Last

Cash Flow (LCF) CMO An Alternative to Too Much Liquidity

As we head into March, many portfolio managers are taking stock of how the balance sheet will look at the end of the first quarter. We continue to have conversations with financial institutions struggling to balance current earnings and long-term cash flow needs. Rates have continued to trend lower over the past year. Consequently, the volume of calls and prepayments has heavily increased in the portfolio (Graph 1). Most managers will agree that their portfolios are more liquid than they would probably like.

While this cash flow graph is an example from one institution, it is indicative of what we routinely see across the landscape. With the high amount of near-term liquidity, portfolio managers are understandably concerned about near-term reinvestment risk. What do I reinvest the cash flow in? Staying invested too short offers very little yield and can even become a negative arbitrage. Therefore, many investors are extending out along the curve. Tactically extending out the curve can help increase yield, all the while limiting near term cash flow, and without significantly increasing the risk profile of the portfolio.

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 For those investors that are comfortable adding on limited duration, there are a variety of options available. One option is a Last Cash Flow CMO (LCF CMO). A LCF CMO is a slightly longer average life investment (between 7 and 10 years in the base case for 15 year collateral) where the principal cash flow window starts towards the end of the investments duration (Table 1).

While a longer average life LCF CMO is not a fit for every investment portfolio, it can be a strategic addition for investors that have too much near-term liquidity. The bond highlighted above has an attractive yield (2.44%) and spread to the treasury curve (100 bps). This can incrementally add income to the institution today. There is some extension risk in a rising rate environment (+300, 11.2 years average life), but Table 1 above shows an instantaneous rate shock of 300 bps today, which is highly unlikely given the Feds recent rate outlook. Also, the bond maintains a positive spread under all rate scenarios (keeping in mind this is an instantaneous 300 bps rate shock). If the Fed keeps rates at current levels through 2014, capacity constraints amongst servicers will start to ease as they add more employees and resources to take advantage of mortgage refinancing. There is a distinct possibility of prepayments picking up outside of HARP 2.0, if the current rate environment persists over the next couple of years. In this case, it is not only important that an investment hold up well in a rising rate scenario, but that it also continues to perform in a falling/lower rates scenario.
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 Graph 2 below also highlights the principal cash flows from this bond. As previously mentioned, this investment product is not necessarily ideal for every institution, but it makes a strategic addition for those investors that are already either sitting on too much cash or have too much principal coming due. As the refinancing risk of HARP 2.0 gets more pronounced over the coming months, and with the possibility of other government interventions to help homeowners stay in and keep their homes, a LCF CMO offers protection against reinvestment risk while positively impacting the bottom line now.

Banks typically add longer duration exposure to the investment portfolio in the form of Municipal securities. For those financial institutions that are already full on their allocation to Municipals, a LCF CMO offers an alternative longer dated investment with both principal and interest over the last years of the investment. A LCF CMO is also a good alternative to longer callable agencies with shorter lockouts of only 1 to 2 years. The investor runs the risk of holding a fixed rate, below market coupon in a rising rate environment with long callables. While the LCF CMO also poses extension risk, the bond will continue to pay interest and principal due to the self-amortizing nature of the security. To discuss if a LCF CMO makes sense for your investment portfolio, call your Duncan-Williams representative today, or please let us know if we can help. Geetika Bansal Senior Market Analyst Fixed Income Strategies & Services.

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 Chad McKeithen Managing Director 901.260.6887 chad.mckeithen@duncanw.com Chris Klass Senior Market Analyst 901.260.6810 cklass@duncanw.com OFFICES Akron Atlanta Birmingham Charlotte Cleveland Chicago Gainesville

Geetika Bansal Senior Market Analyst 901.435.4016 gbansal@duncanw.com Catherine Folk Market Analyst 901.435.4162 Catherine.folk@duncanw.com Houston Jackson Memphis New York Philadelphia Tampa

Disclaimer: This material has been prepared by Duncan-Williams, Inc., member FINRA/SIPC (Duncan- Williams"), from information sources believed to be reliable. Duncan-Williams expressly disclaims any and all liability which may be based on such information, errors therein or omissions there from, or in any other written or oral communication related thereto. This material is for your information only and should not be construed as investment advice or as any recommendation of a transaction. Neither Duncan-Williams nor any of its representatives is soliciting any action based upon this material. Specifically, this material is not, and is not to be construed as, an offer to buy or sell any security or other financial instrument referred to herein.

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