II. Investments Results - Second Quarter 2006

DIF

• The DIF investment portfolio's total return for the first six months of 2006 was 0.52 percent, approximately 61 basis points higher than the return of the benchmark, the Merrill Lynch 1 - 10 Year U.S. Treasury Index (Index), which earned -0.09 percent during the same period. The outperformance relative to the benchmark can be attributed to three factors. First, the DIF investment portfolio’s conventional securities have a slightly lower average duration than those in the Index, and consequently, as yields increased over the course of the first half of 2006, the DIF portfolio’s conventional securities slightly outperformed the Index. Second, during this period, the DIF’s Treasury Inflation-Protected Securities (TIPS) portfolio also outperformed the Index’s conventional securities. And third, during much of the first half of 2006, the DIF’s overnight investment balances typically exceeded 4 percent of the DIF’s portfolio. Besides overnight investments now realizing very attractive returns given the flat yield curve, in a rising yield environment, longer-term securities experience price declines. Accordingly, on a total return basis, overnight investments outperformed the longer-maturity conventional Treasury securities included in the Index during this period.

• During the second quarter of 2006, staff purchased new securities with a total par value of $2.050 billion, a weighted average maturity (WAM) of 10.56 years, a weighted average modified duration of 7.29 years, and a weighted average yield to maturity (YTM) of 5.21 percent. On June 30, 2006, the effective duration of the DIF portfolio was 2.88 years, an increase of 0.35 years from December 31, 2005. With higher Treasury market yields available, staff has been purchasing primarily longer-maturity securities so far this year.

• The DIF’s primary reserve declined by approximately $2.7 billion (18.6 percent) during the first six months of 2006. This is the result of staff implementing an investment strategy that takes account of the relatively healthy banking and thrift industries and the likelihood for this environment to persist prospectively.
  

The Treasury Market

• During the second quarter 2006, real yields on the shortest-maturity TIPS increased dramatically, with one-year yields up 95 basis points, and two-year yields up 42 basis points, again, largely reflecting the federal funds target rate increases. These real yield increases represented a reversal of the first quarter’s TIPS yield curve shift, when shorter-dated TIPS real yields fell. Real yields on longer-maturity TIPS also increased during the second quarter, but more modestly, with yield increases of 18 to 23 basis points on securities with remaining maturities of five to ten years.
  

Prospective Strategies

• The DIF portfolio’s primary reserve target floor balance will be remain at $10 billion for the third quarter of 2006, while the target limit for AFS securities will rise slightly (see attached Approved Investment Strategy).

• Approximately 60 percent, or $26 billion, of the Deposit Insurance Fund’s (DIF) Investments in U.S. Treasury obligations other than overnight investments will mature by 2009. Currently, Treasury yields generally exceed the yield-to-maturity on DIF’s securities that will mature by 2009. If Treasury yields remain stable or continue to rise, proceeds from the maturing securities and coupon payments could be reinvested at higher yields, which would result in higher interest earned on investment securities (see first graph on page 9).