Case AnalysisYield Curve Strategy

An executive of a large mortgage firm was heard on a well-known financial news channel saying something to the effect that "there is a strategy being pitched in the boardrooms of financial firms all over the country every Monday morning, and the return on equity that is available is difficult to resist."

According to the executive, the strategy involves "yield curve arbitrage*" where low interest rate short-term money is borrowed to purchase higher yielding long-term securities." "There is very little risk to the strategy since the bonds being purchased are default-free US Treasury securities," the executive said. This strategy will be attractive for an extended time period, he said, because "the budget deficits will cause the yield curve to remain upward-sloping for an almost indefinite period."

Suppose that you are being asked to make such a pitch. Use the following hypothetical market data. (Assume annual coupons and that the bond is purchased on a coupon date for simplicity).

• Purchase $10 million face value of 4% coupon, 20-year Treasury bonds yielding 4%.
• Use the $10 million in bonds as collateral to borrow $10 million using a one-year term repo (assume an interest cost of 1%).
• Purchase an additional $10 million of the 4% coupon Treasuries.

(1) Compute the expected 1-year ROA and ROE assuming the yield curve is unchanged.

(2) Compute the expected 1-year ROA and ROE assuming the yield curve flattens. Assume that the YTM on the 20-yr. Treasury is 3% one year from now.

(3)Compute the expected 1-year ROA and ROE assuming the yield curve shifts upward by 200 basis points. Assume that the 20-yr Treasury is priced at a YTM of 6% one year from now.

Starting Balance Sheet:

Assets Liabilities and Equity

US 4% 2039 $20 million Liabilities $10 million

Equity $10 million

Totals $20 million $20 million

(4) Do you agree that this strategy is not very risky?

(5) Do deficits cause an upward-sloping yield curve?

(6) Would an unusually steep upward-sloping yield be expected to stay stationary for a long time? Why or why not?

*Warning: The strategy being described is NOT arbitrage!