Book Yield Strategies for Public Fund Investing

Presented by:

Garret Sloan, CFA, Short-Term Fixed Income Strategist

2 May 2020 1

Public Investing: What Type of Investor are You? Investor types vary based on the investment strategy, the purpose of the invested funds and the risk tolerances of the investment manager

Value Indexing Momentum

Active Passive

Cash-flow Matching Credit Arbitrage

Source: Wells Fargo Securities, LLC

Immunizing

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Public Investing: What Type of Investor are You?

Why does it matter how I define myself as an investor?

• Time horizons • Risk tolerances •Cash flow volatility • Investment guidelines Why does it matter what type of investor I am?

All of these factors influence an investor’s perceptions of:

•Value • Suitability • Performance 3

Public Investing: What Type of Investor are You?

• Wall Street has a long history with actively managed clients and many of the tools for analysis are geared toward supporting that segment.

Total Return Investors are generally considered Active

Investors Investopedia:

Total Return in fixed income accounts for two categories of return: income and capital appreciation. Income includes interest paid by fixed income investments. Capital appreciation represents the change in the market price of an asset. Source:Investopedia US, a division of ValueClick, Inc. 4

Public Investing: Metrics of Total Return Valuation Total Return Methods of Bond Valuation capture both income and capital appreciation, but is capital appreciation a goal in public portfolios?

Is a horizon or valuation date useful? YES… …for total return investors.

…and for managing political risk.

Source: Bloomberg, LP, Wells Fargo Securities, LLC 5

Public Investing: Considering Value in Public Portfolios

A Few Practical Examples

Value for Public Portfolio Investors is often different than for Total Return Investors… Scenario Public Portfolio Investor Total Return Investor Two A3/A- corporate securities. Equal duration, similar industry. One yields 180 bps, one yields 170 bps.

Generally, the public funds manager will tend to select the security with a higher yield.

TRR investor may consider both securities, taking into account near term price appreciation opportunities. Two GSE securities of similar duration, one is an MTN one is a benchmark note. The MTN yields 72 and the benchmark yields 69. Generally, the public fund manager will tend to select the security with the higher yield. TRR investor may consider the lower yielding benchmark note due to increased liquidity. Two GSE callables with similar final maturity and lockout, one European at 100 bps, one Bermudan at 105 bps. Generally, the public fund manager will tend to select the security with the higher yield.

TRR investor may consider the lower yielding European callable based on the current realized volatility levels in the market. 6

Public Investing: Marking to Market

Mark-to-Market and GASB 31

• Raise your hand if you mark your portfolio to market… GASB 31 requires that: “All investment income, including changes in the fair value of investments, should be reported as revenue in the operating statement.” - Excerpt from Summary of GASB

Statement No. 31

•Lower your hand if you use a notational mark-to market… • Lower your hand if you back out your mark to market after it hits the books… • Lower your hand if you maintain your book yield cost basis from year to year… • Everyone with their hand up now marks to market like a traditional (active) TRR investor.

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Public Investing: What Type of Investor am I?

Active?

• “Active strategies involve taking speculative positions in which the primary objective is abnormal returns.” GASB 31 requires that: “All investment income, including changes in the fair value of investments, should be reported as revenue in the operating statement.” - Excerpt from Summary of GASB

Statement No. 31

Immunizing?

• “Duration-matching strategy of equating the duration of the bond or asset to the duration of the liability.” • Matching duration may not allow you to cover your cash needs given the timing of the cash flows. •Losses in public portfolios have often stemmed from sales of securities that are underwater, rather than credit events. 8

Public Investing: What Type of Investor am I?

Dedicated (Cash-Flow matching)?

• “Strategy of constructing a bond portfolio with cash flows that match the outlays of the liabilities.” • This describes a portion of the portfolio but not excess cash.

GASB 31 requires that: “All investment income, including changes in the fair value of investments, should be reported as revenue in the operating statement.” - Excerpt from Summary of GASB

Statement No. 31

Indexing?

• “The construction of bond portfolios whose returns over time replicate those of some specified bond index.” • Do you ever let a bond mature? • Do you want the index to make your duration and credit decisions? • Are you marking your portfolio to market similar to an index? 9

Public Investing: What Type of Investor am I?

Hybrid Strategy

• A strategy that looks at an entity’s liabilities in distinct time periods. During the shorter period cash flow matching is used to fund liabilities. The longer period is managed using a duration-matching strategy. A hybrid investment strategy segments cash into buckets that address both cash-flow/liquidity needs and duration matching needs.

America’s First Hybrid, the 1957 Ford Ranchero

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Positioning Public Cash Portfolios

Framing the structure of a cash portfolio is important to determining the mix between cashflow-matched and duration-matched investment strategies

Segmentation of the Public Cash Portfolio – For Illustrative Purposes Only

Liquidity, Stability of Principal

Operating Cash (Horizon - daily) Reserve Cash (Horizon - Quarterly) Restricted Cash (Horizon - longer-term ) Strategic Cash (Horizon - longer-term )

Q1 Source: ICI, Wells Fargo Securities, LLC Q2 11 Q3 Q4 Less liquidity, higher yields, more price volatility

Public Investing: What Type of Investor am I? Cash flow match liabilities against operating and reserve cash. Liquidity buffers will be sized according to forecast accuracy.

Hybrid Strategy Framework

• Know your liabilities. For operating and reserve cash: • Explicit forecasts for immediate liquidity needs are paramount for cash flow portion of the portfolio. • Cash flow match short-term liabilities with liquidity buffers sized according to historical volatility and forecasting accuracy. • Example 1: •

Chinook School District has forecasted its weekly and monthly cash flows in and out of its bank accounts with approximately 5 percent error for the past 36 months. It maintains an additional 10 percent of its cash flow bucket in immediate liquidity to hedge against unexpected outflows.

• Example 2: •

Nunavut Water Board’s cash volatility has resulted in multiple unexpected disbursements over the past two years. Cash outflows have fluctuated unexpectedly and significantly. As such, it maintains an additional 10 percent in immediate liquidity and another 10 percent in weekly liquidity.

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Public Investing: What Type of Investor am I? Duration-match liabilities against restricted and strategic cash.

Hybrid Strategy Framework

• Know your liabilities. For restricted and strategic cash: • Build a longer-term duration target framework by modeling expected liabilities. This will allow you to think in portfolio terms, not single security terms. • Model liabilities out to the investment policy’s maximum allowed investment guidelines and estimate their duration. • Debt servicing is often the primary expenditure. • Beyond debt servicing, government expenditures and revenues are stochastic in nature, making it difficult to discover their response to changes in inflation and interest rates, but attempts to forecast are still important. • Duration-match the strategic investment portfolio with an eye towards maximizing income. • As investments roll down the curve, transfer them into the cashflow matching portfolio to better maintain the duration target of the strategic portfolio. 13

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