City of San Juan Capistrano Fourth Quarter 2013 Portfolio and Market Review Sarah Meacham, Director PFM Asset Management LLC
Federal Reserve Taper Talk Drives Interest Rates The Federal Open Market Committee (FOMC) surprised markets in September by announcing that they would continue their asset purchase program (Quantitative Easing) when most market participants expected a taper. This announcement prompted a reversal of the rate rising trend from the prior four months. In December, rates started to rise again following the FOMC s announcement that they would begin tapering in January. 0.60% 2- Year U.S. Treasury Yield January 1, 2012 December 31, 2013 Taper Talk Begins Announcement of $10 Billion Taper 0.40% 0.20% No September Taper 0.00% Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13 Oct 13 Source: Bloomberg 1
A Longer View of Treasury Yields The Fed s multiple versions of Quantitative Easing were geared towards creating a low-rate environment, and yields at the end of December 2013 were still well below their levels before Quantitative Easing began. 6% 5% Fed Cuts Rate to 0% QE1 QE2 Operation Operation Twist Twist Extended QE3 4% 3% 2% 1% 0% Rates Environment Before Quantitative Easing Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 2-Year 5-Year 10-Year Source: Bloomberg 2
Yield Curve Continued to Steepen With short maturity yields anchored by the Fed Funds rate, the rise in longer-term rates left the yield curve in December 2013 much steeper than it was for most of the year. 2.0% 1.8% 1.6% 1.4% 1.2% U.S. Treasury Yield Curve December 31, 2012 September 30, 2013 December 31, 2013 12/31/12 9/30/13 12/31/13 3 Month 0.04% 0.01% 0.07% 6 Month 0.11% 0.03% 0.09% Yield 1.0% 0.8% 0.6% 0.4% 1 Year 0.14% 0.09% 0.11% 2 Year 0.25% 0.32% 0.38% 3 Year 0.36% 0.63% 0.80% 0.2% 5 Year 0.72% 1.38% 1.74% 0.0% 3 M 6 M 1 Y 2 Y 3 Y 5 Y Maturity 3
Economic Growth Remains Moderate Third quarter GDP surprised the market. The 4.1% annualized growth rate far exceeded the market expectation of 2.0%. It is important to note that the upward surprise was largely attributed to a sizable increase in inventories. QoQ % Change; Seasonally Adjusted Annualized Rate 6% 4% 2% 0% -2% -4% -6% -8% -10% Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Post Recession Average = 2.3% Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 0.1% Q4 1.1% Q1 2.5% Q2 4.1% Q3 Q4 Bloomberg Survey of Economists Q1 Q2 Q3 2008 2009 2010 2011 2012 2013 2014 Source: Bureau of Economic Analysis 4
Inventory Build-Up Overstates Economic Strength The third quarter growth rate may have overstated the underlying strength of the economy as nearly half of the growth was attributable to a 1.7% growth in inventories. If consumers purchases don t accelerate enough to justify the third quarter s 1.7% inventory growth, then companies may slow production in the coming quarters to decrease inventories. This could result in inventories being a negative contributor to GDP growth in future. 5% Contribution of Inventories to GDP 4% 3% 2% 1% 0% -1% 0.4% 3.4% 0.6% 2.1% 2.2% 2.1% -0.9% -2.0% 0.9% 0.2% 0.4% 2.1% 1.7% 2.5% -2% -3% Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Source: Bureau of Economic Analysis, Bloomberg Non-Inventories Inventories 5
Labor Market Conditions Continue to Improve In 2013, the economy added 2.2 million new jobs signaling an improving labor market. In December, the economy added only 74,000, far short of the market s expectation of 197,000. Despite the negative surprise in the number of new jobs added, the unemployment rate finished 2013 at 6.7%. This is 1.2% lower than at the end of 2012. Much of the decline in the unemployment rate is attributable to a decline in the labor force participation rate, which ended the year at 62.8% a 35-year low. 600K 400K 200K 0K -200K Change in Nonfarm Payrolls 7.6 Million Jobs Gained Unemployment Rate: 6.7% 12% 10% 8% 6% -400K 4% -600K -800K 2% 8.8 Million Jobs Lost -1,000K 0% Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Change in Non-Farm Payrolls (left axis) Unemployment Rate (right axis) Source: Bureau of Labor Statistics 6
Janet Yellen Takes Over as Fed Chairman Janet Yellen is generally considered a dove and a Federal Reserve insider; the market expects her to continue the monetary policy path of the current Fed Chairman, Ben Bernanke. Education Brown University: B.A. in Economics Yale University: Ph.D. in Economics Career Professor at University of California, Berkeley since 1980 Served on the Federal Reserves Board of Governors from 1994-1997 Chair of the President s Council of Economic Advisers from 1997-1999 (Clinton Administration) President of the Federal Reserve Bank of San Francisco from 2004-2010 Nominated in 2010 as Vice-Chair of the Federal Reserve System (Obama Administration) Source: Federal Reserve 7
Fourth Quarter 2013 Strategy Recap Our investment strategy for the fourth quarter was based on our view that interest rates would trend gradually higher in anticipation of the Federal Reserve tapering its bond purchases. The key components of our strategy included: Maintaining a defensive duration posture to protect portfolio value Emphasizing high-quality credit instruments as they offer value over Treasury and Federal Agency securities Monitoring yield spreads and relative value between sectors 8
Total Return Our strategy for the fourth quarter proved to be effective. The total return of the City s portfolio was 12 basis points (0.12%) higher than the benchmark (Bank of America Merrill Lynch 1-3 Year U.S. Treasury Index) while maintaining a duration less than the benchmark, which limited the portfolio s interest rate risk relative to the benchmark. Performance is measured on a total return basis, which takes into account interest income, realized gains and losses, and unrealized gains and losses due to changes in market value. The yield to maturity at cost of the portfolio as of December 31, 2013 was 0.55%. The average yield on investments held by the City (LAIF and non-negotiable CDs) was 0.28%. Yield to maturity at cost is a forward-looking earnings indicator that assumes all coupons will be reinvested at the security s yield. Total Return for periods ending December 31, 2013 Duration (years) Past Quarter Past Quarter Annualized City of San Juan Capistrano 1.41 0.18% 0.70% BAML 1-3 Year U.S. Treasury Index 1.83 0.06% 0.24% Difference - 0.12% 0.46% Notes: Performance on trade date basis, gross (i.e., before fees), in accordance with the CFA Institute s Global Investment Performance Standards (GIPS). Bank of America Merrill Lynch Indices provided by Bloomberg Financial Markets. Performance inception date is September 30, 2013. 9
Portfolio Is in Compliance with California Government Code and City s Investment Policy Security Type Market Value as of December 31, 2013 Percentage of Portfolio Permitted by Policy In Compliance U.S. Treasury $8,876,514 22% 100% Federal Agencies $8,965,546 22% 75% Commercial Paper $2,399,767 6% 25% Negotiable CDs $2,207,684 6% 30% Corporate Notes $5,596,383 14% 30% Money Market $121,094 <1% 20% Non-Negotiable CDs $449,332 1% 25% LAIF $11,820,099 29% 40% Totals $28,166,988 100% 10
Portfolio Issuer Distribution and Credit Quality Issuer Distribution Credit Quality Corporate Issuers General Electric CC 2% Wells Fargo 2% JP Morgan Chase 2% Berkshire Hathaway 2% IBM 2% Caterpillar 2% Procter & Gamble 2% Commercial Paper Issuers Mitsubishi UFJ Financial Group 2% Toyota Motor CP 2% HSBC Holdings 2% Non-Negotiable CD Issuers Mission National Bank 1% Capital One <1% Independence Bank <1% Negotiable CD Issuers Ally Bank 1% Discover Bank 1% Goldman Sachs Bank 1% Sallie Mae 1% Sovereign Bank 1% Independent Bank 1% CIT Bank <1% American Express <1% FHLB 4% FNMA 8% FFCB 10% LAIF 29% U.S. Treasury 22% AAA 1% A-1+/A-1 (Short-term) 6% Not Rated (LAIF) 29% AA 52% Not Rated (CDs) 5% A 7% As of December 31, 2013 Ratings by Standard & Poor s CDs that are not rated are insured by the FDIC. 11
Corporate Holdings Procter & Gamble Company An international conglomerate which manufactures and sells consumer products in sectors such as laundry products, paper, beauty products, food and beverage, and many other areas. High profitability ratios compared to industry peers including a pre-tax margin of 17.6%. Low debt/assets ratio of 22.6% Rated AA-/Aa3 by S&P and Moody s. Caterpillar Financial A subsidiary of Caterpillar Inc. that provides retail financing for the purchase of Caterpillar equipment, machinery, engines, and other products. High profitability metrics including pre-tax margin of 12.5%. Return on capital of 6.7% Rated A/A2 by S&P and Moody s. IBM Corp A international company that sells products including technologies, software, IT systems, and other technological services. Strong earnings growth of 16.5% over the past year. High interest coverage ratio of 42.9, representing strong ability to repay debt. Rated AA-/Aa3 by S&P and Moody s. Source: Bloomberg 12
Corporate Holdings continued General Electric Capital Corp A subsidiary of General Electric Co. which provides financing, mortgage, and insurance services. Parent company General Electric has strong 1-year earnings growth of 9.7%. Rated AA+/A1 by S&P and Moody s. Wells Fargo & Company A diversified financial services company providing banking, insurance, investments, mortgages, credit cards, and other services. Strong leverage ratios including a high tangible capital ratio of 9.5. Rated A+/A2 by S&P and Moody s. Berkshire Hathaway A holding company with subsidiaries in many different sectors. The main operations include insurance, a railway, a specialty chemical company, and other diversified companies. Strong earnings growth of 16.8% over the past year. Return on capital of 7.9%. Rated AA/Aa2 by S&P and Moody s. Source: Bloomberg JP Morgan Chase & Co. A financial services company offering global services including investment banking, asset management, private banking, commercial banking, and other banking services. Strong earnings growth of 19.4% and high profitability ratios. Rated A/A3 by S&P and Moody s. 13
Commercial Paper Holdings Bank of Tokyo Mitsubishi UFJ Ltd. A company that offers commercial banking services including deposits, loans, and securities investment trusts. The company also offers other services including securities brokerage, asset management, and more. High profitability metrics including an efficiency ratio of 58.8% High earnings growth of 24.7% over the past year. Rated A-1/P-1 by S&P and Moody s. HSBC USA Inc. A subsidiary of HSBC Holdings PLC which provides banking services including retail and commercial banking, investment banking, insurance, and more. Parent company has high profitability ratios and capital ratios including a earning assets to interest bearing liabilities of 503.4%. Rated A-1/P-1 by S&P and Moody s. Toyota Motor Credit Corp. A subsidiary of Toyota Motor Corp which provides automotive financial services including retail installment sales contracts, leasing contracts, insurance, and other services. Parent company has a strong interest coverage ratio of 57.5, indicating a strong ability to repay debt. Rated A-1+/P-1 by S&P and Moody s. Source: Bloomberg 14
Maturity Distribution Anticipating an uptick in rates due to the potential taper by the Fed, we shortened the portfolio s maturity structure and duration from 1.66 years to 1.41 years during the fourth quarter to protect the value of the portfolio. 40% 35% 32% 38% 36% Percentage of Total Portfolio 30% 25% 20% 15% 10% 5% LAIF 23% LAIF 29% 5% 11% 29% 21% 16% 6% September 30, 2013 December 31, 2013 6% 0% Under 6 Months 6-12 Months 1-2 Years 2-3 Years 3-4 Years 4-5 Years Callable and floating-rate securities in the portfolio are included in the maturity distribution analysis to their stated maturity date, although they may be called prior to maturity. 15
First Quarter 2014 Strategy If rates rise as the Fed tapers its extraordinary monetary stimulus, negative returns on longer maturity securities may become unavoidable for short periods. Active duration management will be a critical aspect of our strategy in early 2014 to mitigate the effects of rising rate and to maximize performance. This will be balanced, however, by recognizing the enhanced earnings potential offered by the current steep yield curve. Federal Agency yields spreads have little value in most shorter maturities, so the search for value will include other high-quality investments such as corporates, CDs, municipals, and commercial paper. With corporate spreads now at the tightest levels in recent years, we do not expect corporate values to appreciate much more. However, the yields of corporates should continue to provide superior income return in 2014. We will seek to maximize portfolio value through careful and prudent active management. 16