CUNA – CFO Council Conference | Anaheim, CA What Every …...May 15, 2016 · • Financial institutions tend to buy longer, riskier bonds at the lows of rates and shorter bonds

What Every CFO Should Know

Nigel Johnson Director of Performance Trust University®

CUNA – CFO Council Conference | Anaheim, CA

Nigel W. JohnsonDirector of Performance Trust University®

Nigel came to Performance Trust Capital Partners with over 20 years’ experience in the capital markets arena. During his tenure with two of the largest Investment Banks in the world, Nigel worked with some of the top money managers in the Midwest, including state and corporate pension funds and mutual funds.

Since joining Performance Trust, he has quickly applied his vast experience to become one of their featured speakers, presenting at both Principles of Performance™ and The Advanced Course®.

PERFORMANCE TRUST UNIVERSITY®

DIRECTOR

NIGEL W. JOHNSON

• Tea time is never interrupted by a dentist appointment

• We can misspell any worde and claim that is the way we do it in England

• We understand everything they say on Downton Abbey

• The accent makes everything sound more interesting than it actually is

• Rainy days remind me of home

• Being English you will never be asked to cook anything

• Better than being French

Top things about being English

Nigel Johnson

Performance Trust’s Mission Statement

We exist to inspire financial decision makers to pursue the Path of Great Performance™

and help them achieve results that surpass those they would otherwise attain.

My objective is to clearly describe nine important facts that every CFO should know and follow to be successful in today’s difficult environment.

Objective

Reality Check

We are faced with a very difficult investment/credit union environment, decisions made today will have an impact for years to come.The CFO/portfolio manager’s role at a credit union is very challenging.As it pertains to the portfolio, most of you are “part-time” investors.Most portfolio managers at credit unions and banks do not come from an investment background; that may be a negative or a benefit!During this speech, we are going to challenge conventional wisdom.

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Reality Check

We are faced with a very difficult investment/credit union environment, decisions made today will have an impact for years to come.The CFO/portfolio manager’s role at a credit union is very challenging.As it pertains to the portfolio, most of you are “part-time” investors.Most portfolio managers at credit unions and banks do not come from an investment background; that may be a negative or a benefit!During this speech, we are going to challenge conventional wisdom.

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Investments

We Need Yield!

CFO’s Dilemma

RATES HIGHLoan Demand Strong

ECONOMY COOLSCredit quality falls

RATES LOW, Liquidity HighLoan Demand Low

Investmentsat a Loss

Loans

ECONOMY HEATING UPCredit quality rising

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Fund Loan Growth: Sell Bonds

• Financial institutions tend to buy more bonds at the lows of rates and buy fewer bonds at the highs of rates.

• Financial institutions tend to buy longer, riskier bonds at the lows of rates and shorter bonds at the highs of rates.

• Therefore, financial institutions tend to do the opposite of what fixed-income investors would prefer to do, which is to buy more long bonds at the highs of rates and fewer long bonds at the lows of rates.

CFO’s Dilemma

Investments

We Need Yield!

Can Rate Guessing Solve this Dilemma?

RATES HIGHLoan Demand Strong

ECONOMY COOLSCredit quality fallsRATES LOW

Loan Demand Low

Investmentsat a Loss

ECONOMY HEATING UPCredit quality rising

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Definition

Top-Down Investing

An investment approach that involves first looking at the “Big Picture” in the economy, then choosing to invest or not to invest in securities that will out‐perform given the “Big Picture.”

• Every six months, the top 50 economists predict interest rates a year from now for a column in the Wall Street Journal.

• How many even come close?

Economic Predictions

Economist Predictions 1 Year in AdvanceWhat percentage of the economists came within 30 bps?

Source: Wall Street Journal

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Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Dec 2012 Dec 2013 Dec 2014 Dec 2015WITHIN 30 BPS 2%8%6%0%10% 0% 24% 1%8%

Economist Predictions 1 Year in AdvanceWhat about 50 bps?

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Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Dec 2012 Dec 2013 Dec 2014 Dec 2015WITHIN 50 BPS 13%17%15%0%33% 0% 35% 0%22%

Source: Wall Street Journal

Economist Predictions

An economic forecaster is like a cross-eyed javelin thrower; they do not win many accuracy contests, but they keep the crowd’s attention.

ANONYMOUS

Why You Should Listen to Economic Forecasts with Caution

And no advisor, economist or TV commentator —and definitely not Charlie (Munger) nor I —can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.

WARREN BUFFETT2014 ANNUAL REPORT, PAGE 19

• In a recent survey, Jim Bianco studied 20 years of the Wall Street Journal interest rate surveys and found that as a group, they successfully predicted the future direction of interest rates only 30% of the time.

• The problem with “top-down investing” • If the forecast is wrong, the investment will be wrong.• And would you know which security to buy even if your forecast

was correct?

Top-Down Investing

Peter Lynch’s Stock Market Wisdom Applies to All Investments

Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to your investments.

If you don’t study your investments you have the same chance of success as you do in a poker game if you bet without looking at your cards.

PETER LYNCHPARAPHRASED FROM BEATING THE STREET

Key Takeaway #1

Seeking fixed-income outperformance is not about guessing future interest rates.

Key Takeaway #2

Potential fixed-income outperformance (in the portfolio) is achievable and can add significant dollars to the bottom line if you are willing to put in the work and be disciplined.

20th vs. 80th Percentile: 1-Yr Total Returns

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3Q15

All U.S. Credit Unions: 1-Yr Total Return Differential

A difference of 109 bps is $1,090,000 per $100MM portfolio!

Why? Luck? Skill?

Source: NCUA

3Q15: 109 bps

Why? Luck Versus Skill

PureSkill

PureLuck

More LuckThan Skill

100% SKILL 100% LUCK

Luck Versus Skill

PureSkill

PureLuck

More SkillThan Luck

More LuckThan Skill

100% SKILL 100% LUCK

FIXEDINCOMEInvesting

How do we get to be a top performer? Principles of Performance

Three Core Principles

Understand, Evaluate, and Price Cash Flows

1Portfolio Approach to Investing

2Discipline

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Repeating Key Takeaway #2

Potential fixed-income outperformance is achievable and can add significant dollars to the bottom line if you are willing to put in the work and be disciplined.

Credit Union CFO Objective

Maximize Return Potential While …Limiting Risk

Managing the Trade-Off between Risk/Reward

CFO/Portfolio Manager Role

RISKREWARD

How do most CFOs do this?

Portfolio Manager Role

DurationYield

Given our directive, which do we choose?

Bond Price Yield Spread Duration Unch. Return

A 5-Yr Bullet 100.25 0.82 18.5 4.50 1.63

B 5-Yr NC 1 100 0.90 26.5 1.00 0.90

C GNR 09-65 GL 105-20 1.642 139 1.64 0.84

D FHR 4070 C 101 2.497 222 2.18 1.95

Given this information, write down your choice.

Maximize Return Potential While … Limiting Risk

As a CFO, what do we care about?

Exercise 1.1

-20%

-15%

-10%

-5%

0%

5%

-200 bps -100 bps 0 +100 bps +2005-Year Bullet 3.90% 3.90% 1.63% -2.26% -6.05%5-Year Non-Call 1 0.90% 0.90% 0.90% -1.85% -5.58%GNR 09-65 GL -0.29% -0.05% 0.84% 1.32% 0.53%FHR 4070 C 0.28% 0.50% 1.95% -1.78% -17.54%

Bonds A, B, C, & D

Look at the Whole Picture!TO

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Board Member Key Takeaway #3

During the Pre-Purchase Analysis, you have to look at the bond’s potential performance (by adding up the dollars!) in all rate scenarios not just rates unchanged.

How Useful Was Duration?Bond Price Yield Spread Duration Unch. Return

A 5-Yr Bullet 100.25 0.82 18.5 4.50 1.63

B 5-Yr NC 1 100 0.90 26.5 1.00 0.90

C GNR 09-65 GL 105-20 1.642 139 1.64 0.84

D FHR 4070 C 101 2.497 222 2.18 1.95

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-200 bps -100 bps 0 +100 bps +2005-Year Bullet 3.90% 3.90% 1.63% -2.26% -6.05%5-Year Non-Call 1 0.90% 0.90% 0.90% -1.85% -5.58%GNR 09-65 GL -0.29% -0.05% 0.84% 1.32% 0.53%FHR 4070 C 0.28% 0.50% 1.95% -1.78% -17.54%

“Failure of Duration”

Definition

Duration sounds like a measure of what?

1938 Macaulay’s Duration DefinedThe weighted average maturity of a bond’s cash flows, where the present values of the cash flows serve as the weights. The greater the duration of the bond, the greater its percentage price volatility.

1×PVCF1 + 2×PVCF2 + 3×PVCF + … + n×PVCFn

K×Price

1938 Macaulay Duration

Where:

K = Number of periods per year

n = Number of years to maturity multiplied by K

PVCFPD = Present value of cash flows in period PD

Period 1 2 3 4 5

PV of Time Weighted Interest*

PV of Time Weighted Principal*

NOTE: Graphic is illustrative. It is not to scale.

Where:

K = Number of periods per year

Modified Duration =Macaulay Duration

(1+ yield ÷ K)

In general Duration measures the price sensitivity of a bond to a small change in interest rates. For securities such as MBS, Duration measures such as “Modified Duration” and another well-known formula “Macaulay Duration” have little meaning when it comes to interest risk management. The formulas are limited since they assume cash flows do not change if interest rates change. In this case these formulas are inappropriate.

IVAN BANDICMANAGING DIRECTOR,RBC CAPITAL MARKETS

CFO Key Takeaway #4

Duration when used to measure the “risk” of a bond runs into problems when the bond has embedded options or when rates move more than 100 bps.

3 Month Period ~7 &10 years Rates up 100 bps, 5 years up 84 bps, 4 years up by 50 Bps

An Example of the “Failure” of Duration

Bond: 15 Year 2.5% PoolActual price went from $104.59 to $99.34Expected Change = 0.50 × 3.78 = 1.89%Actual Price Decline: 5.25 Points

Modified Duration: Not a Great Predictor for MBS

Bond:15 Year 2.5% PoolModified Duration: 3.78Expected Change = 0.50 × 3.78 = 1.89We expect the bond to lose 1.89% in value(1.97 Points)

How do most investors do this?

DurationYield

How do we decide which bonds to buy and what our portfolio should look like?

In the bond world, yield is not what you actually get.

Reprinted from the ABA Banking Journal

We have been educating investors on this

topic for decades!

The assumption behind yield is that all cash flows will be reinvested at the promised yield. Different reinvestment rates assure us we will not get what we were originally promised.

2/15/1981 Yield Curve

Yield Is NOT Return!!Impact of Reinvestment Rate Over a Longer Horizon

Maturity Yield Duration

2-Year 13.97 1.69

3-Year 13.67 2.40

5-Year 13.46 3.56

10-Year 13.33 5.41

Assuming an average reinvestment rate of 7% from 1981–1991, the 10-Yr return was 10.88% and total net dollars was

$1,884,840.79 or $749,610 less than “expected.”

A Note on Negative Yields and Reinvestment RatesCMO:

At a 2.5% reinvestment, not as good as it looks!

A Note on Negative Yields and Reinvestment RatesCMO:

Impact of Reinvestment on Returns

Remember the assumptions behind these numbers!!

ReinvestmentRate

Realized Yield vs Quoted Realized

Yield vs Quoted Realized Spread

Do We “Get” the Spread?

6.31% 5.38% +0.11 6.31% 0 0.93

5.27% 5.27% 0 5.93% -0.38 0.66

4.50% 5.19% -0.08 5.66% -0.65 0.47

3.00% 5.03% -0.24 5.13% -1.18 0.10

Benchmark

5-Yr Treasury

5.27% Purchase Yield

MBS Alternative

15-Yr MBS

6.31% Purchase Yield

MBS Spread

104 bps

Not only is yield not “what you get,” but spread is not the difference in what you get.

CFO Key Takeaway #5

Yield (and Spread) do NOT measure the return of a bond and are NOT what we will “get” on a bond.

3 Year 6% Coupon Yielding ?

Time Cash Flow Yield/ Discount Rate PV

6 months 30,000

12 months 30,000

18 months 30,000

24 months 30,000

30 months 30,000

36 months 1,030,000

Cost ?

So what is yield? Yield to Maturity Calculation

3 Year 6% Coupon Yielding 6%


6 months 30,000 3% 29,126

12 months 30,000 3% 28,278

18 months 30,000 3% 27,454

24 months 30,000 3% 26,655

30 months 30,000 3% 25,878

36 months 1,030,000 3% 862,609

Cost 1,000,000

Yield to Maturity Calculation



6 months 30,000

12 months 30,000

18 months 30,000

24 months 30,000

30 months 30,000

36 months 1,030,000

Cost





6 months 30,000 2.5% 29,268

12 months 30,000 2.5% 28,554

18 months 30,000 2.5% 27,858

24 months 30,000 2.5% 27,179

30 months 30,000 2.5% 26,516

36 months 1,030,000 2.5% 888,166

Cost 1,027,540




6 months 30,000 3.5% 28,986

12 months 30,000 3.5% 28,005

18 months 30,000 3.5% 27,058

24 months 30,000 3.5% 26,143

30 months 30,000 3.5% 25,259

36 months 1,030,000 3.5% 837,906

Cost 973,357

CFO Key Takeaway #6

Yield is the discount rate used to present value the future cash flows of a bond; this gives you the price of a bond. That explains why when yields go up, the price of the bond falls and vice versa.

Managing the Trade-Off between Risk/Reward

Portfolio Manager Role

RISKIncomeREWARDMarket

Value

How do we decide which bonds to buy and what our portfolio should look like?

TOTAL RETURN =

Income + Change in Market Value

“Yield” + “Duration”

WHICH IS ESSENTIALLY

Thus, Total Return captures the risk versus reward trade-off of income versus maturity risk.

6 Year NC 1 (1Time) Call

Most people using conventional wisdom see this as an attractive bond

Price 100

Yield 2.00%

Spread +59 Bps to 6-year (Win!) +190 Bps to 1-year (Win Again!!)

Duration at 100 0.9 (Low Duration)

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-200 bps -100 bps 0 +100 bps +200 bps

1-Year Bullet 2%, 6-Year NC 1 1X call 1.80% 6-Year Bullet

Total Return – 1-Year Horizon

Through the Lens of Total Return

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RATE SHIFT SCENARIO

CFO Key Takeaway #7

Total Return is the only way to see the true risk/reward of a bond, especially those with embedded options.

A SHAPE MANAGEMENT® GAME

Three Rules for Potential Outperformance: Avoid Poor Risk/Reward Securities Buy Good Risk/Reward Securities Buy the Right (Best) Combination

THE MONEY TABLES

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Which is the better risk/reward?

The Money Tables

$140 $100 $90$150 $100 $50

“When we win, we win by more than we lose.”

Good Risk/Reward

$140 $100 $90$150 $100 $50

We call these scenario Total Returns “Shapes”

4.00%

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16.00%

-200 -100 0 +100 +200

Bond A Bond B

A Money Table Look at BondsWhich is the better risk/reward?

This is essentially 2 “tables” with 5 “piles” of money on each table

RATE SHIFT SCENARIO

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The Money Tables

$200 $200 $0 $100 $100 $100


The Money Tables

$0 $200 $200 $100 $100 $100


The Money Tables

$100 $200 $100 $100 $100 $100

The Money Table Solution

= 50% of 50% of+$200 $200 $0 $0 $200 $200

Good Combinations

The Money Tables

$100 $100 $100$100 $200 $100

“When the combination wins, it wins by more than it loses.However, some component pieces may lose in certain scenarios.”

CFO Key Takeaway #8

The right combination of bonds can often outperform a single bond or portfolio trying to find bonds that will do “OK” in every scenario will lead you on the road to mediocrity.

The Money Tables

$? $? $? $? $? $?

How do you play this game if you don’t know how many dollars are in each pile?

• Because the way securities are traditionally sold is not in the long-term best interests of the investor.

• We need to answer the question: “How much money is on each table?”

• Specifically, which sectors look like good risk/rewards in comparison to a broad cross-section of bank investment alternatives?

Why do we do what we do?

Some Decisions Are Simple

Bond A

Bond B

-200 bps -100 bps 0 bps +100 bps +200 bps

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…and Some Decisions Are Less Easy

Bond A Bond B

Put Rate Guessing Aside and Compare and Contrast


IMPORTANT: Determining your desired shape is the most

essential part of portfolio Shape Management®!

Desired Portfolio

Existing Portfolio

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Compare and Contrast

IMPORTANT: Determining your desired shape is the most

essential part of portfolio Shape Management®!

Existing + Bond B

Desired Portfolio

Existing Portfolio

Existing + Bond A

You can see which bond moves you in the right direction, and how far.


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Board Member Key Takeaway #9

Use a whole portfolio approach for running a portfolio (this should complement the rest of your balance sheet).

• Start with a clear understanding of your destination• Start with why you have a portfolio• Do not accept mediocrity

• Total return is the only way to see the true risk/reward of a bond, especially those with embedded options

• Use a portfolio approach towards investing

• Align your behavior with your objectives and make proactive choices after evaluating options

• Stay disciplined

Portfolio Strategy 101Begin With the End in Mind

We exist to inspire financial decision makers to pursue the Path of Great Performance™ and help them achieve results that surpass those they would otherwise attain.

MISSION STATEMENTPERFORMANCE TRUST CAPITAL PARTNERS

© 2016 Performance Trust Capital Partners, LLC (which, along with its affiliates, is referred to as “Performance Trust”). All Rights Reserved. This material is for your internal use only and may not be disclosed to third parties. The content is the proprietary and confidential material of Performance Trust and so designated pursuant to a confidentiality agreement between the intended recipient and Performance Trust. The research and other information provided herein has been prepared for informational purposes only and is not an offer or solicitation to purchase or sell securities. Performance Trust may make a market, or have a position in the securities discussed herein and may purchase or sell the same on a principal basis or as an agent. Investing involves risks, including the potential for principal loss. There is no guarantee that the strategies and services will be successful or outperform other strategies and services. Certain assumptions may have been made in connection with the analysis presented herein, and changes to the assumptions may have a material impact on the analysis or results. Past performance is no guarantee of future results. The investments discussed herein may be unsuitable for investors depending on their specific investment objectives and financial position. Investors should independently evaluate each investment discussed in the context of their own objectives, risk profile and circumstances. The information contained herein has been obtained from sources considered to be reliable, and is subject to change without notice. Performance Trust does not guarantee its accuracy, adequacy or completeness and is not responsible for any errors or omissions or for the results obtained from the use of such information. FOR INSTITUTIONAL USE ONLY.

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CUNA – CFO Council Conference | Anaheim, CA What Every …...May 15, 2016 · • Financial institutions tend to buy longer, riskier bonds at the lows of rates and shorter bonds