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II.
Investments Results -
Third Quarter 2006
DIF
- During the first nine months of 2006, the par value of the DIF
investment portfolio increased by $1.31 billion or by 2.92 percent—from
$44.904 billion on December 31, 2005, to $46.216 billion on September 30,
2006 ($322 million of this increase was due to the depositing of the SAIF
Exit Fee portfolio into the DIF on March 31, 2006, in accordance with the
deposit insurance reform legislation enacted earlier this year).
- The DIF investment
portfolio's total return for the first nine months of 2006 was 3.28
percent, 50
basis points higher than the return of the
benchmark, the Merrill Lynch 1 - 10 Year U.S. Treasury Index (Index),
which earned 2.78 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 nine months of 2006,
the
DIF portfolio’s conventional securities slightly outperformed the
Index (while yields declined in the third quarter of 2006, yields
still have increased over the longer nine-month year-to-date period).
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 nine months of 2006, the DIF’s
overnight investment balances typically exceeded 4 percent of the
DIF 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 third quarter of 2006, due to a significant drop in yields, no
new longer-term securities were purchased. Proceeds from coupons
and maturing investments were invested in higher-yielding overnight
investments. In line with consensus expectations, yields should continue
to trade within their current range, rising modestly from the low
yields exhibited at the end of the third quarter. Staff will take
advantage of instances when yields rise toward the upper end of this
trading range and accordingly will deploy funds into longer-maturity
higher-yielding securities.
The Treasury Market
- During the third quarter of 2006, conventional Treasury yields
decreased across all maturity sectors, reflecting recent economic developments
as well as reflecting strong market expectations that the Federal Reserve
has concluded its most recent interest rate tightening cycle. The largest
yield decreases were posted by intermediate-maturity securities, with
three-, five-, and ten-year note yields all declining by 51 basis points.
The two-year
note yield, which is also sensitive to actual as well as anticipated
changes in the federal funds rate, decreased by 47 basis points. The Treasury
yield
curve ended the quarter very flat and slightly inverted; on September
30, 2006, the ten-year to two-year yield curve spread was a negative 5 basis
points (compared to a negative two basis point spread at end of the second
quarter). From a historical perspective, the curve remains significantly
flatter; over the past five years, this spread has averaged 143 basis
points.
- During the
third quarter 2006, the TIPS yield curve underwent a noticeable twist,
with
the shortest-maturity TIPS real yields increasing
dramatically while longer-maturity TIPS real yields declined, albeit
modestly compared to the nominal yield declines experienced by
similar-maturity conventional Treasury securities. The real yield
on the DIF portfolio’s
shortest-maturity TIPS maturing in January 2007 increased by 47 basis
points, while the real yield on the portfolio’s longest-maturity
TIPS (with a maturity of a little over four years) declined by
nine basis points. The real yield on the ten-year TIPS maturing
on January 15, 2016,
declined by 19 basis points. The short-dated TIPS real yield increases
are reflecting market consensus views that the overall Consumer
Price Index (CPI) should be negative over the near term due to
a dramatic decline
in energy prices, while the more modest decline on the long end
reflects market consensus views that inflation should remain contained.
Prospective Strategies
- The current DIF investment strategy provides the flexibility to
purchase a wide range of different Treasury securities with varying maturities,
depending on Treasury market conditions and developments during the fourth
quarter of 2006. Similar to the third quarter 2006 investment strategy,
if higher yields become available—either as a result of an upward shift
in the yield curve or because of potential yield volatility—the fourth
quarter 2006 strategy provides the flexibility to purchase comparatively higher-yielding,
longer-maturity Treasury securities. Given the flat Treasury yield curve,
purchasing short- and intermediate-maturity Treasuries may also make sense.
- The DIF portfolio’s
primary reserve target floor balance will remain at $10 billion
for the fourth quarter
of 2006. The target limit for TIPS is being increased from
$9.0 billion to $10.0 billion, while the AFS target limit is
being reduced from $9.4 billion to $8.8 billion (see attached
Approved Investment Strategy on page 13).
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