21) (3.04) (2.9) 1.42 In order for the return of a 3-year bond at the end of 2-years to equal the return of the 5-year bond, 3-year yields would need to rise by 161 basis points over the next 2-years. 2yr Yield 5yr Yield = 0.35%* (2/5) + 3/5X = 1.56% X = 2.357% Breakeven = 2.357% - Current 3-year Rate 0.75% = 1.61% certifications. 6
Rising Rate Strategy: Floating rate securities offer low durations and the potential for higher income as rates increase. Floating-rate notes (FRNs) are a type of bond featuring a coupon that resets based on a market index. FRNs carry lower durations than equivalent maturity fixed rate bonds. However, short term market indices will likely remain near zero until the Federal Reserve begins increasing the funds rate. The Treasury Department recently initiated a new FRN program featuring bonds that have coupons that reset every day pegged to the most recent 13-week Treasury Bill auction rate. Floating Rate Treasury (FRN) Historical 3 Month LIBOR, Fed Funds & 6 Month T-Bill Yields 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 Market Yield under 15 bps assuming an Index rate of 9.5bps Duration near zero 0.00 1/2/2009 1/2/2010 1/2/2011 1/2/2012 1/2/2013 1/2/2014 3 Month LIBOR Eff Fed Funds 6 Month T- Bill Yield certifications. 7
Rising Rate Strategy: Callable bonds may lower a portfolio s duration and increase current income if rates increase gradually. Callable bonds tend to have shorter effective durations than fixed rate bullet maturity bonds reflecting the probability that the callable may be redeemed prior to its final maturity. For example, a 3-year bullet Agency carries an effective duration of 2.98, while a 3-year NC 3 month callable Agency carries an effective duration of 1.33. In a steep yield curve environment, the probability that the call feature will be in-the-money increases as the bond shortens in maturity. Example 3-Year Fixed Rate Agency Bullet Example 3-Year NC 3 Month Callable Agency certifications. 8
Rising Rate Strategy: Callable bonds may lower a portfolio s duration and increase current income if rates increase gradually. As time passes and bonds roll down a steep yield curve, a callable bond will have an increased probability of call even in modest rising rate scenarios. In contrast, the duration profile of bonds with bullet maturities will only change marginally as a function of the time value of money at higher interest rates. For example, if interest rates rise gradually rise 50 basis points over a 12-month horizon, the callable bond is still estimated to have a duration of only 1.16 and a nearly even (48%) chance of being called. In the same scenario, the bullet bond will have a duration of 1.94. Parallel Yield Curve Shifts (12 Month Horizon) - 100-75 - 50-25 0 25 50 75 100 3- Year NC 3 Month Callable Agency Effective Duration (12 Month Horizon) Called Called Called Called Called Called 1.16 1.72 1.85 Probability of Call (12 Month Horizon) 99% 99% 99% 99% 86% 68% 48% 38% 27% 3- Year Bullet Agency Effective Duration (12 Month Horizon) 1.94 1.94 1.94 1.94 1.94 1.93 1.93 1.93 1.93 certifications. 9
Rising Rate Strategies: Step Up Coupon Callable Bonds can be effective tools for balancing income and price sensitivity goals. Step coupon callable bonds further reduce price sensitivity relative to fixed rate callables due to the fact that the increasing coupons heighten the probability that the security will be redeemed prior to maturity. As an example, substituting the same 3-year NC 3 month fixed rate callable from the previous slide for a 3-year NC 3 month step coupon can reduce effective duration from 1.33 to 1.12. The cost of this reduced duration is the lower upfront coupons on step-ups vs fixed rate callables. Example 3-Year NC 3 Month Fixed Callable Agency Example 3-Year NC 3 Month Step Coupon Agency certifications. 10
Rising Rate Strategies: Step Up Coupon Callable Bonds can be effective tools for balancing income and price sensitivity goals. Step-Up coupon callable bonds further reduce price sensitivity relative to fixed rate callables as the average remaining coupon on the step structure increases while the bond simultaneously shortens in maturity. The table below shows that in a gradually rising rate environment a step coupon bond will have a significantly increased probability of call relative to a fixed rate callable. For example, in a + 75 basis point parallel increase in the yield curve, a step-coupon structure is estimated to have a shorter duration by 0.86 and a 28% increased probability of call after 1- year. Parallel Yield Curve Shifts (12 Month Horizon) - 100-75 - 50-25 0 25 50 75 100 3- Year NC 3 Month Callable Agency Effective Duration (12 Month Horizon) Called Called Called Called Called Called 1.16 1.72 1.85 Probability of Call (12 Month Horizon) 99% 99% 99% 99% 86% 68% 48% 40% 27% 3- Year NC 3 Month Step Coupon Agency Effective Duration (12 Month Horizon) Called Called Called Called Called Called Called 0.86 1.42 Probability of Call (12 Month Horizon) 99% 99% 99% 99% 99% 93% 83% 68% 48% certifications. 11
Rising Rate Strategies: Callable Capped Floaters Callable capped floaters bridge the gap between fixed and floating rate bonds and often carry short durations with higher yields than FRNs. For example a new issue 5-year NC 3 Month callable capped floater would indicatively carry a floating rate of 3 Month LIBOR + 30 basis points capped at 3%. When 3-Month LIBOR is expected to remain below the coupon cap, the duration of the bond will approximate a pure floating rate instrument. When 3 Month LIBOR is expected to exceed the cap, the duration will extend and more closely resemble a fixed rate security. Example Callable Capped Floater Total Return Comparison - Callable Capped Floater vs Treasury FRN (12 Month Horizon, Parallel Shift) - 100-75 - 50-25 0 25 50 75 100 5- Yr NC 3 Month CCF 0.56 0.56 0.56 0.56 0.73 0.86 0.85 0.79 0.66 Treasury FRN 0.03 0.03 0.03 0.03 0.08 0.34 0.59 0.85 1.11 certifications. 12
Rising Rate Strategies: Bond Ladder One of the easiest strategies to implement to take advantage of rising rates in the future while balancing current income needs now is to build a simple bond ladder. Frequent maturities in the portfolio allow funds to be constantly reinvested at potentially higher rates in the future. At the same time, having some funds at the longer end of the ladder increases the income generated by the portfolio. Example Bond Ladder 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20-1- yr 2- yr 3- yr 4- yr Proceeds from 1- yr Maturity Total Return Comparison of 5- year Bond Ladder with 2.5 Duration to cash (5- year Horizon with any reinvestment at forward 3 Month LIBOR) - 300-200 - 100 0 100 200 300 5- year Ladder 2.05 2.05 2.05 2.13 3.90 5.71 7.54 Cash 0.16 0.16 0.16 0.27 2.80 5.40 8.05 Cumulative total returns over a five-year time horizon assuming gradual parallel shift in the curve over the time horizon. Any reinvestment occurs at the then prevailing forward 3-Month LIBOR rate adjusted by the rate shift indicated in the table. certifications. 13
Preparing for a Rising Rate Environment Interest Rates and Total Returns In an environment characterized by the potential for rising rates it is important to consider the balance between income and return. The negative effect on bond prices that can be caused by rising rates may be offset over time by the income stream generated by the security as well as any roll down to lower yields built into a steep curve as bonds shorten in maturity. The table below quantifies the hypothetical total return of a series of bonds over a 12 month horizon to a given change in interest rates. For example, a 4-year NC 1-year callable Agency could potentially have a positive total return of 1.26% over 12-months even if rates increased by 50 basis points. In fact, this structure has a cushion of approximately 97 basis points to break-even with a 0% total return over a 12 month horizon. 12 Month Total Return (Parallel Shift in the Curve) Description Yield Duration + 0 Bps + 50 Bps + 100 Bps + 200 Bps Cushion in BPS* 1 Yr Agency Bullet 0.15 0.99 0.22 0.23 0.24 0.25 2 Yr Agency Bullet 0.32 1.98 0.57 0.08 (0.41) (1.38) 55 3 Yr Agency Bullet 0.76 2.96 1.48 0.50 (0.48) (2.39) 76 4 Yr Agency Bullet 1.23 3.92 2.49 1.01 (0.44) (3.26) 86 5 Yr Agency Bullet 1.71 4.83 3.21 1.26 (0.64) (4.33) 85 2yr NC 1 Year Callable Agency 0.37 1.64 0.36 0.09 (0.41) (1.38) 60 3yr NC 1 Year Callable Agency 0.77 2.30 0.74 0.66 (0.33) (2.26) 85 4yr NC 1 Year Callable Agency 1.29 2.86 1.24 1.26 (0.03) (2.88) 97 5yr NC1 Year Callable Agency 1.79 3.32 1.72 1.74 0.09 (3.63) 102 certifications. 14
Preparing for a Rising Rate Environment How have short duration strategies performed over the last 30-years? 7.00% Quarterly Total Return of 2- Yr Tsy / Agency Index & 2- yr Treasury Yield 14% 6.00% 5.00% 4.00% 12% 10% 3.00% 8% 2.00% 6% 1.00% 0.00% - 1.00% 4% 2% - 2.00% 3/1/1983 3/1/1984 3/1/1985 3/1/1986 3/1/1987 3/1/1988 3/1/1989 3/1/1990 3/1/1991 3/1/1992 3/1/1993 3/1/1994 3/1/1995 3/1/1996 3/1/1997 3/1/1998 3/1/1999 3/1/2000 3/1/2001 3/1/2002 3/1/2003 3/1/2004 3/1/2005 3/1/2006 3/1/2007 3/1/2008 3/1/2009 3/1/2010 3/1/2011 3/1/2012 3/1/2013 0% Total Return (Qtrly) 5- Year Treasury Yield certifications. 15
Preparing for a Rising Rate Environment Two year average duration strategies have consistently produced positive total returns QTR End Date 2yr Yield Total Change Years Annualized Holding Period Total Return of 2 Year TSY/AGY Index 5yr Yield Total Change Years Annualized Holding Period Total Return of 3-5 Year TSY/AGY Index Trough 9/30/1986 6.33% 6.95% Peak 3/31/1989 9.67% 3.34% 2.50 2.54% 9.47% 2.52% 2.50 5.27% Trough 9/30/1993 3.88% 4.77% Peak 12/31/1994 7.70% 3.82% 1.25 0.65% 7.83% 3.06% 1.25-1.89% Trough 9/30/1998 4.27% 4.22% Peak 3/31/2000 6.48% 2.21% 1.50 2.14% 6.31% 2.10% 1.50 1.17% Trough 6/30/2003 1.30% 2.41% Peak 6/30/2006 5.15% 3.85% 3.00 1.20% 5.09% 2.68% 3.00 0.90% *Source: Data provided by Bank of America Merrill Lynch, Bloomberg Finance L.P., The YieldBook, Stifel certifications. 16
Disclosures Disclosures and Disclaimers For distribution to institutional clients only The Fixed Income Capital Markets trading area of Stifel, Nicolaus & Company, Incorporated may own debt securities of the borrower or borrowers mentioned in this report and may make a market in the aforementioned securities as of the date of issuance of this research report. Please visit the Research Page at www.stifel.com for the current research disclosures applicable to the companies mentioned in this publication that are within Stifel s coverage universe. The information contained herein has been prepared from sources believed reliable but is not guaranteed by Stifel and is not a complete summary or statement of all available data, nor is it to be construed as an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of investors. Employees of Stifel or its affiliates may, at times, release written or oral commentary, technical analysis or trading strategies that differ from the opinions expressed within. No investments or services mentioned are available to private customers in the European Economic Area or to anyone in Canada other than a Designated Institution. The employees involved in the preparation or the issuance of this communication may have positions in the securities or options of the issuer/s discussed or recommended herein. Stifel is a multi-disciplined financial services firm that regularly seeks investment banking assignments and compensation from issuers for services including, but not limited to, acting as an underwriter in an offering or financial advisor in a merger or acquisition, or serving as a placement agent in private transactions. Moreover, Stifel and its affiliates and their respective shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options or other derivative instruments based thereon. Stifel Fixed Income Capital Markets research and strategy analysts ( FICM Analysts ) are not compensated directly or indirectly based on specific investment banking services transactions with the borrower or borrowers mentioned in this report or on FICM Analyst specific recommendations or views (whether or not contained in this or any other Stifel report), nor are FICM Analysts supervised by Stifel investment banking personnel; FICM Analysts receive compensation, however, based on the profitability of both Stifel (which includes investment banking) and Stifel FICM. The views, if any, expressed by FICM Analysts herein accurately reflect their personal professional views about subject securities and borrowers. For additional information on investment risks (including, but not limited to, market risks, credit ratings and specific securities provisions), contact your Stifel financial advisor or salesperson. Our investment rating system is three tiered, defined as follows: Outperform For credit specific recommendations we expect the identified credit to outperform its sector specific peers over the next six months. Marketperform For credit specific recommendations we expect the identified credit to perform approximately in line with its sector specific peers over the next six months. Underperform For credit specific recommendations we expect the identified credit to underperform its sector specific peers over the next six months. Additional Information Is Available Upon Request We, Jim DeMasi, CFA, and Todd Cuppia certify that the views expressed in this research report accurately reflect our personal views about the subject securities or issuers; and we certify that no part of our compensation was, is, or will be directly or indirectly related to the specific recommendations or views contained in this research report. 2014 Stifel, Nicolaus & Company, Incorporated, One South Street, Baltimore, MD 21202. All rights reserved.. certifications. 17