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
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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
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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
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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!
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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
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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
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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
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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
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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
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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
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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
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Funds Balance Cash Flow
This sample illustration is being provided to demonstrate the tools on how we analyze cash balances.
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
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Graphing Balances Over Time
This sample illustration is being provided to demonstrate the tools on how we analyze cash balances.
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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
This sample illustration is being provided to demonstrate the tools on how we analyze cash balances.
$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
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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
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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
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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
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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
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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
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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
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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
(%
)
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Inflation
Please see disclosures at the end of this presentation.
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
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Consumer
Please see disclosures at the end of this presentation.
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
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Economic Activity
Please see disclosures at the end of this presentation.
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
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Housing
Please see disclosures at the end of this presentation.
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
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Manufacturing
Please see disclosures at the end of this presentation.
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
(%
)
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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.
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Gross Domestic Product (GDP)
Please see disclosures at the end of this presentation.
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
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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
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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
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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
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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
Please see disclosures at the end of this presentation.
Section | 3 Portfolio Strategies for Managing Risk and Return
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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
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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
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How Does This Work?
Please see disclosures at the end of this presentation.
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:
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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
Quality Coupon Maturity Income Yield Price
$1 million AAA 5% 4/14/2018 $50,000 5% 100.000
Their Bond Credit
Quality Coupon Maturity Income Yield Price
$1 million AAA 6% 4/14/2018 $60,000 6% 100.000
Please see disclosures at the end of this presentation.
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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
Please see disclosures at the end of this presentation.
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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
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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
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Historic Rising Interest Rate Cycles
January 1, 1994 – February 28, 1995 Time Period: 14 Months Cumulative Performance
BAML 0-5 Year US Treasury Index
BAML 0-3 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.
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Historic Rising Interest Rate Cycles
June 1, 1999 - May 31, 2000 Time Period: 12 Months Cumulative Performance
BAML 0-5 Year US Treasury Index
BAML 0-3 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.
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Historic Rising Interest Rate Cycles
June 1, 2004 - June 30, 2006 Time Period: 25 Months Cumulative Performance
BAML 0-5 Year US Treasury Index
BAML 0-3 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.
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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?
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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
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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
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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
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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
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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
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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
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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.
Please see disclosures at the end of this presentation.
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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
Please see disclosures at the end of this presentation.
Chandler Asset Management | 54
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.
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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.
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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
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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.
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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.
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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
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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.
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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.
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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%
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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%
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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
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0 1 year 2 years 3 years
?? 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
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0 1 year 2 years 3 years
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
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Which would you buy?
• 1-year U.S. Treasury at 1.20%
• 2-year U.S. Treasury at 1.34%
Your Turn
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0 1 year 2 years
?? for 1 Year 1.20% for 1 year
1.34% for 2 years
Break-Even Analysis
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1 Year vs 2 Year GAP Analysis
Source: Bloomberg.
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Eligible Investments for Washington Public Funds
Local Government Investment Pools
U.S. Treasury Obligations
Federal Agency and Government Sponsored Enterprise Securities
Commercial Paper
CDs/Bank Deposits
Municipal Bonds
Corporate Notes
Supranational Securities
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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.
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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.
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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.
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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.
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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
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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
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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
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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)
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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)
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Treasury Bill Quotes
Source: Bloomberg as of August 28, 2017.
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Government Sponsored Enterprises (Agencies)
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Discount Note Window
Source: Bloomberg as of August 28, 2017.
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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
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Commercial Paper Ratings
Source: Bloomberg as of August 28, 2017.
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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
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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
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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
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Partial Two to Four Year Treasuries
Source: Bloomberg as of August 28, 2017.
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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
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Agency Bullet Screen
Source: Bloomberg as of August 28, 2017.
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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
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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
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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
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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.
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Sample Corporate Security
Source: Bloomberg as of August 28, 2017.
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Sample Corporate Security
Source: Bloomberg. As of August 28, 2017.
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Municipal Obligations
Taxable and non-taxable issuers
Various structures
• - Serial, term, discounts, premiums
Credit and liquidity issues
Arbitrage safe haven
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Who are “AAA Supranationals”?
Source: The World Bank and Inter-American Development Bank Supranationals 2016 WFOA Presentation
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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
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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.
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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.
Section | 4 Benchmark Development and Implementation
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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
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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
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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?
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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
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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
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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
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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
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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
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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
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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
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Yield and Return Reference Guide
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Yield and Return Reference Guide
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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.
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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.