October 16, Managing Your Investments in a Rising Rate Environment. Danny Nelson Sr. Managing Consultant. Kathleen Edwards Senior Analyst

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1 October 16, 2013 Danny Nelson Sr. Managing Consultant Kathleen Edwards Senior Analyst Managing Your Investments in a Rising Rate Environment 222 North LaSalle Suite 910 Chicago, IL

2 Running Out of the Bulls 18.00% Returns 10-Year of Treasury Various Indices Yield 12/31/ /30/ % Treasury Index Annualized Total Return 14.00% 12.00% 2-Year Treasury Index 5.02% 10.00% 8.00% 5-Year Treasury Index 6.32% 6.00% 4.00% 2.00% 10-Year Treasury Index 6.86% 30-Year Treasury Index 7.99% 2.63% 10/7/ % Source: Bloomberg and BA/ML Global Bond Indices. 1

3 The Old Normal 5 th year of Fed s Zero Interest Rate Policy (ZIRP) Easy money monetary policy Modest economic recovery Historically low interest rates 6% 5% 4% 3% 2% 1% Federal Fund Target Rate % Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Federal Reserve Stimulus Timeline Financial Crisis: Sept 2008 QE3: Sept 2012 to Dec QE1: Nov 2008 to Mar 2010 QE2: Nov 2010 to June 2011 Operation Twist : Sept 2011 to June 2012 QE4: Dec 2012 to Present Source: Bloomberg 2

4 Short-Term Rates: Anchors Away? Economic and interest rate expectations: Significant unemployment reduction, positive growth, controlled inflation Fed funds target rate move in 2015 Thresholds for Fed rate movement: Unemployment below 6.5% Inflation below 2.5% 5% 4% 3% 2% 1% 0% Targeted Federal Funds Rate at Year-End FOMC Participant Forecasts as of September 18, Individual FOMC participant s judgment of the appropriate level of the target federal funds rate at the end of the specified calendar year. Source: Economic Projections of the Federal Reserve, September

5 Yield Shoulda, Woulda, Coulda.Didn t 3.1% 2.9% 2.7% 2.5% May 22: Bernanke response that (the Fed) could in next few meetings cut pace of purchases. 10-Year Treasury Yield May 22, % 2.1% 1.9% Sep 18: Fed announces no taper 1.7% 1.5% 1/1/13 2/1/13 3/1/13 4/1/13 5/1/13 6/1/13 7/1/13 8/1/13 9/1/13 10/1/13 Source: Bloomberg 4

6 Yield Reading the Tea Leaves: Shape of the Yield Curve The yield curve is positively sloped and has steepened significantly U.S. Treasury Curve September 30, 2013 vs. September 30, % Maturity YoY Change 3.00% 2.00% 1.00% 3 month -0.07% 6 month -0.10% 1 year -0.07% 2 year 0.10% 3 year 0.32% 5 year 0.79% 0.00% 361 my 2 y 3 y 5 y 7 y 10 y Maturity 30 y 10 year 1.06% 30 year 1.02% September 30, 2013 September 30, 2012 Source: Bloomberg 5

7 The Business Cycle We are here 6

8 Interest Rates Will Rise 7

9 Pace of Hikes Will Make a Difference Quick Fed Tightening Slow Fed Tightening Fed raised target rate 3.00% in a 1 year period (February 1994 February 1995) Fed raised target rate 4.25% over 2 years (June 2004 June 2006) 8

10 Major Considerations for Next Interest Rate Hike Unemployment rate and inflation Next Fed Chair: Janet Yellen??? GDP growth Status of any monetary stimulus Debt ceiling and sequester Impacts of Quick Tightening Large market value losses over shorter timeframe Capture higher rates more quickly Rapid rise in inflation Possible recovery killer due to high cost of credit Impacts of Slow Tightening Smaller market value losses over extended timeframe Measured rise in rates Slower rise in inflation Possible investment bubbles 9

11 Strategies for Existing Portfolios 10

12 Rising Interest Rates A Double Edged Sword Market value of portfolio falls: Reporting unrealized losses Potentially taking realized losses Negative periods of total return Higher investment and reinvestment yields: Increased investment income Potential steepening of the yield curve 11

13 The Bad News: Unrealized Market Value Losses Prices and Market Values Interest Rates Interest Rates Prices and Market Values Portfolio size: $20 million* Assuming instantaneous increase in rates Rates +0.25% Rates +0.50% Rates +0.75% Market Value Change (90,461) (180,923) (271,384) Market Value Post Rate Increase $19,909,539 $19,819,077 $19,728,616 *Based on sample portfolio with duration of 1.80 years. 12

14 What to Do With a Portfolio Full of Unrealized Market Value Losses? Option 1: Don t. Do. Anything. Pro: Securities will mature at par and you won t have any realized losses There s NO crying in fixedincome investment!!!! Con: Don t take advantage of available higher yields and increased earnings Option 2: Evaluate the portfolio for swap opportunities. Pro: Add higher yielding securities to portfolio and achieve higher earnings Con: Will realize a loss in the portfolio on security sale There is ALWAYS a cost : opportunity vs. initial loss 13

15 Now, the Good News: Reinvestment Opportunities Sometimes selling at a loss pays off Trade Date Trade Type Security Maturity Par Yield at market Yield at Cost G/L on Sale 6/18/13 Sell FNMA Notes 5/21/18 $5,350, % 1.06% ($62,820) 6/18/13 Buy Chevron Corp Notes 6/24/18 $5,210, % 1.72% - 14

16 Millions Millions Millions Balanced Approach to Portfolio Maturity Distribution Many ways to structure a portfolio to meet maturity target. $12 Bullet $4 Barbell $10 $8 $6 $3 $2 $4 $2 $1 $0 very short short middle long longer $0 very short short middle long longer $3 Laddered Strategy Considerations Fed on hold until 2015 $2 Long-term rates rising Steep yield curve $1 Barbell structure most compatible $0 very short short middle long longer Take advantage of higher rate while minimizing interest risk 15

17 Strategy: Steep Yield Curve and the Power of Roll Down Yield Earnings Summary Investment Today Investment Amount $5,000,000 Term 3-Year Investment Yield 0.93% Price 100 Investment 1-Year from Today Remaining Term 2-Year Investment Yield 0.93% Market Yield 0.50% Market Price Earnings Summary 1-Year from Today (1) Interest Earned $46, % 2.0% 1.8% 1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% Federal Agency Yield Curve October 1, 2013 (2) Principal (Price) Appreciation $42,733 Amounts Returned = (1) + (2) $89, % 3M 6M 1Y 2Y 3Y 5Y Maturity Total 1-Year Return 1.78% Note: Earnings are gross of fees. Past performance is not indicative of future performance. 16

18 Strategy: Capitalizing on Volatility Merrill Lynch Option Volatility Estimate Index 5-Year Treasury Daily Yield Change 140 Callable Purchase 0.2% Purchase Date Call Structure Final Maturity Yield to Next 0.1% Call Yield Comparable Yields (UST/AGN) /29/13 Quarterly call option, beginning 10/29/13 0.0% 4/29/ % 0.32% -0.1% 6-month: 0.08% / 0.10% 2-year: 0.20% / 0.29% /15/12 10/15/12 1/15/13 4/15/13 7/15/13-0.2% 12/31/12 3/31/13 6/30/13 Source: Bloomberg 17

19 Strategy: Diversity Can Offer Value With generally improving economic fundamentals, corporate and municipal sectors can offer value Ensure internal controls and appropriate evaluation resources are in place 6% Yield Curves as of June 30, % 4% 3% 2% 1% U.S. Treasury "AAA" Municipal G.O. U.S. "A" Financial Corporate 0% mm y 2 y 3 y 5 y 10 y 30 y Source: BA/ML Global Bond Indices and Bloomberg 18

20 Strategies for Investing Liquid Funds 19

21 The Price of Liquidity Is Rising 3% U.S. Treasury Curve September 30, 2013 vs. March 31, 2013 September 30, 2013 March 31, 2013 Maturity March 31, 2013 September 30, 2013 Yield Change 2% 3 month 0.07% 0.01% -0.06% 6 month 0.10% 0.03% -0.07% 1 year 0.12% 0.09% -0.03% 2 year 0.24% 0.32% +0.08% 1% 3 year 0.35% 0.63% +0.25% 5 year 0.77% 1.38% +0.61% 10 year 1.85% 2.61% +0.76% 0% 3 M 6 M 1 Y 2 Y 3 Y 5 Y 10 Y Source: Bloomberg 20

22 Net Asset Value at Market Long-term Bond Funds Will Be Negatively Impacted When Rates Move Higher Funds with longer duration and weighted average maturity are subject to greater variability Change in Net Asset Value % % -.50% Interest rate risk is asymmetrical in the current low rate environment Days +.50% % % 21

23 Strategy: Evaluate Options for Establishing a Portfolio Comparison of Strategies Objectives Investment Mandate/ Policy Risk Flexibility Control Performance Portfolio Customized to entity's desired strategy and policy constraints Credit criteria, maximum maturity, and duration determined by entity Portfolio can be restructured to changing cash flow needs and market conditions Entity maintains ownership of asset; held in own name Managed to benefit the entity through specific transaction and individual security selection Overnight Pool / Long-term Bond Fund Strategy determined by fund s investment criteria Credit criteria, maximum maturity, and duration may exceed entity's tolerance for risk Overnight pool fully liquid Bond fund offers limited flexibility to meet specialized requirements Own shares of fund, assets not held in entity's name Yield affected by deposits and withdraws of other fund participants 22

24 When is the Best Time to Invest Liquid Funds? Dollar-cost averaging: Measured approach to investing funds Diffuses interest rate risk by spreading investments over time $ DON T CALL THE MARKET! Bond Movement 23

25 Historically, Longer Portfolios Outperform Over Time Longer investment portfolios historically have generated significantly higher earnings relative to liquidity vehicles Risk/Return of Various Benchmarks 5 Years Ended 6/30/2013 BA/ML Index Duration Average Annual Return Cumulative Value of $50,000,000 Value over 3-Month Treasury Index 3-Month Treasury Index 0.24 Years 0.28% $50,715,394-1 Year Treasury Index 1.00 Years 1.06% $52,698,694 +$1,983, Year Treasury Index 1.89 Years 1.90% $54,929,956 +$4,214, Year Treasury Index 2.72 Years 2.77% $57,327,251 +$6,611, Year Treasury Index 3.97 Years 3.86% $60,429,133 +$9,713,739 Source: BofA/Merrill Lynch Global Bond Indices. 24

26 Periodic Total Returns But, Experience Higher Levels of Volatility 7% 6% 5% Comparison of Periodic Quarterly Returns June June 2013 Return Volatility of Various Benchmarks 5 Years Ended 6/30/2013 4% 3% BA/ML Index Duration Quarters with Negative Returns 2% 1% 0% -1% -2% 3-Month Treasury Index 0.24 Years 1 out of 20 1 Year Treasury Index 1.00 Years 2 out of Year Treasury Index 1.89 Years 4 out of Year Treasury Index 2.72 Years 6 out of Year Treasury Index 3.97 Years 7 out of 20-3% Jun 03 Jun 04 Jun 05 Jun 06 Jun 07 Jun 08 Jun 09 Jun 10 Jun 11 Jun 12 Jun 13 3-Month Treasury Bill 1 Year Treasury Index 1-3 Year Treasury Index 1-5 Year Treasury Index 1-10 Year Treasury Index Source: BofA/Merrill Lynch Global Bond Indices. 25

27 Communication with Managers and Elected Officials 26

28 Clear Communication of Investment Strategy Ensure that major tenets of investment program are conveyed to managers/elected officials: Internal controls Investment policy/risk tolerances Overall investment strategy Tailor communications to audience: Board Officials: Big-picture, 30,000 foot summaries Manager: Detailed, fact-filled, yet concise reports Be prepared to explain: New market conditions Market value losses (unrealized/realized) Initial losses on sales of securities, but over all benefit Importance of long-term approach 27

29 Example Trade Explanation Settle Date Trade Type Issuer Par Maturity Yield at Cost Yield at Market Gain on Sale Earnings to 12/21/15 Total Cash Flow 5/17/13 Sale FNMA $3,240,000 12/21/ % 0.39% $5,392 ($37,784) ($32,392) 5/17/13 Purchase Muni $3,235,000 5/17/ % 0.81% - $68,293 $68,293 Additional Net Benefit to 12/21/15 $35,901 Settle Date Trade Type Issuer Par Maturity Yield at Cost Yield at Market Gain on Sale Earnings to 9/22/14 Total Cash Flow 6/3/13 Sale FHLMC $3,570,000 9/22/ % 0.25% $15,376 ($27,021) ($11,645) 6/3/13 Sale FHLMC $3,415,000 9/22/ % 0.25% $19,363 ($30,227) ($10,864) 6/3/13 Purchase Muni $7,000,000 1/15/ % 0.95% - $86,060 $86,060 Additional Net Benefit to 9/22/14 $63,551 28

30 Summary Interest rates will rise. When? How fast? There are opportunities for your investment program: Maturity management Evaluation of sectors Understanding opportunity costs Communication with board officials and managers is key. Best time to invest was yesterday. Next best time to invest is today. Worst time to start investing is tomorrow. 29

31 Questions? 30

32 Disclaimer This material is based on information obtained from sources generally believed to be reliable and available to the public, however PFM Asset Management LLC cannot guarantee its accuracy, completeness or suitability. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation. All statements as to what will or may happen under certain circumstances are based on assumptions, some but not all of which are noted in the presentation. Assumptions may or may not be proven correct as actual events occur, and results may depend on events outside of your or our control. Changes in assumptions may have a material effect on results. Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not an offer to purchase or sell any securities.