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The Importance of Breakeven CurvesNISA Investment Advisors, L.L.C.

May 19, 2014

150 North Meramec AvenueSixth Floor

St. Louis, MO 63105(314) 721-1900 phone

(314) 721-3041 faxwww.nisa.com

© 2014 NISA Investment Advisors, L.L.C. All rights reserved. All data presented are as of May 7, 2014, unless otherwise noted. NISA Investment Advisors, L.L.C. is not acting in a fiduciary or advisory capacity in connection with the material presented herein. NISA Investment Advisors, L.L.C. shall not have any liability for any damages of any kind whatsoever relating to this material. See other important disclaimers on the last page.

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Time Horizon (years)

0%

2%

4%

6%

8%

1 2 5 10 30

Why Care About Yield Curves or Term Structure of Interest Rates?

• Provide information about the expected rates of return possible for various investment horizons.

• Basis for assessing “consensus” expectations for future interest rates.

• Source of insight into market expectations about the evolution of the economy.

• Concepts are equally applicable to TIPS/real curves, other sovereign countries, and even bonds subject to default risk (with some added complications).

Expe

cted

Ret

urns

for

Ass

et C

lass

es

• Reasonable starting point when building return expectations for asset classes.

30-year Average Equity

Expected Return = 6.9%

4% Equity Risk Premium

Lock-in a 1.7% return for 5 years by buying and holding a 5-yr Treasury Zero-Coupon bond.

Source: Interest rates in this presentation are based on Treasury Zero-Coupon bonds. Barclays as of 5/7/14.

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Expectations of Future Rates Imply a Current Term Structure

• Yield curve should be consistent with equivalent expected returns on all bonds over the intended holding period.

• Prices in interest rate derivative markets should be consistent with these expectations (e.g., futures/forwards/options are priced to forward rates, not current spot rates).

• Expected rates of return on other asset classes (e.g., corporate bonds, equity) should also be consistent with these expectations.

Getting Started:Ignoring uncertainty for a moment, the term structure should be such that for ANY given holding period the expected returns on ALLmaturities of bonds are equal.

Expectations of future rates imply a term structure of “fair” rates on all bond maturities – even other types of bonds and assets.

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Suppose the 1-year rate is 0.14% today, you expect it to be 0.74% 1 year from today, and 1.94% 2 years from today.

Expe

cted

1-y

ear r

ate

%

Source: Barclays, NISA calculations.

Building a Personal Term Structure From Expectations of Future Rates

Now 1 year from now

2 years from now

0.14%

0.74%

1.94%

0.0%

0.5%

1.0%

1.5%

2.0%

Often called “Forward” rates.

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Let’s examine three ways to invest for a 3 year horizon.

A. Buy and mature 1-year bonds each year.

B. Buy a 2-year bond, hold until maturity, and then buy a 1-year bond.

C. Buy a 3-year bond and hold until maturity.

Source: Barclays, NISA calculations.

Expectations of Future Rates Imply a Current Term Structure (an example)

All three ways should havethe same expected returnA

0.14 + 0.74 + 1.94B

2 • u + 1.94C

3 • v

3-year bond rate = v = 0.94%

2-year bond rate = u = 0.44%

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Alternatively, let’s examine three investment strategies for a two-year horizon.

A. Buy and mature 1-year bonds each year.

B. Buy a 2-year bond and hold until maturity.

C. Buy a 3-year bond and sell it at the end of year two.

Source: Barclays, NISA calculations.

The Term Structure is Consistent For All Horizons

All three ways should havethe same expected return

A0.14 + 0.74

B2 • u

C3 • v – 1.94

2-year bond rate = u = 0.44%

3-year bond rate = v = 0.94%

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De-Constructing a Yield Curve

• “Market” expectations are not directly observable, but the yield curve is.

• To impute Forward Rates do the math in reverse…

Source: Barclays, NISA calculations.

Current Zero-Coupon Treasury Curve

Forward Rates: YX Years

0.00%

1.00%

2.00%

3.00%

4.00%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

y0,1

y0,2

y0,3

y0,4 1.37%

0.94%

0.44%

0.14%

~Total Return on a 3-year Zero

Return in year 3 on a 1-year Zero

Total Return on a 2-year Zero

1-year rate 2 years forward:0.94% + 0.94% + 0.94% = 0.44% + 0.44% + Y Y = 1.94%

X = 0.74%

Simplified Forward Rate Math 1-year rate 1 year forward:

0.44% + 0.44% = 0.14% + X

~Total Return on a 2-year Zero

Return in year 1 on a 1-year Zero

Return in year 2 on a 1-year Zero

8 Source: The Yield Book® from Citigroup.

“Breakeven” Par Yield Changes Derived From the UST Curve

Future Yield Curve as Determined by a Breakeven CalculationU.S. Par Treasury Model Curve as of 05/07/2014

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1

2

3

4

5

1 5 10 30

Rat

e (%

)

Maturity (years)

1-Year Breakeven Curve

+58

+68

+44

+18

At +68 bps and +44 bps, the 5-year and 10-year bond will have equal performance over the next year.

UST Model Par Curve

Current Par-Yield

6 months Out 1 year Out

1-year 0.12% 0.35% +23 0.70% +585-year 1.69% 2.03% +34 2.37% +68

10-year 2.69% 2.91% +22 3.12% +44

30-year 3.42% 3.51% +9 3.60% +18

YTD Change YTD Change

5-Year Breakeven Curve

2 years Out 3 years Out 5 years Out

1.96% +184 2.65% +253 3.57% +3453.01% +132 3.35% +166 3.86% +217

3.50% +81 3.72% +104 3.93% +124

3.76% +34 3.86% +44 3.96% +55

YTD Change YTD Change YTD Change

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Betting on Rates is Betting Against the Breakeven Curve

Huh???... (I thought the longer duration of long bonds means they will underperform if rates go up)

• Long bonds will underperform (overperform) cash when rates increase more (less) than what is reflected in the breakeven curve.

• Rate changes have to more than offset carry differences to cause over or under performance across maturities.

Long bonds aren’t necessarily a bad (good) investment compared to cash when everyone expects rates to rise (fall).

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• Everyone is convinced that short rates will go up in the future (currently there is only one direction for them to go).

The Direction of Future Interest Rates Moves May Be Obvious…

Source: Bloomberg

0%

1%

2%

3%

4%

5%

6%

7%

JAN 2000 JUL 2005 JAN 2011 FUTURE

Only place to go…..

Rat

e %

1-Year T-bill Rate

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• But is everybody convinced they will go up more (or faster) than that determined by breakeven calculations?

Rat

e %

But the Market Prices in These Obvious Moves

Source: Bloomberg and Barclays

5/7/14 Rates Determined from 2012 Curve

1-year 0.69%

5-year 1.73%

10-year 2.83%

0%

1%

2%

3%

4%

5%

6%

7%

JAN 2000 JUL 2005 JAN 2011 JUL 2016 DEC 2021 JUN 2027 DEC 2032 MAY 2038

1-Year Rate Path in 2012

Current Path of 1-Year Rates Determined by a Breakeven Calculation

1-Year Rate Path in 20101-Year T-bill Rate

5/7/14 Rates Determined from 2010 Curve

1-year 4.11%

5-year 5.03%

10-year 5.29%

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• Yield curves reflect expectations of future rateso Current yield curve suggests they are going up and fast.

• Expectations of future rates reflect expectations of future economic conditions.

• Useful for building return expectations for all asset classes.

• A way to compare your views against the market.

Summary Observations on Yield Curves

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How should tactical interest rate views influence the asset allocation?• Tactical interest rate views can be considered another investment.

o A tactical view has a certain expected return.o A tactical view has a certain amount of risk.

• Expected return is calibrated from the amount rates are expected to rise (or fall) beyond breakeven rates.

o A timeline should be attached to the view to establish an expected rate of return.

• Risk can be calculated from option markets and may need to be adjusted by the confidence in the tactical rate view.

• All estimates on the following pages should be viewed as illustrative.

Tactical Interest Rate Views

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Calibrating Tactical Views

Note: Duration is sourced from Barclays as of 05/07/2014.

To assess an interest rate bet, know what you are betting against and the incremental risk.• Suppose your belief is that 30-year bond rates are going to be 3.80%

(30-year bond yield is 3.42% now) 1 year from today.

• A naïve calculation would suggest there is 7.10% of expected return from this view… (by shorting the 30-year bond)

(3.80% - 3.42%) • 18.7 7.1%

Expected FutureRate

Current 30-year bond rate

Duration

• A correct measurement assigns a 3.7% expected return from this view, as the market has already priced in a rate increase to 3.60% (the breakeven rate).

(3.80% - 3.60%) • 18.7 = 3.7%

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Attaching Risk to a Rate View

3.7%

Note: Duration is sourced from Barclays as of 05/07/2014. Option implied rate volatility was calculated as of 05/07/2014, based on data from JP Morgan.

To be precise, a distribution of rates should be attached to any rate view.• A reasonable default assumption may be to use the distribution implied by

the option markets.• Uncertainty in the view may add to risk beyond that already implied by the

market.

Uncertainty about the accuracy of the rate view would increase the risk of the tactical view.(This is a big deal)

If 30-year rates are expected to go up 20

bps more than currently priced into market

prices, then a 3.7% expected return for the next year is attached to

the rate view.

7.1%

Expe

cted

Ret

urn

of

View

on

Rat

es

Risk of Tactical (Rate) View

Naïve measurement of expected return to rate

view

0% 5% 10% 15% 20% 25%12.1%

If option implied rate volatility is ~65 bps and duration is 18.7 years, this suggests a baseline volatility of 12.1%.

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Recognize your active bets!

Implicit bets against breakeven rates can show up in:• Corporate Financing Decisions• Asset Allocation Decisions• Liability Hedging Decisions

• Is the path of rates suggested by breakeven calculations all that different from your expectations?

• Is the current market consistent with your view of what Fed Policy is going to be? (e.g., Do you think the Fed will raise rates to 3.5% in the next 5 years?)

• Breakeven rates may not be genuine market expectations.

Considerations When Betting Against Breakeven Rates

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Breakeven rates may not be true reflections of market expectations because of:• Convexity Value

o Driven by volatility of rateso Convexity will result in a slight downward sloping curve observed today,

even if rate expectations are flat forevero More important for longer bonds

• Risk Premiumso Can be anything, but generally thought to be modestly positive for longer

bonds.

Uncertainty in the Real-World Creates Two Complicating Factors

While these are complicating factors, they do not negate any points made here.

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William J. Marshall, Ph.D. – President• Bill focuses on risk management and meeting client-specific needs. In

addition, Bill serves as a member of NISA’s Investment, Management and Executive Committees.

• He has been involved with the investment industry since 1976.• He co-founded NISA in 1994.• Prior to joining NISA’s predecessor, National Investment Services of

America, Inc.1 in 1991, Bill was with Franklin Savings Association (1988-91), Goldman Sachs & Co. (1985-88) and was a Finance professor at the Olin School of Business at Washington University in St. Louis (1978-85).

• He holds a BSBA, MBA and Ph.D. in Finance from Washington University in St. Louis.

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Disclaimer

This material has been prepared by NISA Investment Advisors, L.L.C. This document is for information and illustrativepurposes only and does not purport to show actual results. It is not, and should not be regarded as investment advice or as arecommendation regarding any particular security or course of action. Opinions expressed herein are current opinions as ofthe date appearing in this material only and are subject to change without notice. Reasonable people may disagree about theopinions expressed herein. In the event any of the assumptions used herein do not prove to be true, results are likely to varysubstantially. All investments entail risks. There is no guarantee that investment strategies will achieve the desired resultsunder all market conditions and each investor should evaluate its ability to invest for a long term especially during periods of amarket downturn. No representation is being made that any account, product, or strategy will or is likely to achieve profits,losses, or results similar to those discussed, if any. No part of this document may be reproduced in any manner, in whole or inpart, without the prior written permission of NISA Investment Advisors, L.L.C., other than to your employees. This informationis provided with the understanding that with respect to the material provided herein, that you will make your own independentdecision with respect to any course of action in connection herewith and as to whether such course of action is appropriate orproper based on your own judgment, and that you are capable of understanding and assessing the merits of a course ofaction. NISA Investment Advisors, L.L.C. does not purport to be experts in, and does not provide, tax, legal, accounting or anyrelated services or advice. Tax, legal or accounting related statements contained herein are made for analysis purposes onlyand are based upon limited knowledge and understanding of these topics. You may not rely on the statements containedherein. NISA Investment Advisors, L.L.C. shall not have any liability for any damages of any kind whatsoever relating to thismaterial. You should consult your advisors with respect to these areas. By accepting this material, you acknowledge,understand and accept the foregoing.