Transcript Investment Strategies for the Current Economy

Public Investment Strategy
in the Current Environment
GFOAZ Conference
Sedona, AZ
March 2006
Stra’-te-gy
Macro Strategy:
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Set by policy to outline goals and objectives on liquidity, quality,
applicability to fund type, credit quality, diversification, and
yield.
Based on fundamentals of cash flow and risk tolerance.
Re-evaluate at least annually.
Market Strategy:
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Set by the conditions in the market at the current time and
unique cash flow restraints.
Established by market conditions within overall strategy
guidelines.
Re-evaluate continuously.
Your job as an investor:
Meet known asset/liability requirements.
Prepare for unexpected liabilities.
Use your resources.
Be a strategist more than a tactician.
Balance yield, liquidity, and flexibility.
Read major market trends for applicability and rate
direction.
Strategize for incremental income
What is the current environment?
What makes it the same?
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Fundamental business cycles
Elections
Fundamental market cycles
Risks – internal and external
Your fiduciary responsibilities
What makes it different?
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Oil and gas prices
Productivity
Global growth
Terrorism
Deficits
New Fed Chairman
Housing
Global outsourcing
Some things don’t change
Risk management
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Public investing is risk management
Direct correlation of risk to reward
No risk – no reward
Know risk – know reward
Controls
Technological advances/opportunities
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On line investing pros and cons
Expedited funds and remote deposit changes
The Foundation Doesn’t Change
PORTFOLIO
POLICY AND PROCEDURES
SECURITY
MARKET
ANALYSIS
CASH FLOW
RISK
ANALYSIS
ANALYSIS
REPORTING
STRATEGY
ANALYSIS
Cash Flow Analysis
80
60
40
20
0
General Fund
Sept
Dec
Mar
June
Different Funds – Different Flows
60
40
20
Utility Fund
0
Sept
Dec
Mar
June
Macro Net Balance Cash Flows
Paint a Portfolio Portrait
80
30
60
20
40
10
20
core
0
0
Sets maximum maturity limits
Sets maximum weighted average maturity
Sets your benchmarks
Develops a strategy
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where to invest
where not to invest
when comes from the market
The Pie and the Portfolio
Liquid Sector
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Provides liquidity
Alternatives
Bank demand deposits
Local government pools
Money market mutual funds
Overnight repurchase agreements
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Today’s strategy
Short-Term
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Match upcoming known expenditures
Alternatives – in different scenarios
Securities (discount notes, CDs, some liquidity options)
The Pie and the Portfolio
Long-Term
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Ultimately matching known expenditures
becomes the short-term
Usually 6 to 12 months
Alternatives directed by market yields
Today’s strategy
Core
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Reserves, no planned shorter term use
Focus on rate movements and yield
May call for different securities
Today’s strategy
The special strategy
on capital projects
A large nonrecurring expenditure
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A unique cash flow
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Like projects often create trends
Preliminary work with departments
for an expenditure plan before $$
arrives
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Bond document plans
Updates on ongoing basis with
department heads and engineers to
modify plans
Explaining the importance of cash
flow helps generate support
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Impact of additional earnings
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Arbitrage impacts
Project Trends
Use multiple historical issues
of the same type fund
streets
water mains
land acquisition
Trend often appear over the
time frame of the total project
Streets - 1995
800
600
400
200
0
1
2
3
4
5
6
7
8
9
Streets - 2000
800
600
400
200
0
1
2
3
4
5
6
7
8
9
8
9
Streets Projection 2006
Use for projections on the
same type projects in the
future
800
600
400
200
0
1
2
3
4
5
6
7
Maturity – A Major Factor
The average maturity of the portfolio is arguably the single greatest
determinant of investment performance
Yield enhancement accomplished by:
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extending maturities
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increasing credit risk
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reducing liquidity
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Capital appreciation
9
8
7
6
5
4
3
2
1
0
Paid for risk taken
Rates tell a story..
Today’s story is flat…
Yield curve:
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compilation of the expectations of everyone in the marketplace
Overall view:
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Projection of slow and steady growth and rate increases continue
Sector view:
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sector steepness evident only on close inspection
6
Investment Sector for
5.5
Majority of Governmental investors
5
4.5
4
3.5
3
o/n
3mo
6mo
1yr
2yr
3yr
5yr
Your view and strategy…
10%
Long end pop – normal curve
5%
Your strategy is
dependent on your
expectations
0%
6%
4%
2%
0%
Curve inversion
Your strategy is
dependent on your
portion of the curve
Strategies must change
Jan 2001 – Jan 2002
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Overnight rates move from 6.50% to 1.00%
Need to lock-in rates as long as reasonable
Going long was primary strategy
June 2004 – June 2005
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Overnight rates move from 1.00% to 3.00% ??
Need to move up with the rates
Staying short was primary strategy
Trade strategies
Which do you chose? Does it matter?
S
M
2
T
3
W
T
4
F
S
5
6
7
8
14
15
FNDN
3.4% ?
9
10
11
12
13
16
17
18
19
20
T-Bill
24
25
26
21
22
3.2% ?
3.0% ?
23
CD
payroll
27
28
29
“Strategic” Results
Investment
Interest
FNDN
245,750
4,250
312
T-Bill
246,250
3,750
20
3,770
4,000
0
4,000
CD
250,000
Reinvestment
Gross
4,562
On a $250,000 payroll - 24 times a year - the additional earnings are
$ 562 x 24 = $13,488
Returns Come Only
from Risks Taken
Risk/Return of Various Benchmarks
10 Years Ended March 31, 2000
Overall
Cumulative
Return
Risk
Duration
Yield
3-Month Treasury Bill
.25 Years
5.21%
$8,315,201
6-Month Treasury Bill
.49 Years
5.44%
$8,499,138
1-3 Year Treasury Index
1.64 Years
6.62%
$9,497,797
1-5 Year Treasury Index
2.19 Years
7.16%
$9,985,291
3-5 Year Treasury Index
3.37 Years
7.62%
$10,424,264
5-7 Year Treasury Index
4.73 Years
8.15%
$10,957,156
7-10 Year Treasury Index
6.36 Years
8.46%
$11,273,458
Interpreting Today’s News
Soft patch or slowing economy?
Dollar weakness
Oil and energy impacts
Labor growth and wage pressure
Housing – can it continue?
Inflationary pressures
Fiscal policy
Monetary policy (with and without Greenspan)
Rates increasing or flattening? Curve steeper or inverted?
What part f the curve is moving and where?
The Fundamental View – Federal Funds Rate
Effective Fed Funds from 01/01/01 to present
The Fundamental View – Payroll
Non-farm Payrolls – 01/01/01 to present
The Fundamental View – Producer Price Index
PPI – YOY
01/01/01 to present
The Fundamental View – Capacity Utilization
Capacity Utilization - 01/01/01 to present
The Fundamental View – Oil
Three month oil contract from 01/03 to present
“Conundrum”
Manage Risk - Not Return
Identify the appropriate level of risk for portfolio
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Risk can not be avoided – but can be managed
Structure the risk profile of the portfolio
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to meet objectives
to comply with constraints
To match risk tolerances
Manage risk to increase the value of the portfolio as
much as possible, given the portfolio’s risk parameters
Quarterly Rate Moves
09/01/05
12/31/05
3/3/2006
5
4.5
4
3.5
3
o/n
-
3 mo
6 mo
1 yr
2 yr
3 yr
Clear movement on short end
Danger of leap frog Fed move
Investors target steepness in a curve
Curve directives from market participants
What is keeping the long end down?
5 yr
10 yr
30 yr
Use the available curve
Only steepness on curve
5
4.8
4.6
MAR
DEC
4.4
4.2
4
3.8
3.6
SEPT
3.4
3.2
3
JULY
o/n
3 mo
6 mo
2 yr
3 yr
Possible Bear Market Strategies
Shorten durations
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Shorter maturities
Higher coupon securities
Ride the yield curve
Evaluate Spread products
Identify trading ranges
Callable securities??? Floaters?? Indexed??
Barbell term structure
Portfolio realignments – loss payback swaps
A Bearish Strategy
1
04/01/04
10/01/04
04/08/05
03/03/06
yr
5
yr
3
yr
2
yr
1
m
o
0
6
Stay ahead of rates by 3-6
months investments to
generate extra revenue and
ride up on rates
2
o
= 2.75%
= 3.00%
3
m
2-year in Oct ’04
o/n in May ’05
4
3
2-year in April ‘04 = 1.75%
o/n in April ’05
= 2.75%
5
o/
n
Graph shows rate increases
between 4/1, 10/1 and 04/05
plus what another 6 months
could do
Security Impact
Callables
Floaters
Indexed
Bullets
Full information and
analysis
Callable Securities
Issuers
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Agencies, corporations, public entities
Callable is two securities
1.
Issuer sells fixed income security to investor
Value = present value of stream of cash flows
2.
Investor sells option to call to issuer
Value = probability of being exercised based upon current yield
curve, a rate of volatility, and time to exercise date
Lock-out period
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Call protection; initial period during which issuer can’t call bonds
Callable Structures
Various structures – 3/1; 5/2; 10/3
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European – one-time call
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Bermuda – “Discrete call”, callable only on interest payment
dates
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American – “Continuous call”, callable anytime with specified #
of days notice
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Step-up callables
Fixed coupon to next call date
At call date, bonds either called or coupon “steps
up”/increases to structured higher coupon
Can have multi-step ups
Not the same as floating rate notes
Valuation of Callable Securities
•
Uncertain cash flows and risk is difficult to measure
•
Priced at spread to Treasuries
Yield to Worst (YTW)
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Which is lesser: Yield to Maturity or Yield to Call
Option Adjusted Spread (OAS)
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Creates synthetic “bullet”
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Compare spread from OAS analysis to historical spread for
non-callable securities from same market sector
Continuous Call Description
Continuous Call OAS
Floating-Rate Notes
“Floaters” reset rates periodically
Know the details and their impact
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Index
Spreads
Reset Periods
Day Count Periods
Payment Periods
Maturity
Valuation
Yield Curve Nuances
CHEAP
FLAT
%
RICH
TIME
Yield Curve Maneuvers
Interest rates anticipation not projection
Direction
Magnitude
Timing
Macro curve expectation
“the compilation of expectations”
Implement strategy to address the curve
Current and future
Disciplined investment will outperform
speculation over time
Actual Yield Curve Changes
Curve indicates slowly rising rates
6.25
5.75
2
Mar-99
Sep-99
1
5.25
4.75
4.25
3 Mo
6 Mo
1 Yr
2 Yr
5 Yr
10 Yr
30 Yr
Actual Yield Curve Changes
Rates rose and now indicate a drop
3
6.25
4
5.75
Mar-99
Sep-99
Mar-00
Sep-00
2
1
5.25
4.75
4.25
3 Mo
6 Mo
1 Yr
2 Yr
5 Yr
10 Yr
30 Yr
Actual Yield Curve Changes
Rates drop precipitously
3
6.25
4
5.75
5
2
1
5.25
4.75
4.25
3 Mo
Mar-99
Sep-99
Mar-00
Sep-00
Dec-00
Mar-01
6
6 Mo
1 Yr
2 Yr
5 Yr
10 Yr
30 Yr
Summarizing
Some things never change
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Fundamentals define your portfolio
Cash flow
Risk profiles and tolerance levels
Look at the fundamentals
Develop a market view
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Economic fundamentals by sector
Macro investment strategy
Avoid “tactical” moves
Study the curve
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Develop a long range view of rates
Rates will go up or they will go down…but maybe not today
Maintain your discipline