John Grady, Tom Tight

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  • John Grady, Tom Tight

    1. 1. Presented by: John F. Grady III, CTP, Thomas N. Tight May 22, 2010 The Florida Government Finance Officers Association Annual Conference 2010 Investment Strategies in the Current Market Environment
    2. 2. A look at Permitted Investments
    3. 3. Public Funds Investment Philosophy <ul><li>Safety of Principal : Preserving Principal by selecting investments in accordance with the investment policy </li></ul><ul><li>Liquidity of Assets : Ensuring ability to provide sufficient available funding for liquidity needs </li></ul><ul><li>Return on Assets : Optimize returns within the established investment parameters </li></ul>Safety first philosophy with a diversified strategy to lower return volatility over a long horizon Risk Management Strategies Credit Risk Invest in high quality securities and has a staff of credit analysts unequaled in the industry Market Risk Use active portfolio management to limit its clients exposure to market risk. Reinvestment Risk Sophisticated option adjusted return analysis for security evaluation to limit a portfolio’s exposure to risk. Long Term Investment Strategy High Quality Investments Custom Portfolios with an average AAA rating based on state statutes, investment policy requirements, and market conditions Adequate Liquidity Maturity distribution based on the cash flow analysis to enhance the performance Historical Performance Proven portfolio management, strong credit research and a track record of performance with less risk than
    4. 4. Investment Objectives <ul><li>Investment Objectives for Public Funds </li></ul><ul><ul><li>Safety </li></ul></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><li>Yield (Return on Assets) </li></ul></ul><ul><ul><li>Compliance with Laws and Investment Policy </li></ul></ul><ul><ul><li>Dynamic </li></ul></ul><ul><ul><li>Limited Portfolio and Security Volatility </li></ul></ul><ul><ul><li>Ease of Implementation and Understanding </li></ul></ul>
    5. 5. Maturity and Liquidity <ul><li>Maturity Requirements should be based on </li></ul><ul><ul><li>Type of portfolio (Liquidity Assets versus Core Assets) </li></ul></ul><ul><ul><li>Security Type (U.S. Treasury, Federal Agency) </li></ul></ul><ul><ul><li>Risk Tolerance (Volatility) </li></ul></ul><ul><li>Liquidity Requirements should: </li></ul><ul><ul><li>Provide liquidity to meet anticipated day to day operational needs for a specific period of time </li></ul></ul><ul><ul><li>Deposited in AAAm MMF or AAA rated open market securities </li></ul></ul><ul><ul><li>A specific maturity limitation on Liquidity Assets </li></ul></ul>
    6. 6. Reporting by Portfolio <ul><li>Liquidity Portfolios typically reported on Yield on Cost (Passive Strategy) </li></ul><ul><ul><li>Historically Liquidity Portfolios in Florida have been reported on yield on cost and compared to short term investments such as the Florida SBA or the S&P Money Market Index </li></ul></ul><ul><ul><li>Many investment officers are utilizing money market fund indexes as a benchmark for Liquidity Portfolios </li></ul></ul><ul><li>Core Asset Portfolios typically reported on Total Return (Active Strategy) </li></ul><ul><ul><li>The CFA Institute (formerly AIMR) has established total return as the standard for calculating return on actively managed investment portfolios </li></ul></ul><ul><ul><li>This method takes into account all realized and unrealized gains and losses and a time weighting of cash flows </li></ul></ul>
    7. 7. Interest Rate (Price Fluctuation Risk) <ul><li>Bond Prices and Interest Rates are Inversely Related </li></ul><ul><ul><li>Interest Rate Risk refers to price fluctuations as a result of changes in interest rates </li></ul></ul><ul><ul><li>Bond prices tend to rise in value as interest rates fall, and prices fall when interest rates rise </li></ul></ul><ul><ul><li>As a general rule, the longer the maturity, the greater the degree of price volatility </li></ul></ul><ul><li>Duration is a measure of correlation of Time to Maturity and Price Volatility </li></ul><ul><ul><li>Duration a more accurate measure for time to maturity by factoring in cash flows </li></ul></ul><ul><ul><li>A Bond’s duration is dependent on timing of cash flows, call and put option provisions and final maturity </li></ul></ul>Interest Rates Bond Prices Interest Rates Bond Prices Inverse Relationship $ $ % % Volatility Time to Final Maturity (Duration)
    8. 8. Risks Defined <ul><li>Several factors can impact the liquidity of an investment </li></ul><ul><ul><li>Ability to sell at a competitive price due to supply and demand constraints </li></ul></ul><ul><ul><li>Volatility in the market and time to maturity </li></ul></ul><ul><ul><li>Restrictions that result in redemption penalties </li></ul></ul><ul><ul><li>Call and Put Options, Security Sector, Issuer </li></ul></ul><ul><li>Credit Risk - default or decline in security value due to Issuer financial conditions </li></ul><ul><ul><li>Arguably the biggest issue in the current environment </li></ul></ul><ul><ul><li>Measures the additional return required from an investor to lend money to the institution </li></ul></ul><ul><ul><li>Increases or decreases with changes in ratings </li></ul></ul><ul><ul><li>Regulatory actions can also impact the risk of an issuer </li></ul></ul><ul><li>Risk Interest and/or Principal will be reinvested at a lower rate of return than the current interest rate </li></ul><ul><ul><li>Short term securities have high reinvestment risk (MMF, Discount Notes) </li></ul></ul><ul><ul><li>Securities with higher coupons have higher reinvestment risk than lower coupons </li></ul></ul><ul><ul><li>Mortgage Backed Securities have higher reinvestment risk </li></ul></ul><ul><ul><li>Callable Securities have high reinvestment risk </li></ul></ul>
    9. 9. Making Investment Decisions <ul><li>Several Key Decisions are Involved when Implementing an Investment Strategy </li></ul><ul><ul><li>Maintain an Updated Investment Policy </li></ul></ul><ul><ul><li>Consider the results of the Cash Flow Analysis </li></ul></ul><ul><ul><li>Determine Risk Tolerance </li></ul></ul><ul><ul><li>Determine Appropriate Target Duration </li></ul></ul><ul><ul><li>Evaluate Market Conditions and Economic Data </li></ul></ul><ul><ul><li>Consider Historical Perspective and the Current Environment </li></ul></ul><ul><ul><li>Understand Benefits (Enhanced Earnings, Dynamic Management Approach) and Risks involved with various Investment Strategies (Liquidity, Reinvestment, Credit) </li></ul></ul><ul><ul><li>Assess the relative value of each maturity and sector </li></ul></ul><ul><ul><li>Implement an Active and/or Passive Strategy for Core and Liquidity Funds based on Investment Management Goals and Objectives </li></ul></ul>
    10. 10. Treasury Inflation Protected Securities (TIPS) <ul><ul><li>Direct obligations of the U.S. Government (full faith and credit) </li></ul></ul><ul><ul><li>Principal is protected from inflation </li></ul></ul><ul><ul><li>Principal adjustment tied to CPI-U index </li></ul></ul><ul><ul><li>Treasury guarantees payment of par at maturity </li></ul></ul><ul><li>TIPS – How they work </li></ul><ul><ul><li>Issued with a fixed coupon </li></ul></ul><ul><ul><li>Semiannual coupon payments </li></ul></ul><ul><ul><li>Principal adjusted according to an index based on the Consumer Price Index </li></ul></ul><ul><ul><li>Semiannual payments are adjusted based on the fixed coupon and adjusted par </li></ul></ul><ul><ul><li>Less volatility in certain interest rate environments as result of adjusting interest payment </li></ul></ul><ul><ul><li>Can be purchased through Auction or on secondary market </li></ul></ul>
    11. 11. Authorized Investments <ul><li>Identify Cash Flow Components </li></ul><ul><ul><li>The best strategy is a fund by fund review </li></ul></ul><ul><li>Determine the Degree of Certainty and Predictability </li></ul><ul><ul><li>Have past events skewed historical fund balances </li></ul></ul><ul><ul><li>Are there known future events that may impact fund balances </li></ul></ul><ul><li>Construct A Cash Flow Forecast </li></ul><ul><ul><li>Utilize historical information to develop a cash flow analysis based on timing of revenues and expenditures </li></ul></ul><ul><ul><li>Only include those funds appropriate for consideration of longer term investment strategies </li></ul></ul><ul><li>Conduct Periodic Reviews and Updates </li></ul><ul><ul><li>Cash flow analysis should be conducted at least annually and contain at least 2 years of information </li></ul></ul><ul><ul><li>Compare prior projections with actual results for ongoing certainty and predictability </li></ul></ul><ul><ul><li>Identify trends and determine the expectation of continuation of trends based on internal (fee increases) and external (interest on investments) factors </li></ul></ul>
    12. 12. Authorized Investments FEDERAL AGENCY SECURITIES (AGENCIES) Federal Agency Securities (Agencies) are issued by official government bodies and have the Full Faith and Credit of the U.S. Government. Federal Agency Issuers Include: Government National Mortgage Association (GNMA), U.S. Department of Housing and Urban Development (HUD), Farmer Home Administration Characteristics of Agencies: Issued by the U.S. government to pay for government projects. Issued through an auction process in the primary market at par (except discount notes) Traded in the secondary market as marketable securities at discounts and premiums determined by interest rates Interest Earned is exempt from state and local taxes (not exempt from Federal Taxes)
    13. 13. Authorized Investments U.S. TREASURY SECURITIES (TREASURIES) Negotiable debt obligations issued with by the U.S. Government. Treasuries are backed by the Full Faith and Credit of the U.S. Government. There are three types of securities issued by the U.S. Government: Treasury Bills: Issued at a discount; mature in less than 1 year Treasury Notes: Pay Interest Semi-annually; mature 1 year to 5 years Treasury Bonds: Pay Interest Semi-annually; mature up to 30 years Characteristics of Treasuries include: Issued by the U.S. government to pay for government projects. Issued through an auction process in the primary market at par (except discount notes) Traded in the secondary market as marketable securities at discounts and premiums determined by interest rates. Interest Earned is Exempt from state and local taxes but not from Federal Taxes
    14. 14. Authorized Investments MONEY MARKET FUND (MMF) MMF typically invest in government securities, certificates of deposit, commercial paper of companies, or other highly liquid and low-risk securities. MMF are regulated under the Investment Company Act of 1940 and Rule 2a-7 under the Act. Characteristics of a MMF Include : Goal of maintaining a Net Asset Value (NAV) at a constant $1.00 per share. Typically have relatively lower risks compared to other longer term mutual funds Pay interest that generally reflects short-term interest rates
    15. 15. Authorized Investments GOVERNMENT SPONSORED ENTERPRISE (GSE) GSEs are independent organizations that are in part sponsored by the federal government. Historically, GSE securities did not have the Full Faith and Credit of the U.S. Treasury. Recent Legislation has provided the implicit Full Faith and Credit of the U.S. Government for GSE securities. Federal Agency Issuers Include: Federal National Mortgage Association (FNMA), Federal Home Loan Mortgage Corporation (FHLMC), Federal Home Loan Bank (FHLB), Federal Farm Credit Bank (FFCB) Characteristics of GSEs: Issued to enhance the flow and lower the cost of credit for specific sectors of the economy including housing and farming Issued through an auction process in the primary at par (except discount notes) Traded in the secondary market as marketable securities at discounts and premiums determined by interest rates. Interest Earned is exempt from state and local taxes for FFCB and FHLB (not exempt from Federal Taxes) Interest earned on FHLMC and FNMA is fully taxable
    16. 16. Authorized Investments CORPORATE NOTES/BONDS (CORPORATES) Debt obligations, or IOUs, issued by private and public corporations. Funds they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to expanding the business. Characteristics of Corporates: Typically issued in multiples of $1,000 and/or $5,000. Purchaser lends money to the issuing corporation Corporation promises pay principal, plus interest on a specified maturity date Interest earnings from corporate bonds are taxable Unlike stocks, corporate bonds do not give you an ownership interest in the issuing corporation
    17. 17. Authorized Investments CORPORATE NOTES/BONDS (CORPORATES) Debt obligations, or IOUs, issued by private and public corporations. Funds they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to expanding the business. Characteristics of Corporates: Typically issued in multiples of $1,000 and/or $5,000. Purchaser lends money to the issuing corporation Corporation promises pay principal, plus interest on a specified maturity date Interest earnings from corporate bonds are taxable Unlike stocks, corporate bonds do not give you an ownership interest in the issuing corporation
    18. 18. Authorized Investments COMMERCIAL PAPER Unsecured, short-term debt instrument (promissory note) issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Current Legislation provides U.S. Government Full Faith and Credit for certain CP issues Characteristics of Commercial Paper: Maturities from 1 day to 270 days (does not need to registered with the SEC) Usually issued at a discount, reflecting prevailing market interest rates. Traded in the secondary market as marketable securities at discounts and premiums determined by interest rates. Not usually backed by any form of collateral (unlike Asset Backed Commercial Paper) Proceeds can only be used on current assets (inventories) - not allowed for fixed assets without SEC Involvement.
    19. 19. Authorized Investments CERTIFICATES OF DEPOSIT (CDs) CDs are time deposits on deposit with the bank for a stated period of time. CDs typically earn a stated interest rate. Florida Statute 218.415(16)(c) requires banks to be Qualified Public Depositories to qualify to provide CDs to local governments. Characteristics of CDs: May offer higher rate of interest than other types of deposit accounts due to restricted access Typically the longer the maturity date, the higher the stated interest rate. May require forfeiture of all or a portion of interest earnings and/or principal for early withdrawal Deposits held at FDIC, a government agency that insures bank deposits. Individual Accounts are now eligible for $250,000 of deposit insurance for all the deposits at each bank in each recognized ownership capacity (CDs, checking accounts, etc.)
    20. 20. FDIC Backed Notes <ul><ul><li>Issued through the Treasury Liquidity Guarantee Program </li></ul></ul><ul><ul><li>Full faith and credit of the Government (FDIC Insured) </li></ul></ul><ul><ul><li>Issued by various financial companies to encourage lending </li></ul></ul><ul><ul><li>Fixed and floating rate coupons </li></ul></ul><ul><ul><li>Maximum 3 year maturity </li></ul></ul><ul><ul><li>Considered the equivalent of agency bonds for investment policy considerations </li></ul></ul><ul><ul><li>Yield advantage to Treasury and Agency bonds </li></ul></ul>
    21. 21. Callable Securities <ul><ul><li>Issuer has the option to redeem early </li></ul></ul><ul><ul><li>Various Structures </li></ul></ul><ul><ul><ul><li>3yr/Non Call 1 </li></ul></ul></ul><ul><ul><ul><li>Continuous, discrete, one time </li></ul></ul></ul><ul><ul><li>Trade at a spread over treasury securities </li></ul></ul><ul><ul><li>Issued by Agencies, Corporations and Public Entities </li></ul></ul><ul><ul><li>Attractive in a rising rate environment </li></ul></ul>
    22. 22. Callable Securities Source: Bloomberg Some market conditions favor callable securities and other conditions favor non-callable securities. Use historical analysis to take advantage of current trends. 2-Year Treasury Yield Non-Callable Callable 5 Year Average - 3.92%
    23. 23. Treasury Inflation Protected Securities (TIPS) <ul><li>TIPS Advantages </li></ul><ul><ul><li>Provides a hedge against inflation </li></ul></ul><ul><ul><li>Full Faith and credit of the U.S. Government </li></ul></ul><ul><ul><li>Downside principal limit is par value </li></ul></ul><ul><ul><li>Less volatility in certain interest rate environments as result of adjusting interest payment </li></ul></ul><ul><li>TIPS Disadvantages </li></ul><ul><ul><li>Typically structured with lower coupons than fixed income securities at time of issue </li></ul></ul><ul><ul><li>Not designed for portfolios structured with specific income requirements </li></ul></ul>
    24. 24. TIPS Index Screen Source: Bloomberg
    25. 25. TIPS – 1997 Issue Source: Bloomberg
    26. 26. TIPS 1997 Issue Source: Bloomberg $322,656 $301,327
    27. 27. TIPS 2005 Issue Source: Bloomberg
    28. 28. TIPS 2005 Issue $182,439* $182,439 *Projected
    29. 29. TIPS 2005 Issue – Inflation Assumption Source: Bloomberg
    30. 30. TIPS 2005 Issue – Inflation Actual Results Source: Bloomberg
    31. 31. Step Up Bond with Call Feature Source: Bloomberg <ul><li>Step Up Coupon (with Call Feature) Advantages </li></ul><ul><ul><li>Provides a hedge against inflation </li></ul></ul><ul><ul><li>Call Feature provides additional premium for call risk </li></ul></ul><ul><ul><li>Structured to Provide a higher return vs. fixed structure in the event of a call </li></ul></ul><ul><ul><li>Less volatility in certain interest rate environments </li></ul></ul><ul><ul><li>Provide additional duration and asset class diversification </li></ul></ul><ul><li>Step Up Coupon (with Call Feature) Disadvantages </li></ul><ul><ul><li>Call feature subject to reinvestment rate risk </li></ul></ul><ul><ul><li>Call feature results in uncertain actual maturity (call) </li></ul></ul><ul><ul><li>Not designed for time specific expenditures (debt service payments) </li></ul></ul>
    32. 32. Step Up Bond – Cash Flow to Maturity Source: Bloomberg <ul><li>Step Up Coupon (with Call Feature) vs. Fixed Coupon Cash Flow to Maturity </li></ul><ul><ul><li>Coupon payments increase at each interval with Step up </li></ul></ul>
    33. 33. Step Up Bond – Cash Flow to Maturity Source: Bloomberg $566,250 $392,026
    34. 34. Step Up Bond Cash Flow with Call Scenario Source: Bloomberg <ul><li>Step Up Coupon (with Call Feature) vs. Fixed Coupon Cash Flow to Maturity </li></ul><ul><ul><li>Coupon payments increase at each interval with Step up </li></ul></ul>
    35. 35. Step Up Bond – Cash Flow to Call Source: Bloomberg $263,750* $392,026 *Assumes reinvestment at 50bps
    36. 36. Interest Rates: We know where we’ve been….but where are we going?
    37. 37. Fed Funds Futures Contracts Source: Bloomberg
    38. 38. Fed Funds Survey Forecast Source: Bloomberg
    39. 39. Fed Funds Implied Probability Source: Bloomberg
    40. 40. Fed Federal Funds Rate vs. 3 Month LIBOR Source: Bloomberg
    41. 41. Yield Curve Shape Shift Since Credit Crisis Source: Bloomberg
    42. 42. Short Term Rates by Sector Source: Bloomberg
    43. 43. Short Term Spreads Remain Stable Source: Bloomberg
    44. 44. Maturity Spreads Widen in Longer Term Notes Source: Bloomberg
    45. 45. Yield Curve vs. Sector Spreads – July 2007 Source: Bloomberg
    46. 46. Yield Curve vs. Sector Spreads – December 2008 Source: Bloomberg
    47. 47. Yield Curve vs. Sector Spreads – March 2010 Source: Bloomberg
    48. 48. Yield Curve vs. Sector Spreads – 2007 vs. 2010 Source: Bloomberg
    49. 49. FNMA/FHLMC vs. U.S. Treasury Notes – 2 Year Maturity Source: Bloomberg
    50. 50. Historical Performance Source: Bloomberg
    51. 51. U.S. Treasury Notes - 2010
    52. 52. U.S. Treasury Notes – 5 Year History
    53. 53. Historical Performance Source: Bloomberg
    54. 54. Rolling Returns by Duration Strategy Source: Bloomberg
    55. 55. Annual Performance – 1-3 Year Duration Source: Bloomberg
    56. 56. Annual Performance – Short Term vs. 1-3 Duration Source: Bloomberg
    57. 57. Annualized Performance – 10 Year and Credit Crisis Source: Bloomberg
    58. 58. Growth in Assets – 1-3 Year Duration Strategy Source: Bloomberg
    59. 59. Rolling Returns and Volatility by Sector Source: Bloomberg
    60. 60. Rolling Returns by Duration Strategy Source: Bloomberg
    61. 61. Cash Flows and Portfolio Strategies
    62. 62. Developing a Cash Flow Analysis Cash flows are typically cyclical, and also have a seasonality affect. One time events such as bond proceeds and grants should be excluded. Historical and projected analysis establish trends and assist with the estimation of future cash flows based on internal and external events and impact on short term and core assets <ul><li>A cash flow analysis establishes the foundation for a successful, effective investment program </li></ul><ul><li>One time events such as grants and bond proceeds should be excluded from the general analysis </li></ul><ul><li>The analysis can be conducted on a fund-by-fund and/or pooled approach </li></ul><ul><li>Historical balances can provide an indication of future trends </li></ul><ul><li>Internal and external factors should be considered for projecting future asset balances </li></ul><ul><li>The analysis should be updated annually to compare projected vs. actual results </li></ul><ul><li>An appropriate approach is to analyze multiple scenarios to determine short term and core assets </li></ul>
    63. 63. Enhanced Cash Strategy <ul><li>Sample Portfolio Characteristics </li></ul><ul><li>AAA Portfolio Structure </li></ul><ul><li>Sectors include U.S. Treasury Notes, Federal Agency Notes, U.S. Federal Credit Union, FDIC Insured Notes, Commercial Paper </li></ul><ul><li>Maturity distribution structure for weighted average maturity of approximately six months </li></ul>
    64. 64. Core Strategy <ul><li>Sample Portfolio Characteristics </li></ul><ul><li>AAA Portfolio Structure </li></ul><ul><li>Sectors include U.S. Treasury Notes, Federal Agency Notes, U.S. Federal Credit Union, FDIC Insured Notes, Corporate Notes </li></ul><ul><li>Maturity distribution structure for weighted average maturity of approximately 1.5 – 1.8 Years </li></ul>
    65. 65. Selecting Benchmarks Source: Bloomberg <ul><li>Selecting the right Benchmark based on Goals and Objectives </li></ul><ul><ul><li>The Asset Allocation of the Benchmark should be similar to that of the Investment Portfolio </li></ul></ul><ul><ul><li>The Duration of the Benchmark should be similar to the Investment Portfolio </li></ul></ul><ul><ul><li>The Credit Quality of the Benchmark be similar to the Investment Portfolio </li></ul></ul><ul><ul><li>The selected Benchmark provides a measure of portfolio performance given certain parameters established by State Statute and by the Investment Policy </li></ul></ul><ul><ul><li>Important to calculate the return of an index and the investment portfolio with the total return method to present the return on assets considering all realized and unrealized gains and losses </li></ul></ul>Money
    66. 66. Performance Case Study – Asset Allocation Source: Bloomberg
    67. 67. Performance Case Study – Ratings Distribution Source: Bloomberg
    68. 68. Performance Case Study – Performance Source: Bloomberg
    69. 69. Performance Case Study – Growth in Assets Source: Bloomberg
    70. 70. Summary <ul><ul><li>Protracted environment of challenged employment and growth </li></ul></ul><ul><ul><li>Use this time to clean up your investment policy </li></ul></ul><ul><ul><li>Continue to monitor and update cash flow projections </li></ul></ul><ul><ul><li>Determine short and “core” portfolios </li></ul></ul><ul><ul><li>Rates will be rising in the future? </li></ul></ul><ul><ul><li>Keep an eye on inflation </li></ul></ul><ul><ul><li>Take advantage of current government offerings </li></ul></ul><ul><ul><li>Pay attention to what the yield curve is telling you </li></ul></ul>

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