Enhance Your Returns via Strategic Arbitrage: Solutions for Applying Short-Term Liquidity

With this month’s issue of What Counts, we introduce the first in a series of investment arbitrage solutions designed to address our members’ current financial situations and current economic conditions. This month, we detail a strategy involving the periodic purchase of agency step-up notes, funded internally or with short-term, Seattle Bank auction-rate advances.

The Balance Sheet Situation
Currently, many of you are experiencing high levels of liquidity, as deposit growth, slower loan growth and accelerated prepayments on existing loans have combined to produce large balances of overnight funds. Many believe it’s prudent to invest these funds in overnight or other short-term investments. But is it?

The answer, of course, is “it depends.” If you expect short-term interest rates to rise quickly and soon, leaving money in low-earning overnight accounts could be the best choice. But, if short-term rates remain near current levels for another six to nine months, leaving money in overnight accounts could be costly.

Take a look at the Seattle Bank Yield Curve-Optimal Points Analysis, which illustrates the breakeven point for shorter verses longer-term investments. This chart shows, for each investment maturity, how much interest rates would have to rise in the next 12 months before it would be better to invest liquidity in one-year or shorter terms. The chart currently shows that interest rates would have to rise 130+ basis points in the next 12 months before an investment of one year or less would produce a better return than a two- to three-year investment.

The Economic Condition
In a speech in Seattle on September 4, Robert Parry, president and CEO of the Federal Reserve Bank of San Francisco, noted a discrepancy between the Fed’s forward market prediction of rate increases and its future policy actions—and that it would take several quarters of high (e.g., 5.0%) GDP growth before the Fed would change its current policy. He explained that because of the considerable economic slack accumulated over the last three years, we’d have to see several quarters of strong growth before inflation again becomes a risk.

On September 16, the Federal Reserve uncharacteristically stated its intentions with respect to future policy action: “…on balance, the risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.”

Finally, on September 25, the Wall Street Journal quoted Fed Governor Donald Kohn of the Philadelphia Fed as saying that low rates “will be required for a considerable period” and that increased slack in the economy tends to suppress inflation, which, Kohn said, is already low enough.

The Strategy
Our suggested strategy for dealing with this situation under current conditions is to purchase 3-3.5-year step-up, callable agency bonds to replace overnight money. You can fund the bonds with auction-based advances that would mature at the first call date. If the bond is not called, new funding could be chosen to mature at the next call date.

The reason to use step-ups is that they reset to higher coupons at periodic intervals. The coupon resets make them more callable than fixed-rate callables, as they roll down the yield curve. As long as the yield curve remains steep, the step-ups will likely be called early, near their first or second reset date. During this time, you can realize a significant pick-up in yield—somewhere in the neighborhood of 140 to 160 basis points.

When the investment is called, you can pay off the existing funding and then decide whether to reinvest in another step-up or other investment structure. If overnight rates rise quickly, the step-up may extend to maturity, but the coupon resets provide significant protection against negative carry in all but the most extreme interest-rate shocks. We illustrate this in the modeling below.

The Analysis
For some time, the Seattle Bank and other AAA-rated issuers have offered structured notes with specific coupon payment and call features. Among these structures are step-up notes. Step-up notes pay an initial coupon that’s typically higher than a comparable non-callable agency security. Thereafter, the notes have coupons that rise at specified points in the future in the event the issue is not called. Many step-up notes are issued with more than one coupon reset date.

Consider the features of the recently issued 3.5-year Seattle Bank step-up note:

 Initial rate: 2.50 percent
Term: to 3/15/07
Structure: six-month non-call; callable every three months thereafter
Purchase Price: 99-30/32
Settlement Date: 9/15/03
Coupon Rate Increases: per the following timetable

A step-up note contains embedded call options that are purchased by the investor. This particular example effectively includes 12 separate embedded call options. The Seattle Bank would have the option at various points in time to refund the notes. Since the step-up feature increases the value of the call option to the Seattle Bank, a callable step-up note should trade at a higher yield to maturity than a callable note without a step-up feature. By the same token, a step-up feature increases the probability of early redemption, as compared with a callable note without a step-up feature. Therefore, under a rising interest-rate scenario, a callable note with a step-up feature will represent a more defensive position than that of a callable note with a fixed coupon.

Auction-based advances are loans offered by the Seattle Bank that you order a day before takedown. They are offered at three-, six- and 12-month maturities and generally cost two to 10 basis points less than regular same-day advances. Currently, you could fund the initial period before the first call date of six months with a six-month auction based advance. The rate on this advance has been around 114 basis points, or 116 basis points on a bond equivalent basis. Thus, the initial spread would be 140 basis points (256 –116) for the first year.

Arbitrage Structure: Funding 3.5-Year Step-Up Notes with 6-Month Auction-Rate Advances
In sync with our economic conditions, we’ve assumed that the Fed will hold rates steady for one year and then raise rates. The table below simulates the effects of various rate increases, ranging from small changes during years two and three of 100 to 200 basis points, to more significant increases of 300 and 500 basis points.

The table shows the spread that would be earned for each year and the final six-month period, along with the cumulative spread for each interest-rate scenario. This cumulative spreads assume the bond is not called, which is highly unlikely in the case of the smaller rate increase scenarios. For the more significant rate increase scenarios, note that the higher spreads are earned in the earlier periods and that negative carry may occur in the final periods.

Obviously there is some risk in executing this type of investment structure. If rates rise dramatically, investment spreads can shrink significantly—even into the negative range. Given current economic conditions, however, the risk seems well worth considering.

As with any investment strategy, diversification is important. Just as it doesn’t make sense to hold all liquidity in overnight accounts, it would not make sense to invest all available liquidity in this type of investment structure. How much you choose to commit depends on your future liquidity needs and your expectation for future short-term interest-rate movements.

Finally, the selection of step-up bonds requires detailed analysis of relative value, yield-to-call, duration and option-adjusted spread to ensure good purchase execution. Our Financial Advisory Services group is experienced with step-up selection and analysis, and would be pleased to assist you with a purchase or explore further how this investment alternative could diversify and enhance your investment portfolio. Contact David Kidd at 206.340.2471 or John Biestman at 206.340.2473 for more information.

David Kidd is the Financial Advisory Services Manager at the Federal Home Loan Bank of Seattle.