Hot Topics for Local Government Investment Officials FGFOA Conference June 25, 2011

Transcription

1 Hot Topics for Local Government Investment Officials FGFOA Conference June 25, 2011 Jim DeMasi, CFA Fixed Income Research & Strategy Group Stifel, Nicolaus & Company, Incorporated. Refer to page 26 of this report for Stifel Nicolaus Fixed Income Capital Markets disclosures and analyst certifications. Stifel, Nicolaus Refer & Company, to page 26 Incorporated of this report Member for Stifel NYSE Nicolaus / SIPC Fixed Income Capital Markets disclosures and analyst certifications. 1 of 26

2 Key Questions Can a respectable economic recovery still be salvaged, or is a double-dip recession inevitable? What is the likely end game for GSE reform? What are step-up bonds and are they appropriate for your investment portfolio? 2 of 26

3 Macro Outlook 3 of 26

4 Recovery progressing, but not yet firing on all cylinders Consumer Spending Business Investment 400 in billions Retail Sales in millions New Orders & Inventories in billions Inventories (right axis) New Orders (left axis) Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Source: U.S. Census Bureau as of May' Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Source: U.S. Census Bureau as of April' Residential Construction International Trade 1500 in thousands New Housing Starts 180 in billions Exports Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Source: Department of Commerce as of May' Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Source: U.S. Census Bureau as of April '11. Source: Source: U.S. U.S. Census Census Bureau Bureau as as of of January March '10. 4 of 26

5 Severe recession followed by tepid recovery The economy is slowly repairing the damage from the steep 2008/2009 downturn. However, the upward slope of the recovery hasn t matched the downward trajectory of the recession. External risks could further delay the onset of a self-sustaining recovery. Index of Coincident Indicators Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Source: Conference Board as of May '11. % Inflation vs. Unemployment Core PCE Prices (YoY % Change) Unemployment Rate Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Source: Bloomberg Finance LP as of April '11. 5 of 26

6 Florida Economy: More Cyclical than US Economy During the Recession: Greater job losses More severe home price declines Sharp reduction in population growth Supporting the Recovery: Leading retiree and tourist destination Levered to strong growth in LatAm Fiscal austerity programs underway 6 of 26

7 Three factors supporting economic growth The release of pent-up demand for durable goods is spurring a rebound in consumer spending in billions $ Consumer Income vs. Spending The double-digit growth rate in business investment should continue in 2011, as enhancing productivity remains a key corporate priority. Monetary (QE2) and fiscal policies are providing significant short-term economic stimulus Total Compensation (left axis) Personal Expenditures (right axis) Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Source: Bloomberg Finance LP as of April '11. Industrial Production Index Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Source: Bloomberg Finance LP as of May ' of 26

8 Three headwinds to a stronger recovery Debt repayment and savings accumulation are diverting funds away from consumption. Massive inventory overhang continues to weigh on housing market. Retrenchment at the state and local government level and high commodity prices are mitigating federal stimulus. 8 of 26

9 Economic Outlook GDP Core Inflation Year-End (PCE) Unemployment Rate FI Strategy Group Forecast 2.7% 2.8% 1.4% 1.4% 8.7% 8.2% Consumer spending, business cap-ex, and exports should keep recovery afloat, while de-leveraging, weak housing market, and less accommodative policies will likely restrain the overall rate of economic growth. Slowdown in the first half of 2011 was primarily attributable to rising gasoline prices and other temporary factors. GDP expansion should regain momentum in the second half of the year if commodity prices stabilize or decline. Risks to our forecast remain skewed to the downside. Another significant decline in housing prices, European sovereign debt contagion, and less favorable financial conditions represent material downside risks. 9 of 26

10 Interest Rate Outlook Fed Funds Projections 2.5 Fed Fund Futures 2.5 Combination of moderate growth, low inflation, and high unemployment likely to keep the Fed on hold until the second quarter of Stifel Forecast Real interest rates appear too low in the context of current economic conditions. We expect real yields to gravitate toward fair value after QE2 concludes and growth firms. Curve likely to remain steep until Fed signals that rate hikes are imminent Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 Source: Stifel Nicolaus and Bloomberg Finance LP as of 6/17/2011. Yield Curve Projections 3Q 11 4Q 11 1Q 12 2Q 12 Fed Funds 0.25% 0.25% 0.25% 0.25% 2-year 0.75% 0.95% 1.15% 1.40% 5-year 1.85% 2.05% 2.15% 2.30% 10-year 3.25% 3.45% 3.55% 3.65% 30-year 4.50% 4.70% 4.75% 4.80% 2s to 10s +250 bps +250 bps +240 bps +225 bps *As of June 8, Source: Stifel Fixed Income Research and Strategy Group. 10 of 26

11 Credit Markets: Spreads Have Reverted to Long-Term Averages 700 Investment Grade Corporate Spreads 10-year average year average GSE Debt Spreads Jan-00 May-01 Sep-02 Jan-04 May-05 Sep-06 Jan-08 May-09 Sep-10 Source: Merrill Lynch Indices as of 6/16/ Feb-01 Jun-02 Oct-03 Feb-05 Jun-06 Oct-07 Feb-09 Jun-10 Source: Merrill Lynch Indices as of 6/16/ year average Callable Agency Spreads year average MBS Spreads Jan-00 May-01 Sep-02 Jan-04 May-05 Sep-06 Jan-08 May-09 Sep-10 Source: Merrill Lynch Indices as of 6/16/ Jan-00 May-01 Sep-02 Jan-04 May-05 Sep-06 Jan-08 May-09 Sep-10 Source: Merrill Lynch Indices as of 6/16/2011. *Averages were calculated for the 10-year period from June 97 to January of 26

12 Bond Strategy: Market Yield Comparison Treasuries Agency Discount Notes 3-month day month day year day year month year year New Issue Callable Agencies Commercial Paper - Top Top Tier 2Y NC 6-month day Y NC 6-month day Y NC 6-month day Y NC 6-month day day day Agency Bullets 270-day year year year year year Source: Bloomberg Finance LP and Stifel Nicolaus Fixed Income Trading. Data as of 6/17/ of 26

13 Bond Strategy: Tactical Implementation Shape of the yield curve and interest rate outlook favors focusing on intermediate-duration issues (2 5 year average lives). Emphasize Agency MBS, callable Agencies, and Agency step-ups to generate incremental yield over Treasuries while maintaining solid credit quality and liquidity. We favor overweighting Agency MBS. Within the sector, consider hybrid ARMs, front-end sequential CMOs, and 10- and 15-year fixed rate pass-throughs. Advantage of amortizing MBS is monthly principal flows for reinvestment coupled with diminished exposure over time to rising rates. Short-maturity, floating rate products may be attractive sell candidates due to low projected yields during the expected protracted period of relatively stable short-term rates. 13 of 26

14 Outlook Summary Economy: Weak growth more likely than double-dip recession over next 12 to 18 months, though downside risks have increased. Elevated unemployment and low inflation will likely be defining characteristics of this recovery. Interest Rates: Low interest rate environment likely to persist through the middle of 2012 as monetary policy remains highly accommodative. Process of normalizing rates will likely be slow and gradual. Credit Markets: Consolidation phase in spreads is likely to continue due to growing concerns over economic fundamentals. Lower end of the recent spread ranges should be revisited in late 2011, assuming the economy continues to expand. 14 of 26

15 GSE Reform 15 of 26

16 GSE Reform Timeline Federal Housing Finance Agency (FHFA) created to regulate Fannie, Freddie, and FHLB. US Treasury granted emergency authority to provide financial assistance to GSEs. Fannie and Freddie placed into conservatorship by FHFA. Senior Preferred Stock Purchase Agreement (SPSPA) established by US Treasury. Federal Reserve announces program to buy $200 billion in GSE senior debt and $1.25 trillion in GSE mortgage-backed securities. US Treasury extends and amends SPSPA. US Treasury issues white paper outlining three options for GSE Reform Campbell-Peters bill introduced in House of Representatives Cumulative preferred stock investments by US Treasury total $160B as of 3/31/2011. Cumulative investments by the Federal Reserve: $171 billion in GSE debt and $1.2 trillion in GSE MBS. July 2008 September 2008 March 2009 December 2009 February 2011 May 2011 June of 26

17 Conservatorship Provisions US Treasury is permitted to make unlimited investments in FNM and FRE senior preferred stock through 12/31/12 to maintain positive net worth in GSEs. After year-end 2012, maximum investment is limited to $200B per agency. Senior preferred stock held by US Treasury carries a 10% annual dividend, payable quarterly. Payment of quarterly commitment fee to US Treasury for support provided under SPSPA began in first quarter Retained portfolio limits are set at $810B per agency as of 12/31/10. Starting in 2011, the portfolio year-end limits will be set at 90% of the previous year s cap. 17 of 26

18 GSE Reform: Possible Approaches Nationalization Fold the GSEs into the federal government, like the FHA, VA, and GNMA. Privatization Reconstitute the GSEs as private companies with no government support or replace the GSEs with alternative approaches to mortgage finance. Hybrid Model Combine private capital with some level of government support or backing. 18 of 26

19 GSE Reform: The Uncertain Path Ahead GSE reform is a politically contentious issue, with no obvious solution for garnering bi-partisan support. It is highly unlikely that a compromise will be reached prior to the 2012 elections. FNM and FRE will likely remain in conservatorship through 2012 and possibly for many more years to come. Debt securities and MBS issued by FNM and FRE will continue to be protected by the effective guarantee of the US government regardless of the ultimate outcome of GSE reform. Given the dominant role of the GSEs in the US mortgage market, and the severe dislocations that could result from their absence, drastic changes such as full privatization are highly unlikely. A hybrid model, which gradually replaces Fannie and Freddie with private mortgage insurance companies along with a government backstop against catastrophic losses, would appear to the most likely long-term outcome. 19 of 26

20 Introduction to Step-Up Bonds 20 of 26

21 Step-Up Bond Characteristics Coupon Rate is Fixed to Initial Call Date. If Not Called, Coupon Steps Up to Higher Rate. Call/Step Structures Vary. One Time Call/Step Multi-Step Step-Up Feature Increases Probability of Call. Step-Up Coupon Provides Some Protection if Bond Not Called in Higher Rate Environment. 21 of 26

22 Relative Value Comparisons Compare Yield of Step-Up Versus: Agency Bullet to Call Date Agency Bullet to Maturity Date Callable Agency to Maturity Date Compare Implied Value Versus Theoretical Value of Embedded Options. 22 of 26

23 Step-Up Example 5Yr NC 6-month / Semi-annual Calls Issuer Fannie Mae Settlement Date 6/30/2011 Coupon 0.75% to 12/11; 2.25% Thereafter Call/Step Date 12/30/2011 Maturity Date 6/30/2016 Price Yield to Maturity 2.09% Yield to Call 0.75% 23 of 26

24 Step-Up Example Information as of 6/13/2011 Pricing Date Yield Comparisons Step-Up Yield-To-Call (12/11): 0.75% Yield on FNMA Bullet 12/11: 0.20% Yield Difference: 0.55% Step-Up Yield-To-Maturity (6/16): 2.09% Yield on FNMA Bullet 6/16: 1.84% Yield Difference: 0.25% Step-Up Yield-To-Maturity (6/16): 2.09% Yield on FNMA 5Yr NC 6-month: 2.00% Yield Difference: 0.09% 24 of 26

25 Step-Up Example Information as of 6/13/2011 Pricing Date Implied Option Valuation Yield to Call Yield of Bullet to Call Date = Implied Option Value 0.75% - 0.2% = 0.55% or 55 bps Theoretical Value vs. Implied Value Option Value from Bloomberg Pricing Model: Implied Option Value from Step-Up Yield: Difference: 57 bps 55 bps 2 bps 25 of 26

26 Fixed Income Capital Markets Disclosures Additional information is available upon request. Stifel, Nicolaus & Company, Incorporated makes a market in the aforementioned securities as at the date of issuance of this research report noted at the top of page 1 of this report. Stifel, Nicolaus & Company, Incorporated has managed or co-managed a public debt offering for FannieMae, Freddie Mac, the FHLB and/or the FCCB within the past 12 months. Stifel, Nicolaus & Company, Incorporated has received compensation in the past twelve months, or expects to receive compensation in the next three months, for investment banking services from one or more of the borrowers mentioned in this report. The Fixed Income Capital Markets trading area of Stifel, Nicolaus & Company, Incorporated owns debt securities of the borrower or borrowers mentioned in this report. The information contained herein has been prepared from sources believed reliable but is not guaranteed by Stifel, Nicolaus & Company, Incorporated 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 Nicolaus 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. Stifel Nicolaus and/or its 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. Securities identified herein are subject to availability and changes in price. Stifel, Nicolaus & Company, Incorporated 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 Nicolaus 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. Readers of this report should assume that Stifel Nicolaus or one of its affiliates is seeking or will seek investment banking and/or other business relationships with the issuer or issuers, or borrower or borrowers, mentioned in this report. Stifel Nicolaus 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 Nicolaus report), nor are FICM Analysts supervised by Stifel Nicolaus investment banking personnel; FICM Analysts receive compensation, however, based on the profitability of both Stifel Nicolaus (which includes investment banking) and Stifel Nicolaus Fixed Income Capital Markets. 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 Nicolaus financial advisor or salesperson. I, Jim DeMasi, certify that the views expressed in this presentation accurately reflect my personal views about the subject securities or issuers; and that no part of my compensation was, is, or will be directly or indirectly related to the specific recommendation or views contained in this presentation Stifel, Nicolaus & Company, Incorporated, One South Street, Baltimore, MD All rights reserved. 26 of 26