Active Management of the Debt Portfolio

Remy Hathaway, Prager & Co., LLC Sherry Mondou, University of Puget Sound Thomas Richards, University of Missouri System

Prager & Co. LLC, Financial Advisor to two Very Different Institutions

University of Missouri

University of Puget Sound

Policy, Strategy and Implementation

Comprehensive policy covering debt, derivatives and liquidity Short—so people will read it Establishes risk framework, then optimizes cost Ongoing communication strategy at enterprise level

Financing strategy driven by (in order) 1. Mission 2. Existing portfolio and institutional risk 3. Transactional economics

Evaluation of outcomes—including extreme ones

Strategy – Risk-First Framework

Most debt policies use phrase “risk-adjusted cost of capital” or “risk tolerance” but do not quantify it

Starting with risk—especially tail events—allows the institution to elect where and how much risk is acceptable Taking into account other institutional risks (e.g. market

rate risk and tax risk)

Compensation for risk must be considered. Is it worth it, and where else might we be better compensated for risk?

“Essentially, all models are wrong, but some are useful.” -George E.P. Box

Risk Assessment - Categorization

Debt Service Risk: “How much different could debt service be from what’s in the budget?” Market Rate Risk Credit Risk Tax Risk (and Basis Risk)

Liquidity Repricing Risk Counterparty

Performance Risk

Liquidity Risk: “How much of the balance sheet is exposed to the debt portfolio? Reissuance/Remarketing Risk Liquidity Facility Renewal/Failure Risk Swap Collateralization Risk Swap Termination Risk

One More Risk – Brain Damage Risk

How much management and staff time is dedicated to managing the debt portfolio? Issuance/refundings Renegotiation of liquidity facilities Managing puts/liquidity events

How much board/regent/trustee time is spent?

Is there an appropriate return on invested time? On future

expected demands on time?

Debt Service Risk – From Complex to Basic Max

Rate Ratio Change Impact % of O.E. Market Rate Risk

195 Tax-Exempt Variable-Rate 0.11% 2.9% 5.6 75 Taxable Variable-Rate 0.40% 4.6% 3.4

-165 LIBOR Fixed Payer Receipt 0.15% 67% 3.1% -5.1 LIBOR Fixed Receiver Payment SIFMA Fixed Payer Receipt SIFMA Fixed Receiver Payment Basis Swap Payment Basis Swap Receipt

4.0 0.6% Tax Risk

195 Tax-Exempt Variable-Rate 1.7% 3.3 SIFMA Fixed Payer Receipt SIFMA Fixed Receiver Payment Basis Swap Payment Basis Swap Receipt BABs Subsidy

3.3 0.5% Credit Risk

195 Tax-Exempt Variable Rate 0.11% 4.0% 7.8 75 Taxable Variable Rate 0.40% 7.0% 5.3

13.1 2.1% $ Millions % of O.E. Liquidity Repricing Risk Maximum One-Year Risk: 15.1 2.4%

100 Liquidity Facility 2.0% 2.0 0.3% 50% of Maximum 11.2 1.8% 25% of Maximum 5.6 0.9%

Counterparty Performance Risk -165 Swap Notional 0.0 0.0%

0%

1%

2%

3%

Market RateRisk

Tax Risk

Credit RiskLiquidityRepricing Risk

CounterpartyPerformance

Risk

Max Debt Service Risk Components (as percentage of 1 Year Operating Expenses)

Measuring Risk in Context

$ Millions % of O.E.Maximum One-Year Risk: 4.6 4.6%50% of Maximum 2.3 2.3%25% of Maximum 1.2 1.1%

0%

1%

2%

3%

4%Market Rate Risk

Tax Risk

Credit RiskLiquidityRepricing Risk

CounterpartyPerformance

Risk

Max Interest Rate Risk Components(as percentage of 1 Year Operating Expenses)

$ Millions % of E.R.75.2 49.5%50.1 33.0%37.5 24.7%25% of Maximum

Maximum Three-Year Risk:50% of Maximum

0%

10%

20%

30%

40%Reissuance Risk

Facility RenewalRisk

CollateralizationRisk

Swap TerminationRisk

Max Liquidity Risk Components(as percentage of Expendable Resources)

Example: Collateralization/Termination Exposure

How useful are historical results?

(70%)

(60%)

(50%)

(40%)

(30%)

(20%)

(10%)

0%

10%

1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013

Backward-Looking Maximum Percentage Declines in 10-Year Treasury

From One-Year Prior

From Three Years Prior

5/30/84-8/21/86: 51% decline within

three years

4/17/85-4/16/86: 38% decline within one year

Source: Federal Reserve

Projecting Short-Term Rates using Fed Funds (Fed Funds History + Projections = Potential Outcomes)

30Y Low:4.51% Average: 5.21%

30Y High: 7.53%

0%

5%

10%

15%

20%

1954

1959

1964

1969

1974

1979

1984

1989

1994

1999

2004

2009

Source: Federal Reserve

0%

1%

2%

3%

4%

5%

6%

7%

12/3

1/20

1212

/31/

2013

12/3

1/20

1412

/31/

2015

12/3

1/20

1612

/31/

2017

12/3

1/20

1812

/31/

2019

12/3

1/20

2012

/31/

2021

12/3

1/20

2212

/31/

2023

12/3

1/20

2412

/31/

2025

12/3

1/20

2612

/31/

2027

Fed Funds Expected Rate Range (6/19/2013 Release)

Most hawkish governor up to highest 30-year average

Median governor up to 60-year average

Most dovish governor up to lowest long-term target rate.

“It is better to be vaguely right than exactly wrong.” -Carveth Read

The Experience of Two Very Different Institutions, one large…

University of Missouri System Public research university with 4

campuses + health system Enrollment 75,000 Endowment $1 billion $2.7 billion operating expenses $1.3 billion debt outstanding Aa1 / AA+ Treasurer and Interim VP

Finance

Policy / Governance – University of Missouri

Recently adopted comprehensive policy for debt and derivatives management Outlines authority, responsibilities and reporting

Board approves any issuance of debt Board receives quarterly comprehensive reporting on portfolio Board receives annual evaluation of debt capacity, given anticipated

debt-financed projects within a five year timeframe

Establishes framework for evaluating risks in debt portfolio as well as any new issuance of debt Board receives annual debt portfolio risk assessment

Policy does not define specific limits, giving maximum flexibility to management team and Board.

Strategic Restructuring – University of Missouri

Recently launched $350 million commercial paper program capable of issuing either taxable or tax exempt paper.

CP provides particular flexibility during construction phase of capital projects, allowing for low cost “just-in-time” financing with ability to convert to permanent financing at any time.

CP program was structured in a manner that minimizes our need to provide daily self-liquidity by establishing a $100 million cap on CP maturing within any seven day time period. Even with $350 million in CP outstanding, daily liquidity

requirement remains $100 million due to the cap.

Strategic Restructuring – University of Missouri

Prior to CP Program $100 million weekly reset VRDBs $120 million daily reset VRDBs $220 million daily self-liquidity requirement

Post CP Program Launch $100 million weekly reset VRDBs remain outstanding $120 million daily reset VRDBs converted to CP $60 million new CP issued $200 million daily self-liquidity requirement

Total variable rate debt increased from $220 million to $280 million, yet daily self-liquidity requirement decreased from $220 million to $200 million

Strategic Restructuring – University of Missouri

By reducing our daily self-liquidity requirement and essentially capping it at $200 million, we can better optimize the investment of our working capital to generate additional return.

Opportunity cost of holding daily self-liquidity could easily be 100-300bps when compared to other alternatives.

Our General Pool (essentially working capital) averages $1.7 billion throughout the year. Optimization of risk-adjusted returns is a top priority as investment income helps fund operations.

The Experience of Two Very Different Institutions, one small…

University of Puget Sound, Tacoma, WA National residential liberal

arts college Enrollment 2650 Operating budget $120

million Endowment $275 million $75 million debt outstanding A1/A+ rating VP Finance & Administration

with broad portfolio

Policy / Governance – University of Puget Sound

First adopted debt policy in 2005; now refined annually Provides general framework

Based in mission and strategic goals, with the long term in mind Debt is a valuable and scarce resource Consider affordability, risks, financial structure Monitor capital markets, refunding and other opportunities No specific limits, allows flexibility

Clarifies responsibilities Board approves issuance of debt, committee approves terms Management, with expert counsel, monitors market and risk, makes

recommendations, negotiates terms, interfaces with external parties Board receives annual review of debt portfolio risk

Goals of 2012 Transaction – University of Puget Sound

Improve student success through strong residential programming Policy change, programs,

bed capacity Manage debt portfolio risks Within context of broad

institutional risks Decrease debt portfolio

risk Retain debt capacity at

A1/A+ rating

Risk Assessment and Strategic Restructuring – University of Puget Sound

Comprehensive assessment of risk profile A year in advance of anticipated debt financing Changing market conditions Changes in board’s risk tolerance or risk allocation? Strategic residential objective, upcoming debt financing

Prager & Co. as financial advisor served as an extension of university staff Assessment of financial condition, risks, credit and debt capacity, peer

analysis, structures, etc Quantitative analysis of options

Risk Assessment and Strategic Restructuring – University of Puget Sound

The portfolio before the transaction: $60 million VRDNs, all synthetically fixed, structured in

different rate environment, still low cost of capital, performed well to date $10 mil, 3.6% all-in, self-liquidity, Soc-Gen long-term swap $50 mil ($20 + $30), 4.3% all-in, bank LOC, BoNY long-term swap

Board not as comfortable with debt risks as they once were Swap counterparty performance Mismatch between 67% LIBOR and SIFMA Failed remarketing, deterioration of LOC provider credit Liquidity (LOC) renewal/repricing risk in 2012

Risk Assessment and Strategic Restructuring – University of Puget Sound

Should we issue traditional fixed rate on new money for residence hall?

Should we convert all or some of VRDNs to fixed rate? How would we handle outstanding swaps? What would be the budget impact?

Should we consider a direct bank purchase vs. new LOC

provider for all or some of our variable rate debt?

Comparison of Financing Scenarios

Scenario 1: 4.58%

Scenario 2a: 4.79% Scenario 2b: 5.15%

Scenario 3a: 5.14% Scenario 3b: 6.32%

Scenario 4: 6.82%

0.0%

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0% 10% 20% 30% 40% 50% 60%

Inte

rest

Rat

e Ri

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(as %

of F

Y201

0 O

p. E

xp.)

Liquidity Risk (as % of FY2010 Expendable Resources)

Debt Portfolio Risk Assessment (with Projected WACC)

Scenario 1: 4.58% WACC Scenario 2a: 4.79%

Scenario 2b: 5.15% Scenario 3a: 5.14%

Scenario 3b: 6.32%

Scenario 4: 6.82%

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Principal Duration (in Yrs)

Expected WACC vs. Principal Duration

Risk Assessment and Strategic Restructuring – University of Puget Sound

The Transaction Issued new debt at fixed rate for residence hall Refunded 30% of VRDNs and converted to fixed rate, retained

orphan swap with intent to terminate when conditions are favorable

Refunded 50% of VRDNs through a 7-year direct purchase transaction, retained swap

Retained 20% of VRDNs with self-liquidity, retained swap, may terminate swap in future

Risk Assessment and Strategic Restructuring – University of Puget Sound

End result 47% traditional fixed 40% variable rate direct bank purchase, synthetically fixed 13% VRDN with self liquidity, synthetically fixed

Reduced interest rate risk and liquidity risk Expected WACC of 4.79% and within Board’s risk comfort Level debt service affordable in budget, with new money

structured to accommodate temporary orphaned swap

Ongoing Monitoring and Reporting

Puget Sound assesses debt portfolio review annually, including risk trend

Additional Considerations (at Issuance and Beyond)

Taxable vs Tax-Exempt Cost differential Reporting requirements Value/cost of par call for tax-exempt debt

Term Direct purchase: renewal risk at put date Matched to project life Longer to allow recycling/internal bank structures

Issuance Timing Interest rate outlook Negative arbitrage in refundings Hedging efficacy/outcomes

Conclusions

Clear policy should drive debt portfolio decisions

Portfolio risks and outcomes must be monitored on an ongoing basis

Quantitative frameworks should be established for budget and balance sheet outcomes Current and pro forma debt portfolio

Resources

University of Missouri System Debt Policy http://www.umsystem.edu/ums/fa/treasurer/debt_policy

University of Missouri System Quarterly Debt Report

http://www.umsystem.edu/ums/fa/treasurer/debt_snapshot_reports

Federal Reserve Historical Data http://www.federalreserve.gov/releases/h15/data.htm

Federal Reserve Interest Rate Projections

http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm (Click on “PDF” under Projections Materials)

Appendix – Why Fed Funds? Quarterly average SIFMA rates (and LIBOR rates) correlate

very well with Fed Funds, but with more history.

y = 63.23%x + 0.37% R² = 94.82%

0%

1%

2%

3%

4%

5%

6%

7%

8%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

SIFM

A

Fed Funds (Effective, 3-Day Lag)

Least Squares Regression (Quarterly Average, n=88)

Source: Federal Reserve, SIFMA

Appendix – Why the 10-Year Treasury? Good correlation with LIBOR Swap Rates…not so much MMD,

but even MMD is generally reasonable, and there’s more history.

y = 1.0505x + 0.0073 R² = 0.9632

y = 0.4935x + 0.0254 R² = 0.6619

2.0%

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4.0%

5.0%

6.0%

7.0%

8.0%

1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0%10-Year Treasury Rate

Interest Rate Correlations with 10-Year Treasury (1998-Present)

100% of 30 Yr LIBOR Swap Curve30 Yr Tax-Exempt Fixed RateLinear (100% of 30 Yr LIBOR Swap Curve)Linear (30 Yr Tax-Exempt Fixed Rate)

Source: Federal Reserve, Thompson, Bloomberg