A View July 2013 from the Desk In This Issue Trading Trends... 1 Strategies... 3 Looking Forward... 5 About Ambassador Financial Group At Ambassador Financial Group, our focus is to assist clients in achieving their strategic goals. We do this by offering a personalized approach and a comprehensive suite of capital market services including balance sheet management, investment banking, and investor relations services. 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, taxexempt 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: The graph on the next page shows 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 were 15-yr 2.50% and 10-yr 2.50% as pricing on these pools was down almost 5 points from May levels. These pools have little-to-no premium which will help mitigate yield-erosion from prepayments if rates fall but conversely, the extension risk is smaller than comparable pools with 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 continued on page 2 July 2013 1
Figure 1: Client Purchases: Sector Break Down Figure 1 shows various fixed income asset classes and the percent of client purchases falling in each category. Tax Exempt Munis 10.28% Corporate 3.66% MBS 62.60% Agency 14.68% Treasuries 8.79% Brokered CD s CMO Taxable Munis 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. 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 Tax Exempt Munis 2.38% Taxable Munis 14.86% Agency 11.91% Corporate 30.22% MBS 40.63% Brokered CD s CMO Non Agency MBS continued on page 3 July 2013 2
Figure 3 shows the duration mix of bonds clients have purchased through our trading desk. 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. 70% Figure 3: Duration Mix 63.76% 60% 50% 40% 30% 20% 14.68% 15.62% 10% 0% 4.39% 1.54% 0 2 years 3 5 years 6 8 years 9 11 years 12+ years 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 continued on page 4 July 2013 3
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. 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 still be underwater in a rising rate environment, this amount of cash-flow could prove to be extremely beneficial. It is also worth mentioning that in a +300 Bps environment, a 10-yr 2.50% is estimated to decline by only 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, reducing the par amount owned. 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. The chart on the next page demonstrates 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. 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. July 2013 4
Chart 1: Bank Qualified Tax-Exempt Municipal Scale Maturity Coupon Yield % of Treasury Tax Equivalent Yield Tax Equivalent Yield % of Treasury Tax-Exempt Yield Spread to Treasury Tax Equivalent Yield Spread to Treasury 8/1/2018 2.000 1.800 129% 2.652 189% 40/5 Year 125/5 Year 8/1/2019 2.250 2.000 143% 2.955 211% 60/5 Year 156/5 Year 8/1/2020 2.500 2.300 113% 3.409 168% 27/7 Year 138/7 Year 8/1/2021 2.750 2.500 123% 3.712 183% 47/7 Year 168/7 Year 8/1/2022 3.000 2.700 103% 4.015 154% 9/10 Year 140/10 Year 8/1/2023 3.150 2.950 113% 4.394 168% 34/10 Year 178/10 Year 8/1/2024 3.375 3.100 119% 4.621 177% 49/10 Year 201/10 Year 8/1/2025 3.500 3.250 124% 4.848 186% 64/10 Year 224/10 Year 8/1/2026 3.625 3.350 128% 5.000 191% 74/10 Year 239/10 Year 8/1/2027 3.800 3.500 134% 5.227 200% 89/10 Year 262/10 Year 8/1/2028 4.000 3.650 140% 5.455 209% 104/10 Year 284/10 Year 8/1/2029 4.050 3.800 103% 5.682 155% 13/30 Year 201/30 Year 8/1/2030 4.100 3.950 108% 5.909 161% 28/30 Year 224/30 Year 8/1/2031 4.150 4.000 109% 5.985 163% 33/30 Year 231/30 Year 8/1/2032 4.200 4.050 110% 6.061 165% 38/30 Year 239/30 Year 8/1/2033 4.250 4.150 113% 6.212 169% 48/30 Year 254/30 Year PAR CALL: 5 10yr RATING: AA TEFRA: 5 Bps TAX-RATE: 34% 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 Mark B. Trinkle Senior Vice President, Fixed Income Trading July 2013 5
THE AMBASSADOR TEAM: 1605 North Cedar Crest Blvd. Suite 508 Allentown, PA 18104 866.240.3898 (toll-free) 610.351.1633 4330 East West Highway Suite 305 Bethesda, MD 20814 866.240.3898 (toll-free) 240.207.2306 Joshua A. Albright, CFA Senior Vice President, Fixed Income Trading Allen R. Collins Chief Compliance Officer Arnold G. Danielson Chairman Emeritus, Danielson David G. Danielson Head of Investment Banking Christopher B. Donahue Financial Analyst Jacob Eisen Managing Director Ryan G. Epler Senior Vice President, Fixed Income Trading Tad Gage Managing Director Heidi Geist Administrative Assistant James R. Gillen Business Development Belle Gutschick Administrative Assistant Mike Harrison Vice President Robert J. Pachence, Jr. Co-Founder & Managing Principal John D. Putman Senior Vice President Michael Rasmussen Investment Banking Matthew T. Resch, CFA Co-Founder & Managing Principal Eric R. Tesche Managing Director Mark B. Trinkle Senior Vice President, Fixed Income Trading John S. Walker, Ph.D., CFA Director of Research & Chief Economist The information presented is for informational purposes only. This is not an offer or solicitation to purchase or sell any security through Ambassador Financial Group, Inc., a current member of FINRA/SIPC. For more information contact us at 610.351.1633. 2013 Ambassador Financial Group, Inc.