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Managing Fixed Income Risk in an Uncertain World
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Managing Fixed Income Risk in an Uncertain World


Companies with investable cash are looking for higher yield, but at the same time want to minimize risk and maintain ample liquidity. On the other hand, companies with debt on their books are enjoying …

Companies with investable cash are looking for higher yield, but at the same time want to minimize risk and maintain ample liquidity. On the other hand, companies with debt on their books are enjoying the benefits of low rates but are concerned about possible changes ahead.

This presentation covers:
- The prospects for the U.S. and global economy, the current Federal Reserve stance on rates and how that is likely to evolve
- What is the yield curve currently predicting for inflation, growth and Fed policy and how we see that changing
- Strategies that are typically used by investors to help optimize returns and borrowers to minimize risk in uncertain times
- Searching for yield: Extending and broadening your scope while controlling risk
- Reducing risk: Ways to hedge in this environment and a discussion of a range of hedging solutions

Published in Economy & Finance
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  • 1. Managing Fixed Income Risk in anUncertain WorldSilicon Valley BankFebruary 1, 2012 1
  • 2. Panelists• Dave Bhagat, Senior Advisor, Interest Rate and Currency Risk Management, Silicon Valley Bank• Joe Morgan, Chief Investment Officer, SVB Asset Management 2
  • 3. Agenda• Prospects for our economy• Europe’s prospects – how will that impact us?• The Fed and the yield curve• LIBOR and the futures markets• Investor perspective• Borrower perspective• Wrap up
  • 4. Prospects for our EconomyJoe Morgan 4
  • 5. Prospects for 2012 – Tugs of War 5
  • 6. Tugs of War – Consumer Austerity Takes a Break PCE Consumption Expenditures 10.0 9.0 8.0 7.0 6.0 5.0 Source: Bloomberg• Why the surge? • No cultural shift toward savings • Spending reserves built up over the last three years• Wage income is not keeping up with recent expenditure growth 6
  • 7. Tugs of War – Too Many 99% ers? U.S. Full Time Employment 125 120 115 110 105 100 12/1/2005 3/1/2006 6/1/2006 9/1/2006 12/1/2006 3/1/2007 6/1/2007 9/1/2007 12/1/2007 3/1/2008 6/1/2008 9/1/2008 12/1/2008 3/1/2009 6/1/2009 9/1/2009 12/1/2009 3/1/2010 6/1/2010 9/1/2010 12/1/2010 3/1/2011 6/1/2011 9/1/2011 12/1/2011• Regardless of “unemployment rate” measures, population increasing while number of workers has been decreasing• Job “stimulus” programs can only smooth the bottom of the riverbed• Solution to our economic woes cannot be found in the jobs market 7
  • 8. Tugs of War – Housing FHFA Home Price Change 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0%• Downside wealth volatility at record high for majority of Americans• Mortgage market drives housing• No resolution in sight on mortgage market structure 8
  • 9. Tugs of War – Summary• 2012 will NOT be a repeat of 2011• Many “tugs of war” occurring today will continue through most of 2012• Consumer spending surge in late 2011 will not continue• Housing effects come in two parts • Construction -> showing signs of life • Prices/turnover -> downside volatility remainshttp://www.svb.com/blogs/jmorgan/Tugs_of_War/ 9
  • 10. How Will Europe Impact our Economy?Dave Bhagat 10
  • 11. Europe’s Prospects Look Dim• A break up of the Euro Zone is unlikely in the near-term • Impact could be catastrophic • Not in anyone’s interest – today• The Greek situation is not resolved. It will probably result in a restructuring of debt for some investors. Hedge funds and others may force a default on their portion, triggering insurance payouts• Muddling through is the best possible outcome today• However, the long-term prospects for a stable EU and a strong Euro are poor. At some point, it is likely some countries will leave and the charter will be redefined• Europe will probably be in a technical recession soon; negative growth is possible when Q4 2011 data is in, probably most of 2012 as well• European banks remain under-capitalized and exposed to sovereign risk. An extended credit crunch remains a real possibility 11
  • 12. The Impact Will be Felt Here at Home• Europe accounts for over 20% of our exports• Europe will continue to undermine global confidence and risk appetite• If European banks fail or the credit crunch worsens, the effect on the U.S. will be even more severe• Our banks are in better shape than most European banks, but still have significant challenges and exposure to Europe. They will be impacted more by a recession and by European bank failures than by a single default (Greece?)• Countries with entrenched deficits (like us) will continue to be viewed and rated negatively• The bottom line: My view is that Europe’s problems could shave half a percentage point of U.S. GDP growth in 2012, more if there is a catastrophe 12
  • 13. The Fed and the Yield CurveJoe Morgan 13
  • 14. What has the Fed Done with Rates? Interest Rates 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Fed Funds 2-Yr Treasury 10-yr Treasury• Cost of funds extremely low, yet economic growth remains muted• Inflation concerns will arise when economy catches hold• Market rates will lead the Fed upward 14
  • 15. Today, the Fed is Divided into Two Camps• Camp Fear: • Inflation is prime concern • Protect the Fed’s credibility • Argue for higher interest rates• Camp Greed: • Employment and growth concerns drive viewpoint • Velocity of money is low, leaving room for more stimulus • A thriving economy heals all wounds 15
  • 16. Market Rates are Always Subject to Change 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Fed Funds 2-yr Treasury 10-yr Treasury• Market resets every date/all day• Longer exposures are subject to greater price changes• Even “passive” strategies require an active stance 16
  • 17. LIBOR, the Futures and Swaps MarketsDave Bhagat 17
  • 18. What Fed Funds Futures are Predicting 0.90% 0.80% 0.70% 0.60% 0.50% 0.40% 0.30% 0.20% 0.10% 0.00% Fed Funds Futures 1-23-12 Fed Funds Futures 1-27-12 Source: Bloomberg 18
  • 19. 3 Month LIBOR vs. Fed Funds Effective7.00%6.00%5.00%4.00%3.00%2.00%1.00%0.00% 1/1/2004 1/1/2005 1/1/2006 1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011 1/1/2012 3 month LIBOR Fed Funds Source: Bloomberg • 3 mo. LIBOR has normally maintained a steady relationship to Fed Funds • During times of financial stress, however, the spread tends to widen • October of 2008 is the most dramatic example, when it spiked to over 200 bps above Fed Funds 19
  • 20. Euro zone Concerns Elevate 3-month LIBOR… 3 month LIBOR0.70% Eurozone concerns = increased cost of credit0.60% - August 1, 2011 – 25 bps0.50% - Jan. 27, 2012 – 55.1 bps - 128% increase0.40%0.30%0.20%0.10%0.00% 3 month LIBOR Source: Bloomberg 20
  • 21. … but Swap Yields are Near All Time Lows 3 year swap rates7.00%6.00%5.00%4.00% Near all-time lows3.00% Jun ‘03 to Jun ‘06 - 1.64% to 5.64%2.00% - 250% increase1.00% Oct.10’ to Feb.‘11 - 0.67% to 1.63%0.00% - 143% increase 1/1/2002 1/1/2003 1/1/2004 1/1/2005 1/1/2006 1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011 1/1/2012 3 year swap rates Source: Bloomberg 21
  • 22. What the Markets are Telling Us• European concerns have driven LIBOR higher since August 2011• However, the market is pricing in less than a 25 basis point rise in Fed Funds through mid-2014 and only 50 basis points tightening by the end of 2014• As a result, 2 to 5-year swap rates are at historical lows• However, the curve is steeper further out, commodity prices remain high and the fiscal deficit, national debt and inflation remain concerns• If the economy picks up steam and Europe appears to be on the mend, market rates could rise appreciably even with the Fed on hold• When the economy has recovered and the tightening cycle begins, it is possible that Fed Funds will rise fairly rapidly to a more “normal” level of 3 to 4% 22
  • 23. From the Perspective of an InvestorJoe Morgan 23
  • 24. Stay on Point• Maintain a laser-focus on your objectives of: • Capital preservation – keep it safe! • Liquidity – keep it available! • Return – keep it growing!• Work with an advisor whose incentives and regulatory structure are aligned with you• Ensure appropriate communication and service from your advisor 24
  • 25. An Independent Approach to Portfolio Decisions Credit Portfolio Research Team Management Team Research and analysis Manage investments for capital focused on appropriate preservation, liquidity, and investment vehicles competitive return SVB Asset Management Investment Committee • SVB Asset Management Chief Compliance Officer • Representative of SVB Credit Group • President of SVB Asset Management & SVB Securities • Head of Bank Treasury 25
  • 26. Investment Strategies Mindful of Each Client’s RiskTolerance Client Risk Tolerance No tolerance for credit exposure Comfortable with Minimal corporate credit risk government-related credit riskSuitable Investment Strategy Treasury Strategy Government Strategy Comprehensive Strategy High quality investment grade Government Sponsored Enterprises corporate bonds Treasury securities (GSEs). Select Money Market Instruments TLGP debtAppropriate Investments Government strategy Rule 2a-7 Money Market Funds Government securities Treasury only Rule 2a-7 Money Market Funds Treasury securities Pre-qualified prime 2a-7 money market funds Greater yield pickup than government focused strategies. Treasury strategy with yield enhancements from GSEs and Requires in-depth knowledge of credit government funds. and sector analysis. Should avoid Predominately a buy and hold strategy withPortfolio Characteristics corporate issuers with a high reliance emphasis on highest degree of liquidity Potential opportunity to swap credit on wholesale funding. and duration to improve total return objectives. Select opportunities to capture gains on credit improvements and duration reallocation. 26
  • 27. 12-month Comprehensive Benchmark Strategy Security Type Allocation and Maturity Distribution MMF 1/9/12 10% 40% Corporates 35% 30% 30% Maturity Weighting 25% Treasuries 20% 25% 15% 10% 5% 0% Money Market Agencies Instruments 5% 30% Strategy Summary• Average Maturity: Neutral stance allows for participation in market rallies without • Average credit quality: AA+ increasing undue credit risk.• Maturity Targets: Regardless of maximum allowed in investment policy. Barbell • Average days to maturity: approach places 30 percent of the portfolio near the 1-year part of the yield curve. 365 Days• Liquidity: Twenty-five percent of portfolio maturing within 180 days to capitalize on • Estimated Yield To Maturity: future interest rate increases.• Overall Strategy: Based on our current view of the economy and fixed income markets .60% as they relate to future expectations.• Our Goal: To outperform an investment in the 12-month Treasury - as proxied by the Merrill Lynch 12-month Treasury Bill index - while providing required liquidity needs and preserving capital. Rates and yields shown are representative of the market’s recent activity and are subject to future market conditions and availability. The rates and yields have been obtained from sources we believe to be reliable, but we cannot guarantee their accuracy or completeness. They are for informational purposes only and 27 are not a solicitation or recommendation that any particular investor should buy or sell a particular security or strategy..
  • 28. From the Perspective of a BorrowerDave Bhagat 28
  • 29. Managing Floating Rate Debt Risk• Hedging rate risk is not speculative. Not hedging is a bet that rates will stay low, which is speculative, at least in the medium term• The decision to hedge (or not) should be based on the degree of leverage and the impact of interest payments on cash flow and net income at your company• Even though the Fed has indicated they expect to remain on hold for some time, the situation could change• Managing exogenous risks such as foreign exchange and interest rates is viewed as sound risk management policy, especially for public companies• We will now discuss two commonly used hedging tools 29
  • 30. What is an Interest Rate Swap?• A contract between 2 parties to exchange interest payments over a set period of time based on an agreed upon principal amount (“Notional”) • One party pays fixed (the borrower in most cases), the other pays floating • LIBOR is the foundation for the swaps market, but swaps can be indexed to Prime and other indices • The fixed swapped rate is the present value average of the LIBOR forward curve• No principal changes hands; the parties simply exchange (“swap”) interest payments for a set period of time 30
  • 31. Interest Rate Swap (continued) • Net Effect LIBOR + LIBOR + • Synthetically fix debt service Spread Spread • ProsSVB Debt Borrower SVB Swap • No upfront cost Fixed Rate • Known debt service • Flexibility (hedge all or a portion of the debt, all or a portion of the term) • Possible breakage payment if rates are higher than expectedLIBOR • Cons Fixed Rate • Negative carry (minimal today) • Possible breakage costs if rates are lower than expected Time 31
  • 32. What is an Interest Rate Cap?• Gives the buyer (generally the borrower) the right but not the obligation to pay a pre-determined fixed rate (the strike price)• Guarantees the borrower a maximum fixed rate, yet allows the borrower to retain the properties of a floating rate loan if rates remain below the strike• Costs the borrower a premium to purchase because of the added flexibility and lack of downside• It is most cost-effective for shorter maturities and/or when providing “worst case” disaster protection at a high (out of the money) cap strike rate 32
  • 33. Interest Rate Cap (continued) • Net Effect Cap • Set maximum level for funding Premium cost in a rising rate environment SVB Debt LIBOR + Borrower LIBOR - SVB Cap • Pros Spread Strike • Known cost (premium) which is also the maximum downside (if > 0) • Cap is always an asset – can be sold back if needed • Cons Option • Upfront premium could be significant depending on theLIBOR payout strike and term Cap strike Time 33
  • 34. Conclusions on Managing Rate Risk• Rates are low now and stay low for some time. How long and at what pace they ultimately rise is not clear today• The longer the tenor of your borrowing needs, the more you need to pay attention• Hedging a little early is better than being too late• Even though the risk of official rates rising appear very low today, that could change. Market rates could rise ahead of Fed Funds if the economy gathers momentum• Most importantly, entering into hedges is extremely cost effective today. Example: 3-month LIBOR is currently 0.55%, a 3-year swap is 0.63%, while a 5-year swap is 1.04% as of 1/30/12 34
  • 35. Questions? 35
  • 36. Biographies 36
  • 37. Joe Morgan Joe Morgan is the chief investment officer for SVB Asset Management and has been with the firm for 8 years. For more than 18 years he has successfully navigated the financial markets, managing institutional portfolios for the purposes of total return, current income, and liability diffusion. In his current role, Morgan works with a team of portfolio managers that set and execute investment strategy for all of SVB Asset Management’s client investments. Frequently invited to speak at financial industry events, Morgan is widely sought out by business media and influencers for his perspective on issues affecting the fixed income market. He is most well recognized for his leadership in exiting and speaking out about the substantial risks associatedChief Investment Officer with auction rate securities since 2004. The Wall Street Journal called MorganSVB Asset Management “The Auction Rate Cassandra” once the market started to fail in 2008.jmorgan@svb.com415.764.31498 Prior to joining SVB, Morgan was a senior portfolio manager with City National Asset Management in Beverly Hills, and was responsible for the banks taxable fixed income total return oriented clients. He also spent seven years with Seneca Capital Management in San Francisco. At Seneca, he was responsible for managing institutional fixed income assets totaling over $5 billion with various return objectives and benchmarks. Morgan received both his bachelors and masters degrees in finance from Texas A&M University, and is a Chartered Financial Analyst. 37
  • 38. Dave Bhagat Dave Bhagat is a senior product advisor for SVB Silicon Valley Bank’s global financial services group, based in Palo Alto, Calif. He advises clients on interest rate and currency hedging strategies and other aspects of global banking. In addition, he regularly writes articles on topics covering the global markets and conducts client seminars and webinars. Bhagat has over 25 years of experience in the currency, fixed income and structured products markets and has lived and worked in Asia,Senior Advisor - Global Treasury Europe and North America. Prior to joining SVB Silicon Valley Bank inManagement 2005, he worked at several financial institutions including JP MorganSilicon Valley bank Chase, HSBC and Citigroup. He has been a fixed income and currencydbhagat@svb.com trader and has managed multi-product sales and trading desks.650.320.1158 Bhagat earned a bachelor’s degree in economics and a master’s in business administration from the Wharton School of Finance at the University of Pennsylvania. 38
  • 39. Disclosures This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction. Interest Rate Swaps are offered by Silicon Valley Bank. SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group. Products offered by SVB Asset Management are not FDIC insured, are not deposits or other obligations of Silicon Valley Bank, and may lose value. 0112-0016 39