NCLGIAWC Optimizing Investment Portfolios

NCLGIAWC Optimizing Investment Portfolios Wells Fargo Securities - Fixed Income Market & Portfolio Strategy February 2017 Garret Sloan, CFA Director WFS and its investment representatives do not act as Municipal Advisors and only provide investment advice or recommendations with respect to bond proceeds as permitted by available exemptions

Table of Contents I. Monetary Policy, Rates Outlook II. III. IV. Positioning on the Curve The Supply Situation A Blight of Bills Tactical Liquidity V. Beyond Money Market Reform 2

Monetary Policy, Rates Outlook

Rate (%) How much will Rates Rise? According to Policymakers The 2017 median appropriate Fed funds rate increased to 1.38 percent from 1.13 percent and the 2018 median appropriate rate is now projected at 2.13 percent from 1.88 percent. Fed Fund futures are pricing at the lower end of forecasts. 4.0 3.5 September Projection December Projection Fed Funds Futures June September Dot Plot Comparison 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2016 2017 2018 Longer Run Source: Federal Reserve Board and Wells Fargo Securities, LLC 4

The FOMC has become more confident in the U.S. economy, but remains data-dependent Most FOMC members believe that the pace of the U.S. economy will warrant multiple additional rate hikes in 2017. In [raising the federal funds rate by ¼ percentage point], my colleagues and I are recognizing the considerable progress the economy has made toward our dual objectives of maximum employment and price stability. Janet Yellen, December 2016 Sometimes I m asked whether the FOMC routinely coordinates our monetary actions with those of other countries. The answer is no we set our monetary policy to promote our goals of maximum employment and price stability in the U.S. Loretta Mester, November 2016 I believe that appropriate policy calls for a slow pace of normalization in order to give the real economy an adequate growth buffer to withstand downside shocks that might otherwise drive us back to the zero-lowerbound. Charles Evans, February 2017 I see three modest hikes as appropriate for the coming year, assuming the economy stays on track. Fed policymakers enjoy saying we re data -dependent and this is an area where that rings especially true. Patrick Harker, January 2017 While economic shocks are, by their very nature, difficult to forecast, the risk that the Fed will snuff out the expansion anytime soon seems quite low because inflation is simply not a problem. William Dudley, January 2017 Source: Wall Street Journal, Wells Fargo Securities, LLC 5

Mar-78 Mar-80 Mar-82 Mar-84 Mar-86 Mar-88 Mar-90 Mar-92 Mar-94 Mar-96 Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 But Concerns Remain Labor Force Participation Rate and Unemployment The participation rate has followed the decline in the unemployment rate, suggesting some of the decline is not due to job creation. 12 Unemployment (LHS) Labor Participation (RHS) 70.0 10 69.0 68.0 8 67.0 6 66.0 4 65.0 64.0 2 Mar'78 = 62.8 Jan'17= 62.9 63.0 0 62.0 Source: BLS and, Wells Fargo Securities, LLC 6

and inflation remains below the 2 percent target The argument to keep rates low has been focused on inflation, with wage inflation still low and the PCE Core Deflator still below the 2% target. The challenge of our times right now is becoming clear, and that is growth San Francisco Fed President, John Williams 5-Year Inflation Expectations in 5 Years PCE Core Deflator Remains Below Forecast 12.00 5.00 10.00 8.00 4.50 4.00 3.50 3.00 6.00 2.50 4.00 2.00 1.50 2.00 1.00 0.50 0.00 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 0.00 1990 1993 1996 1999 2002 2005 2008 2011 2014 Source: BLS, University of Michigan and Wells Fargo Securities, LLC 7

Economists When will the Fed Raise Rates next? Depends on Who You Ask Bloomberg Survey Estimates of Expected Fed IOER Mar-17 May-17 60 50 40 The consensus economist estimates show that most call for the FOMC to remain on hold at least through May. 30 20 10 0 75 100 125 Source: Federal Reserve Bank and Wells Fargo Securities, LLC 8

Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Yield (%) When will the Fed raise rates again? Cash markets remain subdued Short Term Rates Remain Low 1.2 3M Tbill 3M LIBOR Short-term cash markets have responded to the second rate hike, though T-bill rates remain at either the lower end or below the Fed s target range. 1.0 0.8 0.6 This is likely to remain the case for the foreseeable future as demand for short-term government assets is at an alltime (non-crisis) high. 0.4 0.2 0.0 Fed funds target range Source: ICE, Bloomberg an d Wells Fargo Securities, LLC 9

When will the Fed raise rates? Futures markets expect two hikes in 2017 and two in 2018 Cash and Futures-Implied Yields Eurodollar and Fed Funds futures contracts have began to rise sharply as the market reacts to the recent rate hike by the FOMC and expects additional near-term hikes. 3.0 Dec '17 Futures Dec '18 Futures 3M LIBOR 3.0 3.0 Dec '17 FF Futures Dec '18 FF Futures Fed Effective 3.0 2.5 2.5 2.5 2.5 2.0 2.0 2.0 2.0 1.5 1.5 1.5 1.5 1.0 1.0 1.0 1.0 0.5 0.5 0.5 0.5 0.0 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan 0.0 0.0 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan 0.0 Source: CBOT, ICE, Bloomberg and Wells Fargo Securities, LLC 10

After Money Fund Reform

Asset ($M) Role Reversal: Government funds take over the money market Money Market Fund AUM 2,500 The shift in assets has created a sharp rise in demand for government assets. This has been absorbed by: 1. Increased Repo Supply (Fed and private) 2. Increased Agency Supply 3. Increased Bill Supply 2,000 1,500 1,000 500 - Prime Funds Government Funds Source: Wells Fargo Securities, ICI 12

Demand for government paper rises Starting in 2016, Funds Became Much More Active in Bill Auctions Percent Awarded in Bill Auctions by Investor Class Source: US Treasury 13

Yield (%) Spreads between credit and government securities widened 90-Day Yields on Money Market Securities 1.2 The spread between T-Bills and Credit markets has widened significantly, peaking around MMF reform at > 60 basis points between LIBOR and Bill rates. Since the last rate hike, the credit spread in 3-month offerings has tightened to ~55 basis points. 1.0 0.8 0.6 0.4 0.2 0.0 13-Wk Treasury Bills Tier 1 Non-Financial CP A1/P1 CDs Agency Discounts Fed RRP (o/n) 3M LIBOR SIFMA Source: Wells Fargo Securities, LLC, Federal Reserve, Bloomberg 14

The Debt ceiling will keep this spread wide US Treasury Operating Balance 500 Between now and March 15, the Treasury s Operating Balance needs to fall by approximately $280 billion. To accommodate that, bill supply will need to fall by an estimated $120 billion - $140 billion. Following the March 15 deadline, the cash balance is expected to climb back to $100 billion by March 30, and $200 billion by June 30. 450 400 350 300 250 200 150 100 50 0 Required Cash Balance by March 15 Source: ICE, Bloomberg an d Wells Fargo Securities, LLC 15

Bills markets have been trading at significant spreads below OIS Treasury Bills began to trade at spreads below the OIS in the aftermath of MMF Reform, suggesting increased demand for Treasury Bills 1-Month T-Bill OIS Spread 3-Month T-Bill OIS Spread 0.8 0.7 0.6 0.5 0.4 0.3 1-Month T-Bill 1-Month OIS Bill-OIS Spread 2013 2016 Post MMF 1M 8.7 14.7 0.8 0.7 0.6 0.5 0.4 0.3 3-Month TBill 3-Month OIS 0.2 3M 8.8 19.2 0.2 0.1 0.1 0 0-0.1-0.1 Source: ICE, Bloomberg an d Wells Fargo Securities, LLC 16

$Bn Credit markets saw a pullback in supply Commercial Paper Outstanding 40 20 Financial issuers were impacted the most by MMF reform, in both CP and CD markets. Peak-to-trough, 2016 Financial CP fell by more than $156 billion. 0-20 -40-60 -80 NonFinancial Financial AssetBacked 1 Month Ago 1 Year Ago Source: Wells Fargo Securities, LLC, Federal Reserve 17

Is there Value in Prime Funds?

Basis Points well? Prime vs. Government Yield Spread Spreads between government and prime funds over the past 10 years have averaged 18.9 basis points in the retail market and 20.8 basis points in the institutional market. 140 120 100 Excluding the financial crisis (2008-2009), the average spread between government and prime funds is 15.2 basis points in the retail market and 16.3 basis points in the institutional market. 80 60 40 20 Current spreads are averaging more than 40 basis points for institutional funds. 0 Retail Spread Institutional Spread Source: Wells Fargo Securities, LLC, imoneynet 19

10/14 11/14 12/14 1/15 2/15 3/15 4/15 5/15 6/15 7/15 8/15 9/15 10/15 11/15 12/15 1/16 2/16 3/16 4/16 5/16 6/16 7/16 8/16 9/16 10/16 11/16 12/16 10/14 11/14 12/14 1/15 2/15 3/15 4/15 5/15 6/15 7/15 8/15 9/15 10/15 11/15 12/15 1/16 2/16 3/16 4/16 5/16 6/16 7/16 8/16 9/16 10/16 11/16 12/16 Portfolio managers are extending and increasing floater allocations WAM and WAL Prior to MMF implementation, we saw a significant shortening of the WAM and WAL of Prime funds in anticipation of: Expected Outflows Possibility of rising rates After MMF implementation, WAM and WAL immediately began to rise, particularly with Prime institutional funds. Most of this exposure is in the floating-rate CD space. It has had the effect of placing some downward pressure on Commercial Paper yields but spreads remain wide. Prime Institutional Funds Government Institutional Funds 80 100 70 90 60 50 80 70 60 40 50 30 40 20 10 0 30 20 10 0 WAM WAL WAM WAL Source: Wells Fargo Securities, LLC, imoneynet 20

Cross Sector Relative Value 0 1 Year

CP and VRDNs Cross Sector Relative Value < 1 Year 2.0% 1.8% For approved asset classes in the state of North Carolina, Tier 1 financial CP and tax-exempt VRDNs are interesting. For comparison with taxexempt VRDNs, the SIFMA 7-day index is similar to the current 30-day CP rate. 1.6% A2/P2 CP 1.4% 1.2% 1.0% 0.8% 0.6% A1/P1 CP 0.4% 0.2% 0.0% O/N 1 Mo 3 Mo 6 Mo 9 Mo 1 Yr Government Repo Non-Traditional Repo Prime Funds A1/P1 CP A2/P2 CP TE VRDNs TAX VRDNs AA Corps AAA TE AA TE AAA LGIP Net Yield Source: Wells Fargo Securities, LLC, Bloomberg, imoneynet, DTCC 22

Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 The term structure of CP Industrial CP Term Structure remains Steep 0.90 0.80 O/N nonfin 30d nonfin 90d nonfin 0.70 0.60 0.50 The term structure of CP has risen, with the spread between 30 and 90-day CP widening to almost triple the historical average. 0.40 0.30 0.20 0.10 0.00 It is also 5 basis points higher than the previous rate-tightening cycle average. 0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00-0.05-0.10 Source: Wells Fargo Securities, LLC, Federal Reserve 23

Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 And discount notes 90-Day Bills vs. Discos 25 20 15 There is significant demand from institutional investors for discount notes, pushing yields to very tighter levels vs. historical averages. 10 5 0-5 -10 Source: Wells Fargo Securities, LLC, Bloomberg, imoneynet, DTCC 24

Tactical Liquidity Portfolio Segmentation to Optimize Investment Objectives

Positioning Corporate Cash Portfolios Curve steepening in the current environment is causing investors to look at their strategic cash allocations to see if there are opportunities to extend or introduce new asset classes. Segmentation of the Corporate/Public Cash Portfolio (for illustrative purposes only) Liquidity, stability Stability of principal of Principal Operating Cash (Horizon - daily) Reserve Cash (Horizon - Quarterly) Restricted Cash (Horizon - longer-term) Strategic Cash (Horizon - longer-term) Less liquidity, higher yields, more price Less liquidity, volatility higher yields, more price volatility Source: ICI, Wells Fargo Securities, LLC Q1 Q2 Q3 Q4 26

Portfolio Construction Approaches Basic Cash Balance Multiplier Approach $30 $30 The Basic Approach manages all expected cash outflows through existing cash balances, represented by the grey area and invested in daily liquid assets, with an additional liquidity buffer for uncertainty. $25 $20 $15 MMFs, LGIP, O/N Inv. $25 $20 $15 The balances represented by the light and dark blue areas are not anticipated to be used as primary liquidity and can be invested further out on the curve to enhance yield. $4M Short-term inv. (6 12M) $10 $9M Short-term inv. (1-3Y) $5 $0 7-Jan 7-Feb 7-Mar 7-Apr 7-May 7-Jun 7-Jul 7-Aug 7-Sep 7-Oct 7-Nov 7-Dec Cash Balance Forecast Source: Wells Fargo Securities, LLC $10 $5 $0 27

Portfolio Construction Approaches Basic Cash Flow Multiplier Approach The Cash Flow Multiplier Approach Identifies your single largest month of net outflows over a historical period plus any expected changes, and the investor identifies a suitable multiplier to that outflow based on the cash flow cycle. Public Entities with chunky cash flows may need to choose a larger multipler. Inflows Outflows Net Cashflow January $5,000 $6,000 ($1,000) February $6,000 $4,000 $2,000 March $10,000 $13,000 ($3,000) Source: Wells Fargo Securities, LLC 28

Portfolio Construction Approaches Basic Cash Flow Multiplier Approach This is an intellectual exercise to help think through actual liquidity needs. Each portfolio s needs will be different based on: 1. Cash cycle 2. Risk tolerances 3. Changes to cash cycle Liquidity Analysis Total Portfolio $100,000 Balance in MMF or LGIP $60,000 Investments $40,000 Largest Monthly Net Outflow ($3,000) Liquidity Multiplier 5 Required Liquidity $15,000 Excess Liquidity? $45,000 Source: Wells Fargo Securities, LLC 29

Portfolio Construction Approaches Maturity Matching Approach $30 $30 MMFs, LGIP, O/N Inv. $25 $25 The Maturity Matching Approach identifies the size and dates of known cash outflows and invests an equivalent amount of cash to those dates. Liquidity is partially managed through maturity matching, allowing short-term investments to constitute a larger part of the overall portfolio. $20 $15 $10 $5 Short-term inv. (1-3Y) Short-term inv. (6-12M). $20 $15 $10 $5 $0 $0 Cash Balance Forecast Source: Wells Fargo Securities, LLC 30

Yield Positioning Corporate Cash Portfolios Product Segmentation Across Liquidity Buckets Money Markets < 12M S/T Investments > 12M Products can be placed in multiple buckets. However, certain products are more suited to certain investment styles based on relative liquidity and duration profiles. Operational Cash Bank Deposits Sweep Accounts Money Market Funds Treasury Bills Discount Notes Repo Commercial Paper Certificates of Deposit TE/Taxable VRDNs Reserve Cash Commercial Paper Certificates of Deposit Short Corporate Bonds Treasury Bills/Notes Agency Discos/Bullets Agency Municipal Securities Floaters Restricted/Strategic Cash Certificates of Deposit Brokered CDs Corporate Bonds Treasury Notes Agency Callables Agency Bullets Municipal Securities Asset-backed Securities Duration Source: Wells Fargo Securities, LLC 31

Disclosure Appendix This publication is intended for institutional accounts only (as defined in FINRA Rule 4512), please do not forward. Strategist Commentary is a product of Wells Fargo Securities Fixed Income Sales and Trading and is not a product of Wells Fargo Securities, LLC s Research, Economics and Strategy. The views expressed herein might differ from those of Research, Economics and Strategy. Important Information for Non-U.S. Recipients This report is prepared by Wells Fargo Securities, LLC in accordance with U.S. law and applicable rules and regulations for use by institutional investors. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. This report is not intended for, and should not be relied upon, by retail investors. Please consult your Investment Representative for additional information. U.S. residents are directed to wellsfargo.com for investment and related services. Important Information for Australian Recipients Wells Fargo Securities, LLC is exempt from the requirements to hold an Australian financial services license in respect of the financial services it provides to wholesale clients in Australia. Wells Fargo Securities LLC is a U.S. broker dealer registered with the U.S. Securities and Exchange Commission and a member of FINRA and SIPC. Wells Fargo Securities, LLC is regulated under U.S. laws which differ from Australian laws. Any offer or documentation provided to you by Wells Fargo Securities, LLC in the course of providing the financial services will be prepared in accordance with the laws of the United States and not Australian laws. Important Disclosures Relating to Conflicts of Interest and Potential Conflicts of Interest Wells Fargo Securities, LLC may sell or buy the subject securities to/from customers on a principal basis. Wells Fargo Securities, LLC has or may have proprietary positions in the securities mentioned herein. The trading desk has or may have proprietary positions in the securities mentioned herein. The author's compensation is based on, among other things, Wells Fargo Securities, LLC's overall performance, the profitability of Wells Fargo Securities, LLC's Markets Division and the profitability of the trading desk. This report is for your information only and is not an offer to sell or a solicitation of an offer to buy the securities or instruments named or described in this report. Interested parties are advised to contact the entity with which they deal, or the entity that provided this report to them, if they desire further information. The information in this report has been obtained or derived from sources believed by Wells Fargo Securities, LLC to be reliable, but Wells Fargo Securities, LLC does not represent that this information is accurate or complete. Any opinions or estimates contained in this report represent the judgment of Wells Fargo Securities, LLC at this time and are subject to change without notice. Wells Fargo Securities, LLC and its affiliates may from time to time provide advice with respect to, acquire, hold or sell a position in, the securities or instruments named or described in this report. About Wells Fargo Securities Wells Fargo Securities is the trade name for the capital markets and investment banking services of Wells Fargo & Company and its subsidiaries, including but not limited to Wells Fargo Securities, LLC, a member of NYSE, FINRA, NFA and SIPC, Wells Fargo Prime Services, LLC, a member of FINRA, NFA and SIPC, and Wells Fargo Bank, N.A. Wells Fargo Securities, LLC and Wells Fargo Prime Services, LLC are distinct entities from affiliated banks and thrifts. Copyright 2017 Wells Fargo & Company SECURITIES: NOT FDIC:-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE 32