CASE 19 First Coast Bank (The Yield Curve) 144 Mike O'Neal graduated from college in June 1983 with a degree in finance and found a job with a major brokerage firm. Shortly after he was hired, Mike was sent to New York City to participate in a training program for new employees. ‘The training program lasted for six months and had as its objective the prepara tion of new employees for a successful career as a retail broker with the firm. ‘After completing the training program in January 1984, Mike was assigned to a brokerage office in Orlando, Florida. He quickly began to develop a clien- tele by aggressively pursuing contacts and by calling on potential customers whose names were supplied by his firms He established a reputation as a knowledgeable and hardworking broker and was quite successful. Despite his success, Mike began to feel that the retail brokerage business did not offer the type of career that he wanted. His interest in investments had been primarily security analysis and portfolio management. His job as a broker, however, consisted entirely of dealing with clients and required very little ana- lytical skill ‘On several occasions, he had been very uncomfortable about accepting the analyses and recommendations supplied by the brokerage firm’s research de- partment, When this first occurred, he had discussed his feelings with the local office manager, who advised against taking a contrary opinion on any security that had been analyzed by the research department. Though he refrained from using his own opinions, Mike continued to follow the stock market in general and a number of stocks in particular. In several instances, he discovered that, his analysis tended to be more accurate than that of the firm's research depart- ment. This reinforcement and his dissatisfaction with being a retail broker f- nally convinced Mike to look for a job as an analyst. ‘is Matera! only tobe used a conjunction with MBAITE LecturesFIRST COAST BANK 145 | Since he and his family were quite happy living in Orlando, his job search was restricted to the central Florida region. He quickly discovered, however, that the number of positions as an analyst was extremely limited in the area, ‘most of the large brokerage firms had their research staffs located in New York City and did little or no analysis locally. Essentially, the only available local positions were at some of the larger financial institutions, especially the banks, where analysts were primarily responsible for recommendations concerning the investment of bank funds. Mike initially faced some resistance from the local banks in his attempt to make the transition from a retail broker to an “in-house” analyst. With his educational background and a strong recommendation from his office manager, however, he finally secured a position with the First National Bank of Oviedo in December 1986. The bank was relatively small, with less than $100 million in deposits, and was located in a community approximately twenty miles from Orlando. Oviedo, like much of central Florida, was growing very rapidly, and Mike was convinced that the bank would expand and provide him with a prom ising career. Despite the small size of the First National Bank of Oviedo, the trust de- partment was well known and had a good reputation. This reputation, com bined with the presence of many retired people in the area, gave the bank over two hundred trust accounts, with assets in excess of $30 million to manage. ‘The bank was conservative in its lending policies, for both individual and com. mercial loans. This conservatism resulted in a relatively low loan /deposit ratio, providing the bank with excess funds that were usually invested in short- and intermediate-term securities of the U.S. Treasury. ‘Mike was responsible for making investment recommendations to the head of the trust department for the trust accounts and to the president and chief executive officer for the bank’s funds. He was the only analyst employed by the bank and consequently dealt with both equities and bonds. After reviewing some of the bank’s portfolios and a few trust portfolios, Mike realized that his job would require him to devote most of his time to ana: lyzing fixed-income securities. His impression of the portfolios, however, was, not entirely favorable. He noticed that both the trust portfolios and the bank’s portfolios had little if any trading activity. The bank seemed to employ a "buy- and-hold” management strategy. Mike questioned whether this was an appro- priate strategy, given the dramatic cycles in interest rates over the previous five years. He decided, however, to be very cautious in recommending any dramatic changes in the bank's portfolio marikement strategy. He felt that his know!- edge of fixed-income security prices was very limited and that he needed to do some research that would provide him with a basis for making such recommendations, Since U.S. Treasury securities constituted such a large portion of the port: folios, Mike decided to gather some historical data on prices and yields-to- maturity for selected U.S. Treasury notes and bonds. Table 19.1 gives a sample of twenty-one Treasury securities with prices and yields-to-maturity in Janu- ary and July, from 1982 through January 1987. To facilitate the analysis, Mike selected only the securities that matured in February of the year indicated. He planned to use the data to analyze the behavior of prices and yields over the[146 BOND VALUATION period and to develop various portfolio strategies appropriate for the bank. This historical analysis could then be used to compare the current strategy to alter: native strategies the bank might employ. Tauestions 4. Use the data in Table 19.1 to plot separate “yield curves” for January 8, 1982; January 7, 1983; and January 6, 1984, For each of the three yield curves, plot the term-to-maturity on the horizontal axis and the yield-to-maturity on the ver- tical axis. Draw a curve through the points you plot. Comment on the three different shapes of the curves with regard to the factors that determine the rel ionship between term and yield. 2. Using the graphs that were constructed in Question 1, explain why some of the bonds do not plot close to the yield curves. 3. Calculate the holding period rates of return for the following portfolio strategies: a. Strategy A: “Buy-and-hold” Buy the 12 3/4s of 1987 on January 8, 1982, and hold this bond until January 9, 1987, at which time the bond. is sold at the price that existed at that time. Calculate both the annual and semiannual return over the entire period. (Ignore commissions and accrued interest.) b. Strategy B: “Rolling over” a long-term bond Buy the 10 1/25 of 1995 on January 8, 1982, and hold until July 9, 1982. Buy the same bond on July 9, 1982, and hold until January 7, 1983, and continue to buy and sell the bond at six-month intervals until January 9, 1987. Calculate each of the 10 semiannual holding period returns that would result from this strategy, and calculate their average. (Ignore commissions and accrued interest, and assume that one semiannual interest pay- ‘ment is received at the end of each semiannual holding period.) ©. Strategy G: “Rolling over” with short-term notes For each of the notes and time periods shown below, calculate the semiannual holding pe- riod returns and the average return, (Ignore commissions and accrued interest, and assume that one semiannual interest payment is received at the end of each semiannual holding period.) Periods Notes 1/8/82-7/9/82 Bs of 1983 7/9/82-1/7/83 Bs of 1983 1/7/83-7/1/83 7114s of 1984 7183116184 7114s of 1984 1/6/84-6/29188 86 of 1985 6/29/84-1/4/85 85 of 1985 1/4/85-7/2/85 18 1/2s of 1986 7/2/85-1/8/86 13 1/2s of 1986 1/8/86-6/3/86 123/48 of 1987 6/3/86-1/9/87 12.3/4s of 1987FIRST COAST BANK 147 | 4. Assume that $100,000 is available to invest on January 8, 1982. Using the semiannual holding period returns estimated above, calculate the terminal value of the $100,000 on January 9, 1987, for each of the three strategies. Do there appear to be significant differences in the terminal values? . Discuss any differences in the risks associated with the three strategies, Does there appear to be any relationship between risk levels and the holding period returns? 6. Briefly discuss the factors that determine whether an active strategy such as a “rollover” strategy will be successful and when it should be preferred to a “buy-and-hold” strategy. Do you think that Mike should attempt to change the strategy the bank is employing? Explain.[ 148 ‘BOND VALUATION TABLE | First Coast Bank 19.1 | U.S. Treasury Secunties ‘Bond sele2 rsi82 7183 71183 ‘Maturity Coupon’ _Date* —_Close®Yield* Close Yield* Close* _Yield* Close® _Yield* 1% 198n 99-15 eB - : - - 2 8 —1983n 94-24 1332-97-10 1335 100-10 7.43, - - 3.13% 1983n 9-29 13.97 100-05 13.61 100-27 7.09 = = 4. 7% 1984n 85-21-1403 91-18 1330 98-18 8.66 98-24 (9.40 5. 8 1985n 85-30 14.11 88-10 1349-97-25 9.19 97-12 9.80 6 13% 1986n 97-17 14.32 98-18 14.11 109-12 9.92 106-29 10.41 7.9 19872 81-24 14.15 84-04 13.78 97-15 9.76 95-23 10.45, 8.12% 19871 94-16 14.28 95-23 14.05 106-18 10.14 106-00 10.70 9.10% 1988. = = - = 100-20 997 98-30 10.66 10.11% 19890 - - aa ee - - - - IL 11 1990 - - = - - e - = 12.14% 19920 - = - 1-18 1034-12 11.24 13. 6% 1993-60-23 13.74 64-18 13.00 = - 77-00 10.62, 4. 9 1994 = = 73-30 1351 91-20 1028 88-04 10.91 15.10% 1995 77-30 1427 81-00 1371 100-20 1041 96-27-1098 16.11% 1995p = = aoe < E- = = 17.14% 1996p = = aes = E S 2 18.11% 2001-83-08 14.41 87-10 1365 107-19 10.79 103-22 11.26 19.14% 2002-98-10 14.50 103-15 13.74 126-24 10.89 123-08 11.25 20. 7% 2002-07 59-30 13.46 61-24 12.75 76-24 1924 72-31 10.80 21. 11% 2005-10 83-22 14.10 87-06 13.53 107-20 1083 104-14 11.20 ‘continuedFIRST COAST BANK TABLE continued nd 16/84 6/29/84 ayes 7/2185 Maturity Coupon’ Date’ Glose* Yield Close? Yield Close” Yield* Close’ _Yield* 1 6% 1982n = E - = 3 = - 2,8 19830 e 2 5 5 : ' 3.13% — 1983n = = eee 7 a 4.7% 1984n 99-28 829 = = + = 5. 8 1985n 98-07 9.75 98-20 1132 100-20 7.16 = - 6.13% 1986n 105-05 10.69 100-25 12.95 104-06 9.42 103-19 7.49 7.9 1987n 94-26 11.02 90-26 1326 97-28 10.15 100-26 8.45 8.12% © 1987n 104-12. 11.05 98-29 13.26 104-22 10.22 106-08 8.55 9.10% 19881 96-07 1130 90-17 13.52 98-28 1056 102-12 9.09 10. 11% = 1989n 99-22, 11.45 11.07 108-17 9.58 IL 1990 E : ee 1119 104-11 9.81 12, 14% 992m L411 11.82 103-25 13.81 1.67 120-22 10.25 13, 6% 1993-74-21 11.28 66-25. 13.35 116 84-11 -9.70 14 9 1994 84-16 11.65 74-31 13.77 1159 93-09 10.19 15.10% 1995 92-20 1.71 81-25 13.82 1155 104-04 1015 16. 11% 1995p + - sete S = — 105-28 107 17. 14% 1996p u = - = = 2 - - 18.11% 2001-93-11 «11.84 86-26 13.79 93-17-1182 108-10 10.65. 19.16% 2002-717, 11.87, 103-11 13.74 117-15 11.84 127-17 1068 20. 7% 2002-07 68-21 1153 58-19 1353 69-17 | 1152 76-07 10.41 21. 11% 2005-10 99-24 11.78 86-05 13.71 99-26 11.77 113-00 10.53 ‘continuedBOND VALUATION TABLE 49.1. | continued ‘Bond 18/86 6/3/86 8/87 Sia N Gy oa Coupon’ Date* —Close*—Yield*Close® Close? Yield 1 6% 1982n é S = z = a 2 8 19830 - = es ~ 2 - 3.13% — 19830 = c = a im - 47% 19840 3 = s s = 5 8 198m, < s 3 a, e 3 6.13% 1986n 100-22. 6.62 BE ss = < 7.9 19872 101-10. 7-74 «101-20 6.23 «110-11. «4.97 8.12% 1987n 105-08 7.71 103-31 599 100-22 4.80 9.10% 1988n 104-10 801-105-3073 104-13. 5.89 10.11% — 1989 108-10 8.39. 110-10 7.09 110-00 6.20 IL 11 1990 108-30 8.62. 111-08 7.39 112-20 6.43. 12, 14% — 1992n 126-10 8.94 131-22 7.68 133-27 «6.67 13, 6% — 1993, M1-00 846 98-06 7.10 100-30 6.56 49 1994 101-13, 875 108-18 7501-12, 6.94, 15.10% 1995 108-30. 9.09 119-10 7.58 121-04 7.08 16.11% 1995p 113-04 9.13. 123-10 7.63 125-20 7.08 17.14% 1996p - = 109-30 7.41 112-00 7.06 18.11% — 2001 118-00 9.48 134-00 7.81 137-04 7.45 19.14% 2002, 138-17 9.62 156-10 7.93 159-22 7.55 20. 7% 2002-07 85-30 9.24 99-24 21. 11% — 2005-10 118-30 9.57 137-00 102-10 7.40 139-15 7.68 SOURCES of price and yield data Barron’ elected issues. "Unerest on all ects inthe tables paid semiannually on February 16 and August 16. “All securities in ee table mature on February 15 forthe year indicated. The “following the year of maturity epresents nots, "p” nepesens treaniry note and non-US. citizen enema om tithholding eaten “Prec uted interme of pins nd hry een ofa pi, or ual sn sven as 85730, the prices $890.375 [e, [5 + 30/33)» 10 Fhe pce repreest over the ‘counter asked prices at the close af the week. = ‘The yield represents yel-vo- maturity percentage.