Real Returns for Fixed Income Investors Investment Update Waiting for Fed Liftoff
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1 Real Returns for Fixed Income Investors Investment Update Waiting for Fed Liftoff CAJPA Fall Conference September 17, 2015 Martin Cassell, CFA CEO, Chief Investment Officer 6225 Lusk Boulevard San Diego, CA Phone Fax
2 Inflation and Investment Returns 1
3 2 Inflation and Real Returns Rolling 5 Year Annualized Return Comparison 12% 1-5 Yr Treasury Benchmark 10% 3 Mo T-Bill Benchmark CPI 8% 6% 4% 2% 0% Long run returns have decreased After accounting for inflation, money market allocations will have a negative return Source: Index return information provided by Bank of America Merrill Lynch and US Bureau of Labor Statistics Source: Bloomberg and Bank or America Merrill Lynch Global Bond Indices
4 3 Inflation and Real Returns Source: Bloomberg
5 4 Inflation and Real Returns Source: Bloomberg
6 5 Inflation and Real Returns Source: Bloomberg
7 6 Inflation and Real Returns Source: Bloomberg
8 7 Inflation, Discount Rates, and Return Rolling 5 Year Annualized Return Comparison 5% 4% 3% 2% 1% 0% -1% 1-5 Yr Treas Real Return 3 Mo Bill Real Return CPI -2% Source: Index return information provided by Bank of America/Merrill Lynch; California State Treasurer Local Agency Investment Fund (LAIF); US Bureau of Labor Statistics
9 8 Inflation and Real Returns Comparison of 1-5 Yr Treas Real Return, 3 Mo Bill Real Return and CPI $1.30 $ Yr Treas Real Return 3 Mo Bill Real Return CPI $1.20 Growth in millions $1.15 $1.10 $1.05 $1.00 $0.95 Source: Index return information provided by Bank of America/Merrill Lynch; California State Treasurer Local Agency Investment Fund (LAIF); US Bureau of Labor Statistics
10 9 Inflation and Real Returns Index Returns Versus Core Inflation (2.00) G5A0 (1-10) (0.49) (1.56) 2.77 GVA0 (1-5) (0.17) 1.25 G1A0 (1-3) CPI Core Long run returns have decreased After accounting for inflation, money market allocations will have a negative return Source: Bloomberg and Bank or America Merrill Lynch Global Bond Indices
11 Federal Reserve and Interest Rate Expectations 10
12 11 Effect of QE on Fed s Balance Sheet $4,500, $4,000, $3,500, QE1 Fed attempting to bring stability to the Banking system & the Housing Market Fed's Balance Sheet QE2 QE3 Taper Begins QE Ends Assets In Millions $ $3,000, $2,500, $2,000, $1,500, $1,000, September 2008 US financial system woes force Fed action and the beginning of Quantitative Easing (QE1) November 2010 The Fed begins QE2 triggering purchases of $600 billion in treasuries over the next six months September 2012 The Fed begins an open ended purchase policy, buying $40 billion in MBS per month December 2012 The Fed announces open ended purchases of treasuries at the rate of $45 billion per month May 2013 Fed Chairman Bernanke comments that the Fed could slow the pace of MBS and Treasury purchases in the next few meetings September 2013 The Fed surprises and does not start taper December 2013 The Fed begins to taper reducing purchases by $10 billion split evenly between MBS and Treasuries. October 2014 Quantitative Easing concludes Source: Bloomberg $500, $ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/2014 Other Assets Emergency Programs Discount Window Borrowing GSE Debt Agency Mortgage Back Security Treasury Bonds
13 Employment Source: U.S. Department of Labor 12
14 Inflation Source: US Department of Labor Source: Bureau of Economic Analysis 13
15 14 Owner s Equivalent Rent Rent and Owners Equivalent Rent account for about 32% of CPI Source: Bloomberg and US Bureau of Labor Statistics
16 15 Oil Energy accounts for about 8% of CPI Source: Bloomberg
17 16 Inflation Source: Bloomberg
18 17 Wage Inflation Source: Bloomberg and US Bureau of Labor Statistics
19 Gross Domestic Product Source: U.S. Department of Commerce 18
20 19 Global Growth Real GDP United States 1.80 (0.30) (2.80) United Kingdom 2.60 (0.30) (4.30) Germany (5.60) France (2.90) Italy 1.70 (1.00) (5.50) (2.80) (1.70) (0.40) Spain (3.60) 0.00 (0.60) (2.10) (1.20) Sweden 3.50 (0.70) (5.05) Switzerland (2.13) China South Korea Japan 2.18 (1.00) (5.53) 4.65 (0.48) (0.03) Relative to 2007, growth expectations are lower for every country besides the United States China s expected growth rate in 2016 is less than half of where it was in 2007 Core of Europe projected 2016 growth rate, ~1.5% Source: Bloomberg
21 Central Banks Policy Rates And The Stronger US Dollar Country Central Bank Policy Rate 10 -Year Govt Bond Yield North America United States % 2.18% Canada 0.50% 1.44% Europe Germany 0.05% 0.64% United Kingdom 0.50% 1.88% Spain 0.05% 1.92% Italy 0.05% 1.77% Asia / Pacific Japan 0.08% 0.41% Australia 2.00% 2.75% China 4.85% 3.57% South Korea 1.50% 2.43% YoY% Change 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% Dollar Index- 19.5% Euro - (18.0%) World Currency Rates *As of 7/31/2015 US interest rates look attractive on a global basis US Dollar has strengthened against global currencies Source: Bloomberg 20
22 21 Demographics United States Dec-10 Dec-20 Dec-30 Dec-40 Dec-50 Total Population (in millions) 310, , , , ,010 Under 20 yea rs 84,150 90,703 97, , , to 64 yea rs 185, , , , , years and older 40,229 54,804 72,092 81,238 88,547 Total Population 100% 100% 100% 100% 100% Under 20 yea rs 27% 27% 26% 26% 26% 20 to 64 yea rs 60% 57% 55% 54% 54% 65 years and older 13% 16% 19% 20% 20% 40% Dependency Ratio (Population of Country 65 and older as a Percentage of those 20-64) 35% Dependency Ratio 35% 37% 37% 30% 25% 28% 20% 22% 15% Source: US Census Bureau
23 22 Where Does the Market Think Inflation is Going? Source: Bloomberg
24 23 Where Does the Market Think Rates Are Going? Source: Bloomberg
25 24 Federal Reserve Federal Funds Rate Projection Fed members federal funds rate projections, ~0.75% in 2015, ~1.75% in 2016, 3.0% in 2017 are the Fed s projections realistic? Each shaded circle indicates the value (rounded to the nearest 1/8 percentage point) of an individual participant s judgment of the midpoint of the appropriate target range for the federal funds rate or the appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. Source: The Federal Reserve
26 Factors Affecting the Debate Over US Monetary Policy Arguments for tightening monetary policy: Labor Market Continued improvement in general labor market data. Inflation Although inflation rates are currently below the Federal Reserve s (FED) target, some members believe this is transitory and inflation rates will move higher. Economic Growth Reported Q2 and recent revisions to the Q1 Gross Domestic Product data show the economy continues to grow at a moderate pace. ZIRP Some members within the Fed question whether the zero interest rate policy (ZIRP) continues to provide positive marginal utility to economic growth. Arguments against tightening monetary policy: Labor Market Some Fed members argue the true employment picture is not as healthy due to the low participation rate and high level of underemployment. Inflation - Inflationary trends are below the Federal Reserve s target. Global Growth There is growing uncertainty regarding global growth as economic conditions in China and Europe remain weak. Strong Dollar There is growing concern an increase in the federal funds rate will cause the US dollar to become even stronger hurting US exports. 25
27 Flattening Yield Curve: Where is the Fed? 10/2 Yr US Treasury Spread Option Adjusted Spread Federal Funds Rate (Basis Points) (Basis Points) Federal Reserve Cycle Start Rate Finish Starting 6 mo* 12 mo** Starting 6 mo* 12 mo** Spread OAS February March % 6.00% n/a n/a n/a April May % 5.50% July July % 6.50% June August % 5.25% % 6.00% 5.00% Federal Reserve Tightening Cycles Fed Tightening Cycle Fed Funds Target Rate 0-25 bps 10/2 YR US Treasury Spread 152 bps 4.00% Percent (%) 3.00% 2.00% 1.00% 0.00% -1.00% *6 mo - 6 months after start of Fed tightening *12 mo- 12 months after start of Fed tightening 26
28 Flattening Yield Curve and Total Return BAML 1-5 YR Govt Index BAML 1-10 YR Govt Index Federal Funds Rate (Total Return) (Total Return) Federal Reserve Cycle Start Rate Finish Starting 6 mo* 12 mo** Starting 6 mo* 12 mo** Yield Yield February March % 6.00% 4.93% 0.22% 2.79% 6.25% -0.31% 2.36% April May % 5.50% 6.34% 4.70% 7.82% 6.43% 5.44% 8.73% July July % 6.50% 5.79% 1.15% 5.19% 5.92% 0.72% 5.21% June August % 5.25% 3.03% 1.63% 2.68% 3.35% 2.40% 4.00% 7.00% 6.00% 5.00% Federal Reserve Tightening Cycles Fed Tightening Cycle Fed Funds Target Rate 0-25 bps 10/2 YR US Treasury Spread 152 bps 4.00% Percent (%) 3.00% 2.00% 1.00% 0.00% -1.00% *6 mo - 6 months after start of Fed tightening *12 mo- 12 months after start of Fed tightening 27
29 Conclusions from the Analysis Tightening of monetary policy by the Federal Reserve typically leads to a flattening of the yield curve. Option Adjusted Spreads are stable in the beginning of a tightening cycle, but tend to widen out as tighter monetary policy begins to slow the economy putting negative pressure on corporate profitability. Total Returns are weaker in the first 6 months after an increase in the federal funds rate, but tend to recover as portfolios adjust to the new interest rate environment through the reinvestment of maturities and other cash flows such as interest payments. Longer duration strategies tend to benefit 12 months after an increase in the federal funds rate due to the flattening of the yield curve. In the long run, higher yields benefit fixed income investors with long-term investment horizons as income is the primary driver of total return. Significant headwinds remain for US Treasury yields to dramatically rise. 28
30 Inflation, Actuarial Discount Rates, and Investment Returns 29
31 30 Asset/Liability Matching If FV of assets ends up lower than FV of claims, more reserves will be needed Interest Rate Drop $40,000 Claims Shortfall $1,020,000 A S S E T S $1,060,000 C L A I M S Duration of Assets Duration of Claims If interest rates drop 2%, a $1 million investment will produce a $40,000 shortfall in claims funding.
32 31 Discount Rates and Return Rolling 5 Year Annualized Return Comparison 12% 1-5 Yr Government Benchmark 10% LAIF 5% Discount Rate 8% 6% 4% 2% 0% Source: Index return information provided by Bank of America/Merrill Lynch; California State Treasurer Local Agency Investment Fund (LAIF)
33 32 Discount Rates and Return Comparison of 1-5 Yr Government Benchmark, LAIF and 5% Discount Rate $1.75 $1.65 $ Yr Government Benchmark LAIF 5% Discount Rate Growth in millions $1.45 $1.35 $1.25 $1.15 $1.05 $0.95 Source: Index return information provided by Bank of America/Merrill Lynch; California State Treasurer Local Agency Investment Fund (LAIF)
34 Developing A Rolling Return Estimate Incorporating historical return information and future earnings estimate Seeking an effective estimate of future returns Portfolio 1 Yr Total Rate of Return 1.91% 3 Yr Total Rate of Return 1.27% 5 Yr Total Rate of Return 2.39% Purchase Yield 1.85% Market Yield 1.42% Future Earnings Estimate 1.63% 33
35 Required Future Return For a given discount rate, what do we need to earn in the future? Discount Rate 2.00% 1.50% 1.00% 3 Year Historical Total Rate of Return 1.27% 1.27% 1.27% Required (breakeven) 2 year return to meet Discount Rate 3.10% 1.84% 0.59% 34
36 Finding an Reasonable Discount Rate The 3 year historical return and the 2 year future return estimate have an expected return of about 1.50% 5 Yr Return Estimate 3yr TRR + Earnings Est. Historical 3 Year TRR 1.27% Future Return Estimate 1.63% 5 Year Rolling Return Estimate 1.42% Reasonable Discount Rate 1.50% 35
37 Rolling Return Estimates Estimate of the future 5 year rolling Total Rate of Return using a combination of Purchased Yield, Market Yield, and historical 3 year Total Rate of Return. 6.50% 5 Year Estimated Return 5.50% 4.50% 3.50% 2.50% 1.50% 0.50% Est 5 yr Rtn 2 yrs Forward 36
38 Rolling Return Estimates Using the combination of historical returns and estimated future earnings provides a very accurate estimate of the 5 year rolling Total Rate of Return. 6.50% 5 Year Estimated and Actual Returns 5.50% 4.50% 3.50% 2.50% 1.50% 0.50% Act 5yr TRR Est 5 yr Rtn 2 yrs Forward 37
39 Rolling Return Estimates The combination of historical returns and estimated future earnings may help provide a relatively stable and effective tool to help a pool manage funding estimates for future liabilities. 6.50% 5 Year Estimated and Actual Returns 5.50% 4.50% 3.50% 2.50% 1.50% 0.50% Act 5yr TRR Est 5 yr Rtn 2 yrs Forward 5 Year CMT 38
40 Rolling Return Estimates Using effective tools can help determine an appropriate and manageable discount rate. 6.50% 5 Year Estimated and Actual Returns 5.50% 4.50% 3.50% 2.50% 1.50% 0.50% Act 5yr TRR Est 5 yr Rtn 2 yrs Forward Discount Rate Used 5 Year CMT 39
41 Conclusions The Federal Reserve and Market interest rate expectations are divergent Although they are both anticipating a rise in rates It is a question of when and the impact on the market Inflation has a direct effect on return Inflation, actuarial assumptions, and return are all interconnected Forecasting is an estimate, not an absolute Known facts can help improve your discount rate estimate - better than a SWAG It is always prudent to be conservative in your forecast Past performance does not guarantee future results 40
42 Biographies Martin Cassell, CFA CEO, Chief Investment Officer Martin Cassell is the chief executive and investment officer at Chandler Asset Management and is a principal of the firm. Mr. Cassell is responsible for defining, planning, and directing company programs. He heads implementation of the firm s investment strategies and portfolio risk management. He designed the proprietary quantitative models that drive our investment process, establishing duration, structure, and asset allocation throughout client portfolios. Mr. Cassell joined Chandler Asset Management in 1991 from the City of San Diego where he managed a $1 billion fixed income portfolio. He began his investment career in 1987 managing portfolios at World Savings and Loan. Mr. Cassell received his B.S. in finance from California State University, Hayward. He is a member of the CFA Society of San Diego and holds the designation of Chartered Financial Analyst. He is also a member of the California Association of Joint Power Authorities (CAJPA) finance committee. 41
43 Disclosures Past performance is not indicative of future results. The information herein is provided for informational purposes only and should not be construed as a recommendation of any security, strategy or investment product, nor an offer or solicitation for the purchase or sale of any financial instrument. References to investment indices are for informational purposes and do not imply that managing portfolios to those styles will achieve comparable returns. Indices do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical performance results. Indices are unmanaged, and one cannot invest directly in an index. Any forecasts, forward-looking statements and assumptions are inherently limited and should not be relied upon as an indicator of future results. Any opinions and views constitute judgments made by the author at the date of this presentation and may become outdated or superseded at any time without notice. Any statements concerning financial market trends are based on current market conditions, which will fluctuate. Economic factors, market conditions and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark. The data contained in this presentation is the property of those providers, which were obtained from sources believed to be reliable, but are subject to change at any time at the provider s discretion. Unless otherwise noted, Chandler is the source of illustrations, performance data, and characteristics contained in this presentation. 42
Estimating Future Investment Earnings Today
CHANDLER A SSET MA N AGEMEN T Estimating Future Investment Earnings Today September 18, 2012 Martin Cassell, CFA CEO & Chief Investment Officer 6225 Lusk Boulevard San Diego, CA 92121 Phone 800.317.4747
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