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II.
DIF Investments Results -
Third Quarter 2007
DIF
- During the first nine months of 2007, the amortized cost (book
value) of the DIF investment portfolio increased by $1.704 billion or by
three percent—from $48.858 billion on December 31, 2006, to $50.562
billion on September 30, 2007. Moreover, during the period, the DIF portfolio’s
market value increased by $2.322 billion or by five percent, from $49.038
billion on December 31, 2006, to $51.360 billion on September 30, 2007.
- The DIF investment portfolio's total return for the first nine
months of 2007 was 5.134 percent, approximately the same as its
benchmark, the Merrill Lynch 1 - 10 Year U.S. Treasury Index (Index),
which earned
5.139 percent during the same period.
- During the third
quarter of 2007, staff purchased just one conventional Treasury security.
This newly purchased held-to-maturity
(HTM) security had a par value of $400 million, a maturity of 12.00
years, a modified duration of 8.22 years, and a yield-to-maturity of
4.87 percent.
The total cash outlay for this high coupon security was $517 million.
On September 30, 2007, the DIF portfolio’s overnight investment
balance was $2.850 billion, well above its $150 million target
floor balance. Consistent with the approved third quarter Corporate investment
strategy, staff deferred purchases of Treasury securities not only
in
light of comparatively low Treasury yields available during much
of the quarter, but more importantly, to build up liquidity for the anticipated
NetBank resolution. (This fairly large bank failure occurred on
September
28, 2007, with significant resolution funding occurring in October
2007.)
The Treasury Market
- During the third quarter of 2007, conventional Treasury yields
decreased substantially, particularly on the short end of the yield curve,
reflecting the 50 basis point cut in the federal funds target rate that
occurred on September 18, 2007, and reflecting market sentiment for additional
cuts in the target rate during the last quarter of 2007 and the first
quarter of 2008. During the quarter, yields on three-month and six-month
T-Bills
decreased by 100 basis points and 86 basis points, respectively. The
two-year note yield, which is also sensitive to actual as well as anticipated
changes
in the federal funds rate, decreased by 88 basis points, again, reflecting
the aforementioned 50 basis point cut in the target rate and reflecting
expectations for additional target rate cuts. Intermediate-maturity Treasury
yields also decreased over the course of the quarter, although not surprisingly,
the yield declines were more modest, as is often the case when an expected
series of interest rate cuts is initiated. The yield on the five-year
Treasury note decreased by 68 basis points. The yield on the ten-year Treasury
note
decreased by 43 basis points. It should be noted that most of the decrease
in yields occurred between mid-July and the early part of September;
towards the latter half of September, yields on intermediate- to longer-maturity
securities actually started to modestly increase as investors unwound
some
earlier so-called “flight to quality” trades. The conventional
Treasury yield curve steepened during the third quarter of 2007; on September
30, 2007, the two-year to ten-year yield curve had a 61-basis point positive
spread (compared to a modestly positive 16-basis point spread at the beginning
of the quarter). Nevertheless, the Treasury yield curve still remains flatter
from a recent historical perspective; over the past five years, this spread
has averaged 106 basis points.
- During
the third quarter of 2007, most Treasury Inflation-Protected
Securities’ (TIPS)
real yields decreased, reflecting lower actual and anticipated interest
rates and concerns over weak economic growth. However, the real yield
on the DIF portfolio's shortest-maturity TIPS (with a maturity
of just over three months at the end of the quarter) increased by 50
basis points during the quarter 1. The real yield on the portfolio's
longest-maturity TIPS (with a maturity of a little over four years)
decreased by 50 basis points. The real yield on the 10-year TIPS maturing
on January 15, 2017, decreased by 36 basis points.
Prospective Strategies
- The current DIF investment strategy provides for purchasing AFS
conventional Treasury securities with maturities of six years or less,
for purchasing AFS TIPS, and for holding excess overnight investments, depending
on Treasury market conditions and developments during the fourth quarter
of
2007.
- The DIF
portfolio’s
primary reserve balance is being increased, with a goal of
reaching a $15 billion target
floor balance over the near term. Any securities purchased
during the fourth quarter will be designated AFS. (See attached
Approved Investment Strategy.)
Other
Matters
- Effective
September 30, 2007, the FDIC and the U.S. Treasury’s
Federal Financing Bank (FFB) entered into an agreement
to extend the FDIC’s existing $40 billion line
of credit with the FFB for an additional one-year
period through September 30, 2008.
1 Very
short-maturity TIPS can have dramatic changes in real yields
stemming from very near-term inflation expectations. Consequently,
it is not unusual for very short-maturity TIPS’ real yields,
which are quoted on an annual basis, to exhibit dramatic swings
as they approach maturity.
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