Techniques for Investing in a Low Interest Rate Environment American Public Power Association Business and Financial Conference September 21, 2004 Presented

Techniques for Investing in a Low Interest Rate Environment

American Public Power Association

Business and Financial Conference

September 21, 2004

Presented by Ross Byers, JEA with assistance from Tom Davis, JEA

APPA CONFERENCE

APPA CONFERENCE, 9/21/04

Investment Objectives

●Safety of Capital

●Liquidity

●Highest Possible Yields in a low interest rate environment consistent with Safety and Liquidity


First, let’s define “low interest rate environment”

● I started in this business in 1979 and low interest rates to me for many years meant under 10%

● For instance, from 1985 through 1999 short/intermediate term rates generally ranged from 4% to 10%

● However, beginning in 2000 we have witnessed an unprecedented decline in short-term rates which bottomed with the Fed funds target at 1% from mid-2003 until the Fed raised rates on June 30, 2004


Fed Funds Target Rate, Jan. 1985 to August 2004

High: 9.75% (Feb. ’89) Low: 1.0% (June ’03 - June ’04) Avg.: 5.25%


3 Month LIBOR, January 1985 to August 2004

High: 10.3% (Feb. ’89) Low: 1.1% (Mar. ’04) Avg.: 5.51%


Risk/Reward

● In the ’85 to ’99 period, let’s assume your short-term portfolio was yielding 6% at a given point in time

● If rates rose 200 basis points, your MTM value would be below cost and your current yield would be below market

● In the current very low interest rate environment since 2000, if rates were to rise 200 basis points the same points made above would be true

● However, the magnitude of the effect on performance measured from a yield viewpoint is much greater, i.e. 1% to 3% versus 6% to 8%

● The impact is a 200% change versus a 33% change

● From an investment income budget standpoint, the magnitude of this variance could be hard to explain to a non-finance CEO. During the decline in rates, you may have already experienced this.


How Do We Manage Our Short-term Portfolios if rates remain in this 1% - 4% range for an extended period, i.e.

the whole decade?

●First, let’s look at some of our available instruments


Risk/Reward Profile

Low Risk/Low Yield

Money Market funds, High grade CP, T-bills, Agency discount notes, Repurchase Agreements

Moderate risk/Higher Yield

2 to 5 year notes, Adjustable rate mortgages, callable agency notes, step-up bonds, Intermediate term MBS and CMOs

Higher risk/Higher Yield

Lower grade corporate bonds, Notes with derivatives, and other exotic instruments



the whole decade?

●Second, what are some of the measurement tools that our various organizations use to judge our performance?


Alternatives for Measuring Investment Performance

● Managing for Yield versus Managing for Total Return

● Select Benchmark Index to correspond with measurement criteria

● Examples of Yield Benchmarks: 12 month rolling one month LIBOR , 1 year or 2 year Treasury constant maturity

● Examples of Total Return Benchmarks – Lehman 1-5 yr. Gov’t/Credit Bond Index, Lehman 1-3 yr. Gov’t Bond Index



the whole decade?

● Lastly, let’s evaluate different strategies in varying interest rate environments, staying in our 1% to 4% range of interest rates.

● Our scope is limited to maturities 5 years and under


Before we discuss specific investment alternatives, let’s quickly review some basic strategies to improve yields.

Depending on your investment philosophy, guidelines and/or policy, some or all of these may not be appropriate.

● Reduce Credit Quality – AAA 10-year agency is +50; AAA Corporate is +70; A- rated 10 year is +100 and lowest investment grade is +140

● Lengthen Maturities – Spread between 2-year and 5-year Treasuries is 90 basis points

● Buy Callables/Step-up bonds – Bullet 2 year is +25; 2 year non-call 3 month Bermuda is +50

● If the portfolio has maturity constraints (i.e. debt service sinking funds), receive fixed – pay floating interest rate swaps are an example of a way to increase yield

2-Year & 5-Year Treasury Rates, Jan. ’94 to Aug. ’04Avg. Spread 52 bp Spread since ’01: 1.07% 9/15 Spread: 90 bp

Like the early ’90s when spreads for 2s to 10s were very wide, similarly spreads for 2s to 5s have widened in the last 3 years on the fear that we will return to higher rates.


Basic Example

● Buy 2.5 year agency versus 6 month agency discount notes

● Evaluating additional yield for extension risk

● Also, evaluating overall yield if not held to maturity


Invest in a 2.5 yr Fannie Mae NC 6 mo. 1X at a 3.12% yield for 2.5 years? Or invest in 6 month agency discount notes at 1.90%, waiting for higher rates. What’s the breakeven rate that you’d need at the end of 6 months for the last 2 years? 3.426%. Will 2 year agency bullets yield that much 6 months from now? Check the forward curve to get an idea…


Agency forward curve at 3/21/05 indicates a 2 year agency yield of 3.24%. This is below the breakeven rate of 3.426% from last slide. Relying on the forward curve would tell you to go ahead and buy the 2.5 year callable instead of waiting for higher rates.


What if you have to sell the bond after 6 months and rates have risen? You could have earned 1.90% for 6 months in discount notes. At what price can you earn still earn 1.90% if you sell? 99-12+ . This equates to a 75 basis point increase in rates at the end of 6 months; i.e. an increase to 3.45% for a 2 year agency bullet.


Another approach could be to use somewhat more sophisticated bond analytic tools.

Utilizing analysis tools available from your Investment Advisors and/or Investment Broker/Dealers can help you model various scenarios that provide information on expected returns.

The example I’m going to show you is from Citigroup using “Yield Book.”


Assumptions Used for Computer Simulation (Yield Book)

● Maximize Yield subject to a maximum loss constraint of 3%

● A 3% loss on a 2 year is approximately a 160 bp immediate increase in rates and a 325 bp increase in rates after 1 year. Loss constraint does not include coupon interest earned.

● Securities have maximum maturity of 5 years

● Available Securities - Treasuries and Agencies


Four One-Year Scenarios

● 1994 Style Bear Flattener – 2-yr. rises 344 bp and 10-year up 190 bp

● 1999 Style Bear Flattener – Much Tamer than ’94 case. Two-yr. rises to 4.11% and 10-year increases to 5.43%

● Bear Steepener – A prolonged bear steepener is unusual, but is not impossible if the fiscal situation deteriorates while the economy weakens. Two-yr. yield at 2.44% and the 10-year is 5.32%

● 12-month Forwards – 12-month forward curves are realized


Current Rates vs. 12 Month Forward RatesSource: Bloomberg, as of 9/16/04

0.00

1.00

2.00

3.00

4.00

5.00

6.00

3 mo. 6 mo. 1 yr. 2 yr. 5 yr. 10 yr.

Perc

ent Y

ield

Current Rates 12 month Forward Rates


Securities Universe

● Treasuries with maturities less than/equal to 5 years

● Bullet/Callable agencies with maturities less than/equal to 5 years

● Step-up agencies – With a 2007 final maturity

● Floating-rate agencies - Five-yr. floating rate at LIBOR – 9 and Four callable cap floaters – 5 NC1 and 5 NC2 with 5% and 5.5% caps


Next Par MarketDescription Coupon Maturity Call Date Yield DurationConvexityAmount Value PercentFreddie Mac Bullet 2.125 11/15/2005 2.423 1.232 0.021 20,000 20,028 20.0%Freddie Mac Bullet 1.875 2/15/2006 2.374 1.468 0.029 17,426 17,466 17.5%FHLB Callable 2.1 10/13/2006 4/13/2005 3.039 2.014 -0.126 20,000 19,758 19.8%Fannie Mae Callable 3.75 9/15/2008 9/15/2005 3.834 2.762 -0.734 17,499 17,709 17.7%Fannie Mae Callable 3.875 11/17/2008 11/17/2005 3.905 2.904 -0.692 5,000 5,039 5.0%Agency Floater (L - 9) 1.602 8/13/2009 3.803 0.253 0.001 20,000 20,000 20.0%

Totals 2.344 2.9 Yrs 3.137 1.587 -0.18 99,925 100,000 100.0%

Effective

OPTIMAL PORTFOLIO (SELECTED BY COMPUTER MODEL)

$100 Million Portfolio:

Two bullet agencies (38%)

Three callable agencies (42%)

August 2009 Libor Floater (20%)

Yield to mat. is 3.14%, compared to 2-Yr. Treas. yield of 2.44%

Duration is 1.6 years compared to 2 yr. T-note of 1.9 years


One- Year Performance Across Scenarios

Scenario Total Principal Interest1994 Style Bear Flattener -0.42 -3.00 2.581999 Style Bear Flattener 1.50 -0.93 2.43Bear Steepener 3.29 0.92 2.37Forward Curves Realized 2.22 -0.24 2.46

% Return


Scenario Total Principal Interest1994 Style Bear Flattener -0.42 -3.00 2.581999 Style Bear Flattener 1.50 -0.93 2.43Bear Steepener 3.29 0.92 2.37Forward Curves Realized 2.22 -0.24 2.46

% Return

One-year Total Return by Scenario

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1994 Style BearFlattener

1999 Style BearFlattener

Bear Steepener Forw ard CurvesRealized

Scenario

Tot

al R

etur

n (%

)


This has been a brief look at some strategies we utilize at JEA.

I’m sure I’ve only touched on a handful of options that are available. I’d like to open it up to the floor to hear some additional ideas that you may be utilizing.

Documents

Techniques for Investing in a Low Interest Rate Environment American Public Power Association Business and Financial Conference September 21, 2004 Presented