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Investment Structures and Risk Management
Moderator: Debbie Higgins President Higgins Capital Management
March 28, 2012
Presenters: Nancy Jones
Managing Director
Sarah Meacham Senior Managing Consultant PFM Asset Management LLC
Ray Johnson Fixed Income Specialist
Bloomberg LP
Risks
1© 2012 PFM Asset Management LLC
Manage Risks by Knowing Where You Want to Go
2© 2012 PFM Asset Management LLC
YOU ARE HERE
Risk of Not Having a Long-Term Investment Strategy
3© 2012 PFM Asset Management LLC
0%
1%
2%
3%
4%
5%
6%
2007 2008 2009 2010 2011 2012
2-Year U.S. Treasury Note Yield January 2007 – February 2012
Yield of sample longer-term portfolio
LAIF
First Principle of Managing Risk
• Know what risks you are willing to take
4© 2012 PFM Asset Management LLC
Manage Risk by Establishing Guidelines
5© 2012 PFM Asset Management LLC
• Write them
• No more than [??%] in securities other than Treasuries and Agencies
• No more than [??%] in any one issuer
• Target average maturity? Or average duration? Or targeted maturities?
• Real performance metrics that measure level of success achieving purpose of the portfolio
Target Maturity Buckets
6© 2012 PFM Asset Management LLC
$0.0
$2.5
$5.0
$7.5
$10.0
$12.5
$15.0
$17.5
1/1/12-6/30/12 7/1/12 -12/31/12
1/1/13 -12/31/13
1/1/14 -12/31/14
1/1/15 -12/31/15
1/1/16 -12/31/16
Beyond 12/31/16
Mill
ions
Target
Actual
Target Benchmark Sector Composition
7© 2012 PFM Asset Management LLC
U.S. Treasury 63%
Federal Agency 12%
Corporate 17%
Other Governmental
8%
Source: Bank of America/Merrill Lynch 1-5 Year U.S. Government/Corporate (A or better) Index holdings as of December 31, 2011
Benchmark: 1-5 Year U.S. Government/Corporate (A or better)
Target Benchmark Maturity Distributions
8© 2012 PFM Asset Management LLC
4%
56%
40%
0% 0% 3%
33%
25%
17%
22%
0%
10%
20%
30%
40%
50%
60%
Under 1 Year 1 - 2 Years 2 - 3 Years 3 - 4 Years 4 - 5 Years
1-3 Year 1-5 Year
Source: Bank of America/Merrill Lynch U.S. Treasury Index holdings as of December 31, 2011
Benchmark: 1-3 Year U.S. Treasury Index vs 1-5 Year U.S. Treasury Index
Most Common Types of Risk
• Interest rate risk
• Call risk
• Credit risk
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10© 2012 PFM Asset Management LLC
• The risk that an investment's value will change due to a change in: – Absolute level of interest rates – Shape of the yield curve – Spread between sectors
• Inverse relationship exists between the direction of interest rates and the price of a bond
• Longer maturities have more interest rate risk
11
Interest Rate Risk
© 2012 PFM Asset Management LLC
Interest Rate Risk
12© 2012 PFM Asset Management LLC
0.00%
0.25%
0.50%
0.75%
1.00%
1.25%
3 mo
6 mo
1 yr
2 yr
3 yr
5 yr
Yiel
d
Maturity
Forgone Income
Interest Rate Risk Can Be Managed
13© 2012 PFM Asset Management LLC
• Investors can quantify how much the price of a bond will change as the yield changes through duration.
• Duration is a measure of the percent change in a bond’s value as yields change.
-$300,000
-$250,000
-$200,000
-$150,000
-$100,000
-$50,000
$0 1 2 3 4 5
Maturity (Years) Effect of 50 Basis Point (0.50%) Rise in Rates on $10 million
Barbell Maturity Structure
Under 1 Year 1-2 Years 2-3 Years 3-4 Years 4-5 YearsUnder 1 Year 1-2 Years 2-3 Years 3-4 Years 4-5 Years
Portfolio Structure Affects Performance
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Ladder Maturity Structure
Portfolio Structure Affects Performance
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3 Month 6 Month 1 Year 2 Year 3 Year 4 Year 5 Year
Yiel
d
Maturity
Portfolio Structure Affects Performance
Portfolio Structure
Yield Curve Effect (%)
Yield Curve Effect ($ on $50 million)
Under 1 Year
1-2 Years
2-3 Years
3-4 Years
Ladder
4-5 Years
-0.70% -$350,000
Under 1 Year
1-2 Years
2-3 Years
3-4 Years
Barbell
4-5 Years
-0.33% -$165,000
16© 2012 PFM Asset Management LLC
Portfolio Structure Affects Performance
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Opportunities in Steep Yield Curve
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Federal Agency Yield Curve March 22, 2012
0.12% 0.17%
0.25%
0.45%
0.70%
0.99%
1.31%
Rates rise 0.75%. Buy new 2-Year Agency at 1.20%.
$120,000$120,000$330,000
$145,000$145,000$380,000
Rates rise 0.50%. Buy new 2-Year Agency at 0.95%.
$95,000$95,000$280,000
Breakeven Analysis
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Annual Interest on $10 million
Year 1 $45,000 Year 2 $45,000 Year 3 Year 4 Total
Annual Interest on $10 million
Year 1 Year 2 Year 3 Year 4 Total
Buy 4-Year Agency at 0.99%
Buy 2-Year Agency at 0.45%
$99,000
$396,000
$99,000 $99,000 $99,000
Rates rise 1.00%. Buy new 2-Year Agency at 1.45%.
? ? ?
Consider the FOMC’s Outlook for Interest Rates
20© 2012 PFM Asset Management LLC
Targeted Federal Funds Rate at Year-End FOMC Member Forecasts as of January 25, 2012
Source: Federal Reserve Open Market Committee
0%
1%
2%
3%
4%
5%
6%
201420132012
THENNOW
Note: Briefcase in left hand.
Note: Briefcase in right hand.
21© 2012 PFM Asset Management LLC
No Held to maturity/next call date, at lower than market yield
Yes Must reinvest at lower yields
Call Risk
• The risk that an investment will be called prior to maturity.
• Call risk premium: Callables tend to have higher yields than non-callables to compensate for the risk that the bond will, or will not, be redeemed.
• Issuer will always exercise call option to investor’s disadvantage.
22
Movement of Interest Rates
Call Option Exercised? Outcome
Rise Higher
Fall Lower
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Types of Call Options
23
Non-callable
Purchase Final Maturity
Call periodLock-out period
American: Callable Anytime
Call Date Call DateLock-out period
Bermudian: Specified Dates
Call Date
Lock-out period
European: One-time Call Date
Call Date
Lock-out period
Step-Up: Specified Dates or Coupon “Steps Up”
Call/Step-Up Call/Step-Up Call/Step-Up
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24
Bullets versus Callables
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0%
1%
2%
3%
4%
5%
6%
7%
Jan 02 Jan 04 Jan 06 Jan 08 Jan 10
3-Year Federal Agency January 1, 2002 – December 31, 2011
Source: Bloomberg
Purchase 3-year bullet security: 3.49%
Purchase 3-year callable, 6-month call protection: 2.88%
25
Callables Add Complexity to Duration Management
Portfolio Maturity Distribution
Perc
enta
ge o
f Tot
al P
ortfo
lio
0%
7%
65%
28%
0%
10%
20%
30%
40%
50%
60%
70%
0-6 months 6-12 months 1-2 years 2-3 years 3-4 years 4-5 years
Duration to Next Call: 1.25 years
4%
37%
19% 18% 22%
0%
Duration to Final Maturity: 2.25 years
© 2012 PFM Asset Management LLC
Rising Rates Extends Duration on Callable Bonds
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Rates Rise 0.50%
Duration Extends 2.13
26
Call Risk Can Be Managed
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• Limit percentage of callable securities held in portfolio
• Utilize different call structures
• Diversify callable issuers
• Evaluate relative value using option adjustment spread analysis (OAS)
– OAS assumptions can change the results dramatically
27
Agency Option-Adjusted Spread Analysis
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Step-Up Callable: Yield to Call vs. Yield to Maturity
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0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 Oct-16 Apr-17
Step-Up Security • Issuer: FHLB • Maturity: April 2017 • Yield to Maturity: 2.13% • Initial Coupon: 0.50%
Yield to Maturity
Yield to Call
Yield Differential
Step-Up Callable vs. Fixed Coupon Callable
30© 2012 PFM Asset Management LLC
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 Oct-16 Apr-17
Step-Up Callable • Issuer: FHLB • Maturity: April 2017 • Yield to Maturity: 2.13% • Initial Coupon: 0.50%
Fixed Coupon Callable • Issuer: FNMA • Maturity: April 2017 • Yield to Maturity: 1.50% • Initial Coupon: 1.50%
Fixed Coupon Yield to Call
Step-Up Yield to Call
Yield Differential
31© 2012 PFM Asset Management LLC
The Many Faces of Credit Risk
• Default Risk: – Risk that an issuer of a note or bond will be unable to meet its financial
obligations.
• Market Value Risks: – Downgrade: the risk that a bond’s price will decline
due to a downgrade in its credit rating.
– Credit spread: risk of market value loss resulting from changes in the level of credit spreads.
Bond yields correlate strongly to their perceived credit risk.
32© 2012 PFM Asset Management LLC
Manage Default Risk by Monitoring Other Markets The Warning Signs for Lehman Brothers
33
Stock Price January 2007 – October 2008
Credit Default Spread January 2007 – October 2008
Bond Price January 2007 – October 2008
1
1. Sep. 9 – Put on negative credit watch by S&P
2. Sep. 15 – Downgraded from A to CCC- by S&P
3. Sep. 16 – Declared bankruptcy
2
3
Source: Bloomberg
1
2 3
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Manage Market Value Risk by Following Credit Spreads
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2-Year AA Corporate
2-Year U.S. Treasury
Spread
Monitor Credit Rating Trends
35© 2012 PFM Asset Management LLC
Monitor Corporate Profits
36© 2012 PFM Asset Management LLC
Monitor Credit Default Spreads
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Monitor Yield Relative to Other Issuers
38© 2012 PFM Asset Management LLC
Monitor Earnings and News Announcements
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Other Risk: Corporate Note Structures – 144A
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Other Risk: Corporate Note Structures – Death Notes
Source: Bloomberg
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Other Risk: Corporate Note Structures – Make-Whole Callable
Source: Bloomberg
42© 2012 PFM Asset Management LLC
Credit Risk Can Be Managed
43
• Staff with experience evaluating credit quality
• Credit evaluation resources
• Issuer percentage limits
• Formal approval process
• Approved issuer list
• Procedures for ongoing credit monitoring
• Be proactive when warning signs arise
© 2012 PFM Asset Management LLC
Conclusion
• Establish written guidelines and stick to them
• Risks can be managed
• Monitor duration to manage interest rate risk
• Limit callables to manage call risk
• Manage credit risk by monitoring spread relationships and other markets
• Measure performance
44© 2012 PFM Asset Management LLC
?
© 2012 PFM Asset Management LLC
Disclaimers
© 2012 PFM Asset Management LLC
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.