Washington Finance Officers Association...Washington Finance Officers Association Comprehensive Review of the Public Sector Investment Program September 12, 2017 Scott Prickett, CTP

Washington Finance

Officers Association

Comprehensive Review of the Public Sector Investment Program September 12, 2017

Scott Prickett, CTP Executive Vice President,

Portfolio Strategist

Julie Hughes Senior Vice President,

Portfolio Strategist

801 2nd Avenue, Suite 800, Seattle, Washington 98104

Section 1

Section 2

Section 3

Section 4

Chandler Asset Management | 1

Table of Contents

Determining Liquidity and Core Fund Investment Components

Economic and Market Update

Portfolio Strategies for Managing Risk and Return

Benchmark Development and Implementation

Section | 1 Determining Liquidity and Core Fund Investment Components


Why a Cash Flow Analysis?

GFOA Best Practice

“The analysis is intended to measure and assess the government’s ability to meet its needs, to negate the need for any short-term borrowing or liquidation of long-term investments before maturity, and to identify any idle funds, and the duration of that idle period, to determine whether those funds could be invested over that time frame. Cash flow analysis is therefore an essential tool for informed management decision making.”

Source: GFOA


What is a Cash Flow Forecast

Projection of anticipated cash receipts

Projection of anticipated cash disbursements

To create an estimate of investable cash balances

• Liquid funds

• Reserve funds

“Cash” is the operative word in “cash flow forecasting”.

• It is not accruals or budgeted funds

• Only cash is spendable or investable!


Identify Liquid & Reserve Balances

Total balances are trending higher

But balances fluctuate throughout the year

The “Liquid Balances" are established to meet cash needs

The “Core/Reserve Balances" are generally stable and

available for longer-term more diversified investing

Core/Reserve Balances

Liquid Balances

Entity’s Balances 5 Year Period


Objectives of Cash Flow Forecasting

Ensure sufficient liquidity for 6-12 month disbursements

Improve investment earnings by

• Matching sources and uses of funds

• Investing reserve/core funds longer-term and more diversified

• Managing investment risks

o Liquidity risk

o Market risk

Identify short-term cash deficits

Warn of impending budget problems


Annual Cash Flow Forecasts

Estimates monthly cash position

Determines cash available for investments of more than 30 days

Provides a useful monthly overview for investment decision-making

Prepared for this fiscal year and next one to three fiscal years


Creating Annual Cash Flow Forecast

Beginning balance of cash and investments

Monthly revenue projections

Monthly expenditure projections

Projected net change

Projected cumulative balance of cash and investments

Schedule of current investments and coupon payments


Identify Revenues and Expenditures

Major revenues

Property tax

Sales and use tax

User fees

Shared revenues

Non-recurring

Bond proceeds

Other

Major expenditures

Payroll and benefits

Operating expenses

Debt service

Capital projects

Draw-down schedule

Non-recurring

Other


Sources of Information

Historical data from general ledger

Historical data from bank and pool statements

Current year budget

Capital project spending projections

Schedule of investment maturities and coupon payments


Annual Cash Flow - Example

This sample illustration is being provided to demonstrate the tools on how we analyze cash balances.

Beg. Balance Jan-16 Feb-16 Mar-16 Apr-16 May-16

Liquid Fund Balance 95,542,961.00 94,422,259.00 93,301,557.00 92,180,855.00 91,060,153.00 89,939,451.00

Inflow

Sales Tax Collections 3,516,116 3,516,116 3,516,116 3,516,116 3,516,116

Property Tax Collections 10,507,259 10,507,259 10,507,259 10,507,259 10,507,259

Intergovernmental 10,264,623 10,264,623 10,264,623 10,264,623 10,264,623

Other Revenues 7,919,282 7,919,282 7,919,282 7,919,282 7,919,282

Outflows

Personnel (12,778,319) (12,778,319) (12,778,319) (12,778,319) (12,778,319)

Operating & Maintenance (1,199,030) (1,199,030) (1,199,030) (1,199,030) (1,199,030)

Charges for Services (1,597,717) (1,597,717) (1,597,717) (1,597,717) (1,597,717)

Debt Service (1,093,706) (1,093,706) (1,093,706) (1,093,706) (1,093,706)

Other Expenses (6,659,210) (6,659,210) (6,659,210) (6,659,210) (6,659,210)

Actual/Projected Net Change (1,120,702) (1,120,702) (1,120,702) (1,120,702) (1,120,702)

Projected Liquid Balance 94,422,259 93,301,557 92,180,855 91,060,153 89,939,451

Projected Invested Balance 141,565,000 141,565,000 141,565,000 141,565,000 141,565,000

Total Projected Balance 235,987,259 234,866,557 233,745,855 232,625,153 231,504,451

Actual Liquid Balance 85,562,465 203,231,573 124,216,038 201,625,430 150,181,434

Actual Invested Balance 141,565,000 146,645,000 146,645,000 146,645,000 149,645,000

Total Actual Balance 227,127,465 349,876,573 270,861,038 348,270,430 299,826,434

Difference (8,859,794) 115,010,016 37,115,183 115,645,277 68,321,983


Funds Balance Cash Flow


Month Beg Balance Cash Inflows Cash Outflows Net Change

January-16 95,542,961 243,572,384 (253,257,765) (9,685,381)

February-16 85,857,580 143,962,217 (26,607,427) 117,354,790

March-16 203,212,370 41,584,603 (119,098,784) (77,514,181)

April-16 125,698,189 94,526,488 (17,116,990) 77,409,498

May-16 203,107,687 33,277,738 (84,727,349) (51,449,611)

June-16 151,658,076 102,278,132 (76,404,216) 25,873,916

July-16 177,531,992 2,747,874 (36,416,262) (33,668,388)

August-16 143,863,604 32,888,804 (39,493,932) (6,605,128)

September-16 137,258,476 251,833,487 (251,697,780) 135,707

October-16 137,394,183 242,834,825 (242,187,729) 647,096

November-16 138,041,279 232,485,117 (239,719,807) (7,234,690)

Low Balance $85,857,580

High Balance $259,994,231

Prior 12 Months $155,641,677

Prior 36 Months $159,324,198

For Period

Consolidated Cash Flow

Fund Balance

Average Balance


Graphing Balances Over Time



Putting It Together and Forecasting Future Levels

■ Assume future growth rates

■ Factor in seasonality and known future budget events

■ Forecast future liquid and longer-term balances

Total Estimated Balances: $751

Million on June 2020


$0

$100

$200

$300

$400

$500

$600

$700

$800

Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 Jul-19 Jan-20

Millio

ns

Sample Invested Assets FY 2015—FY 2020

Historical Balances

Forecast Balances


Challenges to Developing Forecasts

Systems

• Limitations of computer systems for historical data or data management

Physical structure

• Locations of people

Political

• Elected officials agenda

Inter-departmental communications

• Departments not understanding importance of information


Review and Maintain Cash Flow Forecast

Compare actual versus forecast

Identify reasons for variances

Adjust assumptions if warranted

Follow up with department heads on capital project slippage

Update database for accurate future projection

Retain documentation for future reference


Segmenting the Portfolio for Optimal Structure

Matching maturities to known expenditures

Invests in short-term securities

Average maturity short

Very low volatility

LGIPs and money market instruments

Higher duration to enhance the potential to increase earnings

Longer-term securities

Normally not used for liquidity, but invested in highly marketable securities, in case

Greater volatility

Total Portfolio

Core/Reserve Portfolio Liquidity Portfolio


Revised Code of Washington (RCW) Eligible Investments for Liquidity Portfolio (Typically 1 year and under)

Local Government Investment Pools

Treasury Bills

Agency Discount Notes

Commercial Paper

CDs/Bank Deposits


Revised Code of Washington (RCW) Eligible Investments for Core Portfolio (Typically 5 years and under)

U.S. Treasury Obligations

Federal Agency and Government Sponsored Enterprise Securities

Municipal Bonds

Corporate Notes

Supranational Securities

Section | 2 Economic and Market Update


Major Indicators

Employment report, (1st Friday of month)

CPI: Consumer Price Index, (Mid-month)

PCE: Personal Consumption Expenditures, (End of month)

Retail Sales, (Mid-month)

Institute for Supply Management (ISM) Survey, (1st day of new month)

Quarterly GDP


Employment

Please see disclosures at the end of this presentation.

Source: US Department of Labor Source: US Department of Labor

0

50

100

150

200

250

300

350

MO

M C

han

ge In

(000's

)

Nonfarm Payroll (000's)

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

13.0%

Unemployment Rate

Underemployment Rate (U6)

Unemployment Rate (U3)

Rate

(%

)


Inflation


Source: US Department of Labor Source: US Department of Labor

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

Consumer Price Index (CPI)

CPI YOY % Change

Core CPI YOY % Change

YO

Y(

%)

Ch

an

ge

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

Personal Consumption Expenditures (PCE)

PCE Price Deflator YOY % Change

PCE Core Deflator YOY % Change

YO

Y(

%)

Ch

an

ge


Consumer


Source: US Department of Commerce Source: Federal Reserve

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

Retail Sales YOY % Change

YO

Y (

%)

Ch

an

ge

85

90

95

100

105

110

115

120

125

130

Ind

ex L

evel

Consumer Confidence


Economic Activity


Source: The Conference Board Source: Federal Reserve Bank of Chicago

-0.4%

-0.3%

-0.2%

-0.1%

0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%

Leading Economic Indicators (LEI)

MO

M ( %

) C

han

ge

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

Chicago Fed National Activity Index (CFNAI)

3 M

on

th A

vera

ge


Housing


Source: US Census Bureau Source: S&P

0

200

400

600

800

1000

1200

1400

1600

MO

M C

han

ge (In

Th

ousan

ds o

f U

nit

s)

Housing Starts

Multi Family Housing Starts

Single Family Housing Star ts

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

S&P/CaseShiller 20 City Composite Home Price Index

YO

Y(

%)

Ch

an

ge


Manufacturing


Source: Institute for Supply Management Source: Federal Reserve

46

48

50

52

54

56

58

60

Institute of Supply Management Purchasing Manager Index

Expanding

Contracting

74.0%

75.0%

76.0%

77.0%

78.0%

79.0%

80.0%

Capacity Utilization

Rate

(%

)


The most common indicator of economic growth measures the change in value of

all final goods and services produced in the U.S.

Two consecutive quarters of negative GDP indicates recession

GDP averaged +3.1% from 1947 to 2016, although the -5.1% contraction rate

during “the Great Recession” was the worst in seven decades

GDP has yet to reach +2.5% in any single year during the 7-year recovery cycle,

despite massive stimulus

From 2011-2016, real GDP increased by at an annual rate of +2.0%

Lagging indicator

GDP Statistical Data

Source: U.S. Department of Commerce, Bureau of Economic Analysis Please see disclosures at the end of this presentation.


Gross Domestic Product (GDP)


Source: US Department of Commerce Source: US Department of Commerce

9/16 12/16 3/17 6/17

1.9% 2.0% 1.3% 1.9%

0.4% 1.3% -0.2% 0.3%

0.4% -1.6% 0.2% 0.2%

0.1% 0.0% -0.2% 0.2%

0.0% 0.1% 0.1% 0.0%

2.8% 1.8% 1.2% 2.6%

State and Local (Consumption and Gross

Investment)

Components of GDP

Total

Net Exports and Imports

Personal Consumption Expenditures

Gross Private Domestic Investment

Federal Government Expenditures

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

Gross Domestic Product (GDP)

GDP QOQ % Change

GDP YOY % Change


Potential Reduction in the Fed’s Balance Sheet

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

3,500,000

4,000,000

4,500,000

Securites Held on the Fed's Balance Sheet

Federal Agency Debt

Mortgage-Backed Securities

US Treasuries

$m

illion

s

Source: Bloomberg


Historical Perspective

Source: Bloomberg

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

2 Year Treasury Note


Historical Perspective

Source: Bloomberg

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

US Federal Funds Rate


Incorporating Economic Data into Investment Strategy

Watch for trends in the data, and how the market reacts to data releases

Weigh current yields against future expectations to assist in determining optimal

portfolio structure

Irrespective of your interest rate outlook, stay disciplined and avoid significant

inconsistencies with your portfolio’s benchmark

Risk is something to be managed, not avoided

Diversify portfolio by sector, issuer, and maturity


Section | 3 Portfolio Strategies for Managing Risk and Return


Portfolio Management Is Risk Management

The greater an investor’s exposure to properly diversified risk, the higher the expected return over time

The greater an investor’s exposure to risk, the higher will be the volatility of return from period to period

The objective of “safety” requires establishing risk constraints


Risks

Credit risk

• Will the investment be repaid by the issuer?

• Will the investment be downgraded?

• Are there potential administrative or headline risks?

Liquidity risk

• Is there an active secondary market for the investment?

• Could the secondary market be affected by economic or market developments?

Market risk - exposure to interest rate fluctuations

• Securities prices change as interest rates change - in the opposite direction


How Does This Work?


Par Credit

Quality Coupon Maturity Income Yield Price

$1 million AAA 5% 4/14/2018 $50,000 5% 100.000

You purchase on 4/14/2017:


Impact of Rising Rates

Rates rise on 4/15/2017, and someone else purchases a newly-issued security similar to yours, but with a higher yield:

Your Bond Credit


$1 million AAA 5% 4/14/2018 $50,000 5% 100.000

Their Bond Credit


$1 million AAA 6% 4/14/2018 $60,000 6% 100.000



Impact of Rising Rates

Here is some math to contemplate:

Par Income Yield

Their Bond $1 million $60,000 6%

Your Bond $1 million - $50,000 5%

= $10,000

$1,000,000 -$10,000 $990,000

Your security would have to be sold at approximately $990K to make up for

the rise in interest rates



Snapshot of the Impact of Rising Rate Levels

Maturities and new investments will be invested at higher yield levels increasing the earnings of the portfolio

Budgets will benefit with increased cash flow

Portfolio returns will be negatively impacted by rising rates

Interest Rate Change

3 Month Horizon 12 Month Horizon

US Treasury US Treasury

1 Year 2 Year 3 Year 1 Year 2 Year 3 Year

- 10 BPs 1.54 2.02 2.52 1.25 1.43 1.63

No Change 1.25 1.33 1.44 1.25 1.33 1.44

+ 25 BPs 0.51 (0.38) (1.22) 1.25 1.08 0.95

+ 50 BPs (0.23) (2.08) (3.85) 1.25 0.84 0.47

+ 100 BPs (1.69) (5.42) (8.99) 1.25 0.35 (0.50)

Source: Bloomberg


Income is an Important and Dependable Source of Return - Acts as a cushion during periods of price decline

Source: Bloomberg. Past performance is not indicative of future results. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. Please see attached Bank of America Merrill Lynch index disclosures for details.

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

11.00%

12.00%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Yield (Income Return) vs. Total Return by Year

0-3 Yr BAML Treasury Income Return

0-5 Yr BAML Treasury Income Return

0-3 Yr BAML Treasury Total Return

0-5 Yr BAML Treasury Total Return


Historic Rising Interest Rate Cycles

January 1, 1994 – February 28, 1995 Time Period: 14 Months Cumulative Performance

BAML 0-5 Year US Treasury Index


Source: Bank of America Merrill Lynch Indexes; Bloomberg. Past performance is not indicative of future results. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. Please see attached Bank of America Merrill Lynch index disclosures for details.



June 1, 1999 - May 31, 2000 Time Period: 12 Months Cumulative Performance






June 1, 2004 - June 30, 2006 Time Period: 25 Months Cumulative Performance





How To Begin

What are the goals of the investment program?

What are investment constraints?

What are risk tolerances?

How can investments be structured to meet those goals?

What experience does staff have?


Considerations

Sources of return

• Coupon income

• Reinvestment income

• Capital gains and losses

Factors that affect gains and losses

• Changes in interest rates

• Changes in the shape of the yield curve

• Changes in spreads between sectors

• Changes in the spread for a particular bond

• Changes in OAS for bonds with options

Passive & Active strategies


Passive Management

Passive Management Requires

• Low to no market analysis

• Minimum resources

Strategies

• Liquidity pool

• Cover next disbursement

• Asset/liability matching

• Maturity ladder

Objective

• Buy and Hold

• Routine discipline to meet cash flow needs


Active Portfolio Management

Strives to achieve a return equal to or in excess of market return by building and maintaining a portfolio structure with optimal exposure to risk through:

• Duration management

• Yield curve placement

• Sector weighting decisions

• Individual security selection

• Portfolio rebalancing and realignment

Active management requires resources and expertise to perform market analysis such as:

• Yield Curve Analysis

• Credit Analysis

• Spread Analysis


Benefits of a Strategy

Decision Making Strategy Tools

Improved Process

Improved Communication

Monitoring

& Accountability

• Duration is the primary contributor for portfolio returns

• Asset (Sector) Allocation

• Yield Curve Positioning

• Efficient

• Pre-determined strategy

• Accountable

• Same Vocabulary

• Board, Committee and Staff

• Consistent over interest rate cycles

• Understand outcome of decisions

• Tracking of decisions

• Value added can be measured


Positioning securities along the yield curve to capture value across maturities

Portfolio Strategies for Managing Risk and Return

Portfolio Duration

Sector Allocation

Term Structure

Security Selection

Constraining portfolio duration relative to the benchmark

Strategic allocations to key sectors, with value-based rotation

Selecting bonds that we believe are undervalued and offer the greatest potential for risk-adjusted return


Facts About Duration

Duration is a direct measure of exposure to market risk in a fixed maturity

bond

Duration is a better measure of the sensitivity to changes in interest rates

than term-to-maturity

Duration is a close approximation of the percent change in the price of a

bond for a given change in yield

Securities with equal maturity dates may not have equal interest rate risk

- duration quantifies the difference


Market risk is best measured as Modified Duration for bullet securities

Invest in $1MM Tsy. 0.75% 2/15/19

0.5 1.0 1.5 2.0 2.5 3.0 Years

$3.750 $3.750 $3.750 $3.750 $3.750

$1,003,750

Duration 2.95 yrs.



Impact of Duration

Portfolio #1: $50 million and 2.0 duration

If rates increase 2.25%, then ($2,250,000) Loss

$50 million x 2 x 2.25% x -1 = $50 million x -4.5% = ($2,250,000)

If rates decrease 2.25%, then $2,250,000 Gain

$50 million x 2 x 2.25% x 1 = $50 million x 4.5% = 2,250,000

Portfolio 2 = $50 million and 1.0 duration

If rates increase 2.25%, then ($1,125,000) Loss

$50 million x 1 x 2.25% x -1 = $50 million x -2.25% = ($1,125,000)

If rates decrease 2.25%, then $1,125,000 Gain

$50 million x 1 x 2.25% x 1 = $50 million x 2.25% = $1,125,000



Duration Management

Targeting duration of benchmark within a range (e.g. + 10% of benchmark)

• Bank of America Merrill Lynch 0-3 Year US Treasury Index

• Index duration approximately 1.40 years

• Bank of America Merrill Lynch 0-5 Year US Treasury Index

• Index duration approximately 2.20 years

Source: Bank of America Merrill Lynch Indexes. Please see attached Bank of America Merrill Lynch index disclosures for details.


Update Benchmarking Study BofA ML 0-3 and 0-5 Year US Treasury

BofA ML 0-3 Year US Treasury BofA ML 0-5 Year US Treasury

0-6 months 15.30% 10.16%

6-12 months 17.37% 11.53%

1-3 years 67.33% 44.69%

3-5 years 33.63%

5-10 years

Treasury 100.00% 100.00%

Agency

Corporate

Modified Duration 12/31/2016 1.43 2.15

10 Year Annualized Total Return 1.78% 2.37%

10 Year Standard Deviation 2.28% 2.76%

Sharpe Ratio 0.43 0.57

Qualitative Risk Objective 12/31/1992-12/31/2016 06/30/1992-12/31/2016

Negative Quarterly Return Occurrences

10 16

Negative Return For Year Occurrences 0 2

Worst Year Total Return 0.00% -0.12%

Source: Bank of America Merrill Lynch Indices. Please see Benchmark disclosures; Past performance is not indicative of future results. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index.


Yield Curve and Term Structure Strategies

Bullet: Bond maturities in a portfolio are concentrated at one point on the curve.

• Strategy utilized when expectations are for a steepening curve

Barbell: Bond maturities are concentrated at extreme maturities on the curve.

Typically on the short and long end of a portfolio strategy range.

• Strategy utilized when expectations are for the curve to flatten

Ladder: Equal amounts at each maturity. Typically equal amounts maturing each

month.

• Neutral relative to yield curve expectations


Portfolio Structure - Bullet

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

Portfolio Structure - Bullet

This sample illustration is being provided to demonstrate the Bullet portfolio structure.


Portfolio Structure - Barbell

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

Portfolio Structure - Barbell

This sample illustration is being provided to demonstrate the Barbell portfolio structure.


Portfolio Structure - Laddered

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

Portfolio Structue - Laddered

This sample illustration is being provided to demonstrate the Ladder portfolio structure


Duration Distribution

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

0 - 0.25 0.25 - 0.50 0.50 - 1 1 - 2 2 - 3 3 - 4 4 - 5 5+

Sample Client BAML 1-5 Yr US Treasury/Agency Index

Portfolio Compared to the Benchmark as of April 30, 2017

0 - 0.25 0.25 - 0.50 0.50 - 1 1 - 2 2 - 3 3 - 4 4 - 5 5+ Portfolio 3.4% 3.0% 13.8% 18.4% 20.4% 21.2% 19.8% 0.0% Benchmark* 0.1% 0.1% 1.9% 31.9% 28.5% 22.0% 15.5% 0.0% *BAML 1-5 Yr US Treasury/Agency Index

Based on a representative portfolio as of 4/30/17. This sample illustration is being provided to demonstrate the tools on how we segment duration distribution versus its benchmark. Please see disclosures for BAML 1-5 Yr US Treasury/Agency Index. Past performance is not indicative of future results.


1.31% 1.20%

0.00%

0.50%

1.00%

1.50%

2.00%

0 1 2 3 4 5

U.S. Treasury Yield Curve

12/31/2015

12/30/2016

“Rolling Down” the Curve

Purchase a $3MM, 3-Year UST on

12/31/2015 at Par

One year later, it is a 2-YR UST, but new UST in the 2-YR range

only yield 1.20%

Yiel

d

Years

Source: Bloomberg.


Roll Down - Doing the Math

Purchase UST on 12/31/2015 One Year Later… …Total Return After One

Year

Par Value: 3,000,000 UST Now a 2-YR Security Earned Income: $39,300

Maturity: 12/31/18 (3 Years)

Purchase Yield: 1.31% Price Appreciation: 9,690

Price: $100.000 Market Yield: 1.20% Total $ Return: $48,990

Yield to Maturity: 1.31%

Market Price: $100.323 Total % Return: 1.63%


Break-Even Analysis (GAP Analysis)

Yields expected to rise in coming months.

What should you buy?

Which would you buy?

• 1-year investment at 1.20%

• 3-year investment at 1.46%


What rate do you need to earn for the last two years to break even?

0 1 year 2 years 3 years

?? for 2 years 1.20% for 1 year

1.46% for 3 years

Break-Even Analysis



?? for 2 years 1.20% for 1 year

1.46% for 3 years

1.46 * 3 years = (1.20% * 1 year) + (x * 2 years)

4.38 = 1.20 + 2x

3.18 = 2x

X = 1.59

Break-Even Analysis



1.59% for 2 years 1.20% for 1 year

1.46% for 3 years

Will rates rise enough to get a 2 year investment at 1.59% one year from now?

Break-Even Analysis


Which would you buy?

• 1-year U.S. Treasury at 1.20%

• 2-year U.S. Treasury at 1.34%

Your Turn


0 1 year 2 years

?? for 1 Year 1.20% for 1 year

1.34% for 2 years

Break-Even Analysis


1 Year vs 2 Year GAP Analysis

Source: Bloomberg.


Eligible Investments for Washington Public Funds




Commercial Paper

CDs/Bank Deposits

Municipal Bonds

Corporate Notes



Sector Allocation

Municipal Bonds 5.4%

US Treasury 28.7%

Agency 65.9%

Sample Portfolio Allocation

Sector Allocation is based on a representative portfolio as of 6/30/17.


Historical Treasury vs Agency Spreads

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

12

/1/1

99

8

6/1

/19

99

12

/1/1

99

9

6/1

/20

00

12

/1/2

00

0

6/1

/20

01

12

/1/2

00

1

6/1

/20

02

12

/1/2

00

2

6/1

/20

03

12

/1/2

00

3

6/1

/20

04

12

/1/2

00

4

6/1

/20

05

12

/1/2

00

5

6/1

/20

06

12

/1/2

00

6

6/1

/20

07

12

/1/2

00

7

6/1

/20

08

12

/1/2

00

8

6/1

/20

09

12

/1/2

00

9

6/1

/20

10

12

/1/2

01

0

6/1

/20

11

12

/1/2

01

1

6/1

/20

12

12

/1/2

01

2

6/1

/20

13

12

/1/2

01

3

6/1

/20

14

12

/1/2

01

4

6/1

/20

15

12

/1/2

01

5

6/1

/20

16

12

/1/2

01

6

6/1

/20

17

1-3 Year US Treasury Index vs 1-3 Year US Bullet Agency Index

1-3 Year US Treasury vs 1-3Year US Bullet Agency

Source: Bloomberg.


Current Treasury Agency Curves

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

Difference in Yield at Historic Lows

US Agency US Treasury

Source: Bloomberg.


Historical Credit Spreads to U.S. Treasuries

0

50

100

150

200

250

12/31/2009 12/31/2010 12/31/2011 12/31/2012 12/31/2013 12/31/2014 12/31/2015 12/31/2016

BAML 1-5 AAA-AA Foreign Govt and Supranational BAML 1-5 Bullet Agency

BAML 1-5 AAA-A U.S. Corporate BAML 1-5 AAA-AA Municipal

Source: Bloomberg. Past performance is not indicative of future results. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. Please see attached Bank of America Merrill Lynch index disclosures for details.


Revised Code of Washington (RCW) Eligible Investments for Liquidity Portfolio (Typically 1 year and under)


Treasury Bills

Agency Discount Notes

Commercial Paper

CDs/Bank Deposits


Local Government Investment Pool

Pooling Public Funds

• State-operated pool

• County-operated pool

Benefits

• Professional Management

• Daily Liquidity

• Normally constant NAV (Net Asset Value) of $1.00

• Economies of scale

• Diversification

• Services

Enrollment • Prospectus

• Resolution

• Procedures for deposits and withdrawals


Money Market Instruments

Discount securities (no coupon)

• Treasury bills

• Agency discount notes

• Commercial paper

Certificates of deposit

Treasury and Agency Notes/Bonds whose remaining maturity is 13 months or less


Discount Securities

100.00

99.854

$1,000,000

6 Month 0.29% Disc 0.295% BEY

$998,541

{$1,459}

(T-Bills, Agency Discount Notes, CP, BAs)


Treasury Bills

Considered the “risk-free” investment

Zero coupon; trade at discount to par

Maturities of 1 year or less

• 4-week; 3- & 6-month; 1-year; cash management

Auctions

• 3 & 6-month auctioned every Monday*

• 4-week auctioned every Tuesday

• 1-year auctioned every 4 weeks

• Cash management bill auctioned as needed

Settlement & maturities Thursdays (unless a holiday then next business day)


Treasury Bill Quotes

Source: Bloomberg as of August 28, 2017.


Government Sponsored Enterprises (Agencies)


Discount Note Window



Commercial Paper

Unsecured promissory note

Maximum maturity 270 Days

Discounted (most common) or coupon security

Typically held to maturity

Washington State Investment Board Guidelines

• Highest short-term credit rating category of any two NRSROs at time of purchase (highest rating from all who rate)

• Maturity longer than 100 days must have underlying long-term senior unsecured credit rating in one of the three highest rating categories of an NRSRO

• Maximum 3% per issuer

• Purchased in the secondary market


Commercial Paper Ratings



Certificates of Deposit

Restrictions on CDs - Public Depositories

• Issued by financial institutions qualified by the Washington Public Deposit Protection Commission

Non-Negotiable

Interest calculations

• 360 or 365 day years

• Compounding

Sold at par or at a discount

Illiquid

Early Redemption Penalties


Revised Code of Washington (RCW) Eligible Investments for Core Portfolio (Typically 5 years and under)



Municipal Bonds

Corporate Notes



U.S. Treasury Coupons

Notes

• Original maturity 10 years & under

• 2, 3, 5, 7 & 10 year notes

Bonds

• Original maturity greater than 10 years

• 30 year bond

Structure

• Mature either the 15th or last day of the month

• Fixed coupons

• Semi-annual payments

• Coupons multiples of 1/8


Partial Two to Four Year Treasuries



GSE (“Agency”) Securities

GSE’s - Government Sponsored Enterprises

• Federal National Mortgage Association (“Fannie Mae”)

• Federal Home Loan Mortgage Corp (“Freddie Mac”)

• Federal Home Loan Banks (FHLB)

• Federal Farm Credit Banks (FFCB)

Usually simply referred to as “Agencies”

No explicit government guarantee

Issued: Auctions, Syndicates, Reverse Inquiry

Senior debt: Aaa/AA+

Various structures

“Bullets,” discount notes, callables, step-ups

Liquidity considerations for small issues


Agency Bullet Screen



Callable Agency Securities

Issuer has right to redeem the security on a given date or dates - call date(s)

The value of the “call option” varies depending on the following factors:

• Current market rates relative to the security’s coupon rate

• Time remaining to the call date

• Call type

What are the risks?

• Issuers exercise call options in periods of declining interest rates causing you to reinvest

proceeds at lower yields

• Issuers do not exercise call option when rates rise reducing your ability to reinvest at higher

yields


Corporate Securities

A security obligation of a corporation, either secured or unsecured that pays

interest periodically (usually semi-annually), and returns principal at maturity

A direct loan from an investor to a corporation

Investing in corporate obligations can improve income from investments

BUT…as with all investments, the potential for increased return goes hand-in-

hand with the assumption of more risk

Credit Research and Analysis

• Fundamental Analysis (balance sheet, income statement, ratios, competitive strategy,

management strength, etc.)

• Relative Value Analysis – spread levels

• Diversification between sectors and issuers


Resources Necessary for Investing in Corporate Bonds

Independent pricing source

Access to several corporate dealers for competitive transactions

Timely, independent access to ratings and rating services actions

Credit analysis capabilities

Independent sources for credit research

Policy regarding sales due to credit downgrades


Elements of Credit Methodology

The 4 “C’s” of Credit Evaluation

• Capacity – ability to pay debt obligations

• Character – willingness to pay debt

• Collateral - assets that back the issuer’s debt.

• Covenants – legal protections provided to bondholders.


Sample Corporate Security



Sample Corporate Security

Source: Bloomberg. As of August 28, 2017.


Municipal Obligations

Taxable and non-taxable issuers

Various structures

• - Serial, term, discounts, premiums

Credit and liquidity issues

Arbitrage safe haven


Who are “AAA Supranationals”?

Source: The World Bank and Inter-American Development Bank Supranationals 2016 WFOA Presentation


What is a Supranational?

Supranationals are international institutions that provide development financing, advisory services

and/or other financial services to their member countries. Their goal is to achieve improving living

standards through sustainable economic growth.

A supranational entity is formed by two or more central governments with the purpose of

promoting economic development for the member countries. Supranational institutions finance

their activities by issuing debt, such as supranational bonds. Similar to the government bonds, the

bonds issued by these institutions are considered very safe and have a high credit rating.

Example of Supranational organizations are:

• The World Bank

• International Bank of Reconstruction and Development Bank

• International Finance Corporation

• Inter-American Development Bank

• European Bank of Reconstruction and Development Bank


Supranationals for Local Governments

RCW permits supranationals with the U.S. government as the largest shareholder*:

• Inter-American Development Bank

• International Bank for Reconstruction and Development

• International Finance Corporation

• Asian Development Bank

The opportunities these securities provide:

• High quality AAA issuers to further diversify the portfolio

• A potential replacement for shrinking supply of US Agency securities

• Yield pickup of approximately 5-15 basis points to similar US Agency securities

*As of December 31, 2016.


Supranational Facts

International Bank for Reconstruction and Development (IBRD)

International Finance Corporation (IFC)

Inter-American Development Bank (IADB)

Development purpose Global source of funding to member

governments Global source of finance for private enterprise in developing countries.

Regional source of development finance for Latin America and the

Caribbean.

Membership Global –188 members Global–184 members

Regional(Latin America and the Caribbean) -48

Year established 1944 1956 1959

Largest shareholder United States –16% United States –24% United States –30%

Balance Sheet USD 359 billion USD 84.1 billion USD 97 billion

Annual Funding Program USD 40-50 billion USD 18 billion USD 21 billion

SEC exemption* Yes Yes Yes, but still required to file certain

information with SEC under SEC Regulation IA

Act of Congress Authorizing US membership

Bretton Woods Act 22 USC 286 et. Seq.

International Finance Corporation Act 22 USC282 et. Seq.

Inter-American Development Act 22 USC 283 et. seq.

Type of Lending Preferred Creditor Status (PCS) Lending to Sovereigns or Sovereign guaranteed

only

Lending to or equity investment in Emerging Market private sector

entities

PCS Lending to Sovereign or Sovereign guaranteed (approximately

94%) plus Lending to private sector

Part of World Bank Group Yes Yes No

Source: www.worldbank.org and www.iadb.org. Please see disclosures at the end of this presentation.

http://www.worldbank.org/

http://www.iadb.org/

Section | 4 Benchmark Development and Implementation


What is a Benchmark?

An unmanaged portfolio that includes the types and maturities of securities that

are permitted in the investor’s policies

The benchmark represents the appropriate level of risk for the portfolio

Examples:

• S&P 500 Index for stocks

• 0-3 year Treasury

• Index of 1-3 year government notes

• Index of 1-5 year government and corporate securities rated “AA” or higher


Why Benchmark?

Compare Returns:

• How is your portfolio performing relative to the benchmark?

Compare Risk:

• Is your portfolio’s volatility within expectations versus benchmark?

Accountability/Guidelines

Improves Communication


Representative of assets in which the fund may invest:

Includes only real securities that are available for sale

Constructed in a disciplined and objective manner

Formulated from publicly available information

Exhibit similar risk characteristics as the investment objectives

The information derived from both the benchmark and the portfolio should use the same

calculation methods

Known in advance

What Makes a Good Benchmark?


Provides discipline and guidance to portfolio manager in making investment

decisions

Helps control risk exposure in the portfolio

• Portfolio structure properly reflects risk tolerance of agency as defined by selected

benchmark

o Duration

o Credit

Manages the returns to expectations:

• Performance will be close to the benchmark return

• Variance of return will be due to variance in duration, sector weighting and maturity

structure

Provides clarity of strategy in communication to board

What a Benchmark Does


Primary criteria:

• Compliance with policy and statutes

• Risk tolerances; risk profile

• Growth objectives

Additional criteria:

• Allowable types of securities

• Time horizon of portfolio- Core Fund

• Maturity constraints of portfolio- Investment policy

Selection of Appropriate Benchmark


Evaluating Return

How is return measured?

• Yield

Income

• Realized Return/Book Value Return

Income +/- realized gains (losses)

• Total Rate of Return

All income earned +/- realized and unrealized gains and losses


Yield and Realized Return/Book Value Return

Yield: income from current and new investments + projection of income from

reinvestment

• Used to project income for line item in next year budget

• To update income projection in current budget

• And often, to compare portfolio return to a yield benchmark

Realized Return/Book Value Return

• Adds realized gains and losses

• No “traditional or standardized” realized return benchmark


Total Rate of Return

Total Rate of Return (TRR) measures the outcome of the portfolio

Incorporates all three elements of return:

• Interest income

• Market value gains and losses—realized and unrealized

• Reinvestment of interest

Agreed upon industry standard

Uniformly applied to all portfolios

To provide comparable, consistent results


Total Rate of Return: A Tool for Risk Management

Total rate of return in a vacuum does not tell us much

The appropriate level of risk must be established

• Cash flow needs

• Tolerance for market value fluctuations

• Need for return

The characteristics of that level of risk is represented with a benchmark


Total Rate of Return Aids Performance Management

Always put your performance in perspective, given market conditions

Can manage the governing body’s expectations

Demonstrates how the interest rate environment is impacting the portfolio

Measures the financial health of the portfolio

Our objectives in alignment with our tolerance for market volatility/risk


Yield and Return Reference Guide


Yield and Return Reference Guide


Disclosures

The information herein is provided for informational purposes only and should not be construed as a recommendation of any security, strategy or investment product, nor an offer or solicitation for the purchase or sale of any financial instrument. References to investment indices are for informational purposes and do not imply that managing portfolios to those styles will achieve comparable returns. Indices do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical performance results. Indices are unmanaged, and one cannot invest directly in an index. Past performance is not indicative of future results.

Any forecasts, forward-looking statements and assumptions are inherently limited and should not be relied upon as an indicator of future results. Any opinions and views constitute judgments made by the author at the date of this presentation and may become outdated or superseded at any time without notice. Any statements concerning financial market trends are based on current market conditions, which will fluctuate.

Economic factors, market conditions and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark. The data contained in this presentation is the property of those providers, which were obtained from sources believed to be reliable, but are subject to change at any time at the provider’s discretion.

Fixed Income investments are subject to interest, credit and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions, especially during periods of rising interest rates.


Disclosures

Bank of America Merrill Lynch 0-3 Treasury Index The Bank of America Merrill Lynch Treasury 0-3 Year Index is comprised of U.S. Treasury securities issued by the U.S. Government. All securities in the index must have fixed coupon rates and a maturity not greater than three years regardless of any call features. Bank of America Merrill Lynch 0-5 Treasury Index The Bank of America Merrill Lynch Treasury 0-5 Year Index is comprised of US Treasury securities issued by the US Government. All securities in the index must have fixed coupon rates and a maturity not greater than five years regardless of any call features. Bank of America Merrill Lynch 1-5 Year US Treasury & Agency Index The Bank of America Merrill Lynch 1-5 Year US Treasury & Agency Index is comprised of securities issued by entities of the US Government, including the US Treasury and Agencies such as Fannie Mae, Resolution Trust Funding and the Federal Home Loan Bank. Corporate or foreign debt guaranteed by the US Government, such as USAID securities, may also be included in the index. All securities in the index must be investment grade, have fixed coupon rates or rates that change according to a predetermined schedule, and have at least one year but not greater than five years to maturity regardless of any call features. Bank of America Merrill Lynch US Corporate 1-5 Year AAA-A Index The Bank of America Merrill Lynch US Corporate 1-5 Year AAA-A Index is comprised of securities issued by Corporations having a rating of no less than ‘A’ by a NRSRO (National Recognized Statistical Ratings Organization). All securities in the index must have a fixed coupon rate or rates that change according to a predetermined schedule, and must have at least one year but not greater than five years to maturity regardless of any call features. Bank of America Merrill Lynch 1-5 Year US Treasury & Agency Index (1-5 Year Government Benchmark) The BofA/ML 1-5 Year US Treasury & Agency Index is comprised of securities issued by entities of the US Government, including the US Treasury and Agencies such as Fannie Mae, Resolution Trust Funding and the Federal Home Loan Bank. Corporate or foreign debt guaranteed by the US Government, such as USAID securities, may also be included in the index. All securities in the index must be investment grade, have fixed coupon rates or rates that change according to a predetermined schedule, and have at least one year but not greater than five years to maturity regardless of any call features.

Documents

Washington Finance Officers Association...Washington Finance Officers Association Comprehensive Review of the Public Sector Investment Program September 12, 2017 Scott Prickett, CTP