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II.
Investments Results -
Fourth Quarter 2006
DIF
- During 2006, the book value (amortized historical cost) of the
DIF investment portfolio increased by $1.820 billion or by 3.87 percent—from
$47.038 billion on December 31, 2005, to $48.858 billion on December
31, 2006 ($345 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 in 2006).
- The DIF investment portfolio's
total return for 2006 was 4.06 percent, approximately 49 basis points
higher than the return of the
benchmark, the Merrill Lynch 1 - 10 Year U.S. Treasury Index (Index),
which earned 3.57 percent during the same period. The outperformance
relative to the benchmark can be primarily attributed to two 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 2006, the DIF portfolio’s
conventional securities slightly outperformed the Index. Second, during
much of 2006, the DIF’s overnight investment balances typically
exceeded 4 percent of the DIF portfolio. This was a result of the
decision, particularly over the second half of 2006, to keep larger than
normal
balances in high yielding overnight investments. On a total return
basis, overnight investments outperformed the longer-maturity conventional
Treasury
securities included in the Index during this period.
- During
the fourth quarter of 2006, staff purchased Treasury securities
on four occasions, including the purchase of a five-year Treasury
Inflation-Protection
Security (TIPS), the first such TIPS purchase since August
2001. Staff purchased eight securities with a total par value
of $3.019
billion, a weighted average maturity of 4.62 years, a weighted
average duration of 3.55 years, and a weighted average yield-to-maturity
of 4.76 percent. Notwithstanding the high dollar amount of
new investment
purchases, staff continued its recent practice of deferring
purchases of longer-maturity securities and holding excess
funds in higher
yielding overnight investments from a strategic investment
perspective. On December 31, 2006, the DIF portfolio’s overnight
investment balance was $2.949 billion, well above its $150 million
target floor,
and higher than the $2.312 billion balance on September 30, 2006.
- Treasury
market yields are expected to continue to generally trade within their
current range,
but with consensus expectations for
a modest rise from year-end levels. Similar to our strategy during
the fourth 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 fourth quarter of 2006, conventional Treasury yields
increased modestly across all maturity sectors, reflecting recent economic
developments as well as reflecting market expectations that while the
Federal Reserve may have concluded its most recent interest rate tightening
cycle,
it may not be reducing rates until sometime later in 2007. The yields
on three-month and six-month Treasury bills increased by 14 and 8 basis
points,
respectively. The two-year note yield, which is also sensitive to actual
as well as anticipated changes in the federal funds rate, increased by
13 basis points. Intermediate-term Treasuries also increased modestly,
with the five-year Treasury note up 11 basis points and the ten-year
note up
7 basis points. The Treasury yield curve ended the fourth quarter very
flat and slightly inverted; on December 31, 2006, the ten-year to two-year
yield
curve spread was a negative 11 basis points (compared to a negative 5
basis point spread at end of the third quarter). From a historical perspective,
the curve remains significantly flatter; over the past five years, this
spread has averaged 133 basis points.
- During
the fourth quarter 2006, the TIPS real yield curve underwent
a twist, with the shortest-maturity TIPS real yields decreasing dramatically
while intermediate- to longer-maturity TIPS real yields increased
modestly.
The real yield on the DIF portfolio’s shortest-maturity TIPS
maturing in January 2008 decreased by 42 basis points, while the real
yield on the portfolio’s five-year TIPS increased by 13 basis
points. The shorter-maturity TIPS real yield decline in particular
reflected near-term inflation expectations. The real yield on the ten-year
TIPS maturing on January 15, 2016, increased by 14 basis points.
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 first
quarter of 2007. Similar to the fourth 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 first
quarter 2007 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 be remain at $10
billion for the first quarter
of 2007. The target limit for TIPS will also remain at its
$10 billion target, while the AFS security target limit is
being reduced from $8.8 billion to $8.7 billion (see attached
Approved Investment Strategy).
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