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
Role of Information and technology in banking and finance .pptx
Managing Fixed Income Risk in an Uncertain World
1. Managing Fixed Income Risk in an
Uncertain World
Silicon Valley Bank
February 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
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 remains
http://www.svb.com/blogs/jmorgan/Tugs_of_War/
9
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
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
19. 3 Month LIBOR vs. Fed Funds Effective
7.00%
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
21. … but Swap Yields are Near All Time Lows
3 year swap rates
7.00%
6.00%
5.00%
4.00%
Near all-time lows
3.00% Jun ‘03 to Jun ‘06
- 1.64% to 5.64%
2.00% - 250% increase
1.00% 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
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 Risk
Tolerance
Client Risk Tolerance
No tolerance for credit exposure Comfortable with Minimal corporate credit risk
government-related credit risk
Suitable 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 debt
Appropriate 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 with
Portfolio 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..
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
• Pros
SVB 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 expected
LIBOR
• 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 the
LIBOR 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
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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 associated
Chief Investment Officer
with auction rate securities since 2004. The Wall Street Journal called Morgan
SVB Asset Management “The Auction Rate Cassandra” once the market started to fail in 2008.
jmorgan@svb.com
415.764.31498 Prior to joining SVB, Morgan was a senior portfolio manager with City National
Asset Management in Beverly Hills, and was responsible for the bank's
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 bachelor's and master's 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 in
Management 2005, he worked at several financial institutions including JP Morgan
Silicon Valley bank Chase, HSBC and Citigroup. He has been a fixed income and currency
dbhagat@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