pre-conference fixed income essentials

Rick PhillipsPresident & Chief Investment Officer702-932-5330 [email protected]

Portfolio Strategies

Government Investment Officers Association

March 25, 2009

Public Fund Investment Managerswww.MainStreetCap.us

Public Fund Investment Managerswww.MainStreetCap.us2


Economics: “A Balance of Trade-Offs”

“People Respond to Incentives”

“Invisible Hand” “Benevolent Hand”


Consumers Pulling BackU.S. Retail Sales—YOY % Change

9/11S&P -50% NAZ -85%2002


Government Stepping UpU.S. Federal Deficit % of Nominal GDP

WWII

2009 Estimated: GDP $14.1T, Deficit $1.45T


Tril

lions

Federal Reserve Balance Sheet (Assets-Reserves)

Quantitative Easing

$3T+?


Adam Smith-Wealth of Nations (1776)“Every individual endeavors as much as he can to employ his capital so that its produce may be of the greatest value. He generally, neither intends to promote the public interest, nor knows how much he is promoting it; he intends only his own gain, led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

Bill Gross (PIMCO)-Investment Outlook (Feb 2009)“The simplicity of the solution, however, is not easily achieved once deflationary momentum takes hold. Animal spirits, once dampened, are hard to reignite; “fear of fear itself” dominates greed. Under such circumstances, the benevolent hand of government is required and Keynes is reincarnated in an attempt to plug the dike via fiscal spending and imaginative monetary policies that support asset prices.”


The Great Depression


Dow Jones Industrial Average

It took 25 years to get back to the same level


U.S. Nominal GDP – YOY % Change

A Rare Negative Print in 2009?


Bad

U.S. Savings Rate


The Stealth Banking System-CP Outstanding

Bill

ions


Subprime Nation: U.S. Federal Debt % of Nominal GDP

2009 Estimated

(IRS: Interest Expense 9 cents/dollar-2007)


U.S. Treasury Debt Outstanding

Log

Sca

le

$10.7 Trillion


U.S. vs Walmart Credit Default Swaps (CDS)

Walmart

U.S.A


“The Great Recession” or “The Depression” ??U.S. Consumer Confidence

Lowest Recorded Level

Oil CrisisPrime: 21.5%

Gulf War

9/11


Are We Japan?Japanese Nikkei Index

Same Level as 25 Years Ago


Japan Real GDP YOY % Change

2009 Estimated

9.4%

4.2%


Source: DailyWealth.com

Japanese Real Estate Prices


The Housing Mess"Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited." Ben Bernanke March 2007


Who/What Got Us Into This Mess?

Interest Rates Pushed Down to 40 Year Lows


The Push for Home Ownership


Subprime Lenders


The GSEs


The Enablers


CNBC’s House of Cards: “Arturo Trevilla bought a house with an adjustable rate mortgage. He planned to refinance his mortgage before the payments went up. The idea seemed simple, but the paperwork was tricky. Arturo says “it was hard for me to understand…I just trusted a broker.”

But with a salary of $900 a week ($46,800 annually*) he knowingly signed documents claiming he made four times as much….and bought a $584,000 San Clemente, CA townhouse.

Trevilla eventually lost his home to foreclosure.”

*That’s 12.5 times income!!

The Buyers


A History of Home ValuesYale Professor Robert Shiller created an existing home price index back to 1890, factoring in inflation. For example, if a home sold for $100,000 in 1890, it peaked at $202,000 in 2006 and bottomed at $66,000 in 1920. Real return is approximately 1% annually.

Housing Is a Expense, Not An Investment

?


?

Approx 100 million households


S&P 500 Stock Index vs U.S. Existing Home Prices$100 Invested Jan 1, 1968 --- Real Returns


S&P 500 Real P/E Ratio vs Long Term Interest Rates

P/E Ratio using 5 year trailing earnings Source: Robert Shiller


S&P 500 Quarterly Operating Earnings

2008-4 to 2009-4 Estimated

6240

2009 Estimates

First Ever Qtrly Loss

Historical Avg


The Cost of Missing a Market Rebound

S&P 500 Including Dividends, Source: DFA Funds


S&P 500 Bear Market Rallies


Can You Beat the House?Market Efficiencies – The Random Walk—Winning the Loser’s Game

% of Managers Beating Benchmark*Large Cap 10.6%Mid Cap 5.6%Small Cap 8.8%

* Journal of Financial Planning 20 yr Study

NFL 2008-09 Regular Season/Playoffs267 Games121 Won by Favorites— 45%146 Won by Underdogs—55%

Biggest Favorite Win (+35.5):NY Jets 47 vs St. Louis 3 – Spread was 8.5

Biggest Underdog Win (-37.5):New England 13 vs Miami 38 – Spread was 12.5

Avg Season Spread Difference _____?


Questions:Why should state and local governments take any risk with their investment portfolios?

Why not buy only overnight treasury repo or 1 week t-bills ?

Reason:Investment portfolios are one of the only places in government where incremental revenues can be prudently generated without collecting taxes or fees; thus benefiting their citizenry.


GFOA Model Investment Policy - Foundation

Safety: Safety of principal is the foremost objective of the investment program. Investments shall be undertaken in a manner that seeks to ensure the preservation of capital in the overall portfolio. The objective will be to mitigate credit risk and interest rate risk.

Liquidity: The investment portfolio shall remain sufficiently liquid to meet all operating requirements that may be reasonably anticipated. This is accomplished by structuring the portfolio so that securities mature concurrent with cash needs to meet anticipated demands (static liquidity). Furthermore, since all possible cash demands cannot be anticipated, the portfolio should consist largely of securities with active secondary or resale markets (dynamic liquidity). A portion of the portfolio may be placed in money market mutual funds or local government investment pools, which offer sameday liquidity for short-term funds.

Yield: The investment portfolio shall be designed with the objective of attaining a market rate of return throughout budgetary and economic cycles, taking into account the investment risk constraints and liquidity needs. Return on investment is of secondary importance compared to the safety and liquidity objectives described above. The core of investments are limited to relatively low risk securities in anticipation of earning a fair return, relative to the risk being assumed. Securities shall generally be held until maturity, with the following exceptions: • A security with declining credit may be sold early to minimize loss of principal. • A security swap would improve the quality, yield, or target duration in the portfolio. • Liquidity needs of the portfolio require that the security be sold.


Three Main Portfolio Management DecisionsLegal vs. Suitable

Interest Rate Risk: 1year time horizon/cash flow need: Cash Four 3 month securities, Two 6 month securities One 1 year security One 2 year security and sell it in 1 year

Credit Risk: Treasury, Agency, Corporate, ABS

Prepayment/Optionality Risk: Callables, MBS


Fed Funds Futures – Start of FY2008


U.S. Treasury Yield Curve – FY2008

Fed Funds 5.25 to 2.00


A Suitable Level of Interest Rate RiskDoes It Pay To Extend Maturities?

Maturity Yield Spread*

3M 4.57%

1Y 4.90% 0.33%

2Y 5.24% 0.34%

3Y 5.43% 0.19%

4Y 5.59% 0.16%

5Y 5.74% 0.15%

Avg U.S. Treasury Yields 12/87 to 12/08

*Spread: Yield pickup from previous maturity

A $100,000,000 portfolio with an average maturity of 1 year (2yr t-note) verses 1.5 months (3 month t-bill), would have earned an extra $6,700,000 over a 10 year period. (5.24% minus 4.57% = .67%)

4.25

4.50

4.75

5.00

5.25

5.50

5.75

6.00

3M 1Y 2Y 3Y 4Y 5YP

erce

nt Y

ield

“Sweet Spot”

Data Source: Bloomberg

US Treasury Yield Curve12/87 to 12/08


Courtesy: Kevin Webb

Sweet Spot

Main Street Sharpe Ratio = (Return – Risk-free rate) / Duration


What is the appropriate average maturity or duration for an Operating Fund?

Between 1 and 2 years

•An entity generally has to budget interest income 12 to 18 months in advance of the entity’s fiscal year end for the next fiscal year’s budget.

•For example, if the portfolio has a 6 month average maturity, budgeting interest income is challenging due to the fluctuation of interest rates (portfolio turns over 3Xs).

•If the portfolio has a 1.5 year average maturity, then the existing book yield gives a good approximation of next fiscal year’s interest income (portfolio turns over 1x).

A Suitable Level of Interest Rate RiskA Budget Perspective


A Suitable Level of Credit Risk

1-3 Years 1-5 Years MBS/ABS


Data Source: Bloomberg

3-5 Year Corporate and Agency Spreads

LTCMTech 9/11 Corp Acct

Subprime Crisis


10 Yr Periods Future??Portfolio Size 1,000,000,000 1,000,000,000 Corporates 20% (20 x $10mil) 200,000,000 200,000,000

Incremental Yld (corp vs agy) 0.53% 1.50%Annual Incremental Interest 1,060,000 3,000,000 10Yr Incremental Interest 10,600,000 30,000,000 3 Positions Downgraded -5pts (1,500,000) (1,500,000)1 Position Bankrupt -80pts (8,000,000) (8,000,000)Total Loss (9,500,000) (9,500,000)Net Income over 10yrs 1,100,000 20,500,000 Annual Net Income 110,000 2,050,000 Annual Incremental Basis Pts 1.1 20.5

Are Corporate Bonds Worth the Risk?

Assumptions: 1% per issuer limitation, 3 issuers/positions downgraded below “A” and are sold at 5 point discounts, 1 issuer/position files bankruptcy and liquidates at 20 cents

Sector ReturnTreasury 1-5yr 6.37Agency 1-5yr 6.54Corporate 1-5yr 7.07Mortgage 2.1 dur 7.12

1988 - 2008


A Suitable Level of Prepayment/Optionality RiskEffective Duration: 1-5Yr Bullet (Non-Callable) vs 1-5Yr Callable Index

Non-Callable

Callable

2000 2008


Call Types Callable Strategy Suggestions/Facts:•Buy primarily one-time calls•Rarely buy continuous calls•A new issue is more expensive than an existing, but customizable•Structured callables should be a small % of portfolio•Compare short callables’ MMKT yields vs. MMKT instruments•Limit callables to no more than 30-40% of portfolio•Diversify maturities and lockouts

Coupons

Mat Non-Call1yr-1X

Call

1Yr Semi-Annual

Call

Continous Call After

1yr

2Yr 1.53 1.75 1.76 1.78

3Yr 1.75 2.17 2.22 2.25

4Yr 2.12 2.53 2.59 2.63

5Yr 2.56 2.90 2.99 3.05

Number of Calls

Mat Non-Call1yr-1X

Call

1Yr Semi-Annual

Call

Continous Call After

1yr

2Yr N/A 1 2 360

3Yr N/A 1 4 725

4Yr N/A 1 6 1,090

5Yr N/A 1 8 1,455


Coupon (25 BPs Steps

Step-Up’s Progressive Avg

CouponYR Periods/Yrs

Yr 10 to .5yr 1.75 1.75

.5yr to 1yr 2.00 1.875

Yr 21yr to 1.5yr 2.25 2.00

1.5yr to 2yr 2.50 2.125

Yr 32yr to 2.5yr 2.75 2.25

2.5yr to 3yr 3.00 2.375

Average Coupon: 2.375

Matched Maturity Regular Callable Coupon (3NC 6): 2.200

Variance 0.175

Step-Up vs. Regular Callable3yr Semi-Annual Step-Up vs. 3Yr NC 6Mon Discrete Call

Breakeven for the step-up’s income to equal the regular callable’s income is approximately after 2 years have passed or approximately 2/3s of the time.

3Yr-NC 6Mon Semi-Annual Step-Up Callable

Steps 25 basis points each 6 months

Callable on coupon dates (semi-annual)

Starts at a 1.75% Coupon

3Yr-NC 6Mon Semi-Annual Callable

Fixed 2.20% coupon

Callable on coupon dates (semi-annual)


Floating Rate Notes

Fed Funds

LIBOR


Step Up Analysis - 3yr Annual Steps

TimeStep Cpns

Cumltv Cpn

Non-Step Cpns Var

1Yr 2.125 2.125 2.450 (0.325)2Yr 2.500 2.313 2.450 (0.138)3Yr 3.500 2.708 2.450 0.258

Step Up Analysis - 5yr Annual Steps

TimeStep Cpns

Cumltv Cpn

Non-Step Cpns Var

1Yr 2.500 2.500 3.450 (0.950)2Yr 3.000 2.750 3.450 (0.700)3Yr 4.000 3.167 3.450 (0.283)4Yr 5.000 3.625 3.450 0.175 5Yr 6.000 4.100 3.450 0.650

3Yr 5Yr Var1Yr 2.125 2.500 0.3752Yr 2.500 3.000 0.5003Yr 3.500 4.000 0.5004Yr 5.000 5Yr 6.000

Step Up Comparison3yr vs 5yr

Annual Steps – Semi-Annual Calls


Over long periods of time, the vast majority of a short-term fixed income portfolio’s returns are generated by coupon.

Volatility of Total Return – 1-3Yr Trsy/Agy Index

Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Avg % of

Return

Coupon Rtn 6.41 6.38 5.87 6.42 5.81 4.71 3.69 3.22 3.52 5.19 4.63 4.10 5.00 97%

Price Rtn 0.25 0.60 (2.75) 1.70 2.60 1.17 (1.69) (2.22) (1.83) (1.05) 2.52 2.63 0.16 3%

Total Rtn 6.66 6.98 3.12 8.13 8.41 5.88 2.00 1.00 1.70 4.14 7.14 6.73 5.16 100%


Main Street Portfolio Risk Is Asymmetrical

•A dollar of gain = a dollar of painA dollar of recognized loss is a much bigger deal than a recognized gain

•Political fact: Rarely are sub-optimal returns questioned but political pressure is always present to avoid reported losses

•You are not running a hedge fund!

pre-conference fixed income essentials

Documents

nominal gdp yoy

nominal gdp wwii

federal debt

federal deficit

great depression

fear of fear

estimated irs

great recession