Techniques for Investing in a Low Interest Rate Environment American Public Power Association...
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Transcript of Techniques for Investing in a Low Interest Rate Environment American Public Power Association...
Techniques for Investing in a Low Interest Rate Environment
American Public Power Association
Business and Financial Conference
September 21, 2004
Presented by Ross Byers, JEA with assistance from Tom Davis, JEA
APPA CONFERENCE
APPA CONFERENCE, 9/21/04
Investment Objectives
●Safety of Capital
●Liquidity
●Highest Possible Yields in a low interest rate environment consistent with Safety and Liquidity
APPA CONFERENCE, 9/21/04
First, let’s define “low interest rate environment”
● I started in this business in 1979 and low interest rates to me for many years meant under 10%
● For instance, from 1985 through 1999 short/intermediate term rates generally ranged from 4% to 10%
● However, beginning in 2000 we have witnessed an unprecedented decline in short-term rates which bottomed with the Fed funds target at 1% from mid-2003 until the Fed raised rates on June 30, 2004
APPA CONFERENCE, 9/21/04
Fed Funds Target Rate, Jan. 1985 to August 2004
High: 9.75% (Feb. ’89) Low: 1.0% (June ’03 - June ’04) Avg.: 5.25%
APPA CONFERENCE, 9/21/04
3 Month LIBOR, January 1985 to August 2004
High: 10.3% (Feb. ’89) Low: 1.1% (Mar. ’04) Avg.: 5.51%
APPA CONFERENCE, 9/21/04
Risk/Reward
● In the ’85 to ’99 period, let’s assume your short-term portfolio was yielding 6% at a given point in time
● If rates rose 200 basis points, your MTM value would be below cost and your current yield would be below market
● In the current very low interest rate environment since 2000, if rates were to rise 200 basis points the same points made above would be true
● However, the magnitude of the effect on performance measured from a yield viewpoint is much greater, i.e. 1% to 3% versus 6% to 8%
● The impact is a 200% change versus a 33% change
● From an investment income budget standpoint, the magnitude of this variance could be hard to explain to a non-finance CEO. During the decline in rates, you may have already experienced this.
APPA CONFERENCE, 9/21/04
How Do We Manage Our Short-term Portfolios if rates remain in this 1% - 4% range for an extended period, i.e.
the whole decade?
●First, let’s look at some of our available instruments
APPA CONFERENCE, 9/21/04
Risk/Reward Profile
Low Risk/Low Yield
Money Market funds, High grade CP, T-bills, Agency discount notes, Repurchase Agreements
Moderate risk/Higher Yield
2 to 5 year notes, Adjustable rate mortgages, callable agency notes, step-up bonds, Intermediate term MBS and CMOs
Higher risk/Higher Yield
Lower grade corporate bonds, Notes with derivatives, and other exotic instruments
APPA CONFERENCE, 9/21/04
How Do We Manage Our Short-term Portfolios if rates remain in this 1% - 4% range for an extended period, i.e.
the whole decade?
●Second, what are some of the measurement tools that our various organizations use to judge our performance?
APPA CONFERENCE, 9/21/04
Alternatives for Measuring Investment Performance
● Managing for Yield versus Managing for Total Return
● Select Benchmark Index to correspond with measurement criteria
● Examples of Yield Benchmarks: 12 month rolling one month LIBOR , 1 year or 2 year Treasury constant maturity
● Examples of Total Return Benchmarks – Lehman 1-5 yr. Gov’t/Credit Bond Index, Lehman 1-3 yr. Gov’t Bond Index
APPA CONFERENCE, 9/21/04
How Do We Manage Our Short-term Portfolios if rates remain in this 1% - 4% range for an extended period, i.e.
the whole decade?
● Lastly, let’s evaluate different strategies in varying interest rate environments, staying in our 1% to 4% range of interest rates.
● Our scope is limited to maturities 5 years and under
APPA CONFERENCE, 9/21/04
Before we discuss specific investment alternatives, let’s quickly review some basic strategies to improve yields.
Depending on your investment philosophy, guidelines and/or policy, some or all of these may not be appropriate.
● Reduce Credit Quality – AAA 10-year agency is +50; AAA Corporate is +70; A- rated 10 year is +100 and lowest investment grade is +140
● Lengthen Maturities – Spread between 2-year and 5-year Treasuries is 90 basis points
● Buy Callables/Step-up bonds – Bullet 2 year is +25; 2 year non-call 3 month Bermuda is +50
● If the portfolio has maturity constraints (i.e. debt service sinking funds), receive fixed – pay floating interest rate swaps are an example of a way to increase yield
2-Year & 5-Year Treasury Rates, Jan. ’94 to Aug. ’04Avg. Spread 52 bp Spread since ’01: 1.07% 9/15 Spread: 90 bp
Like the early ’90s when spreads for 2s to 10s were very wide, similarly spreads for 2s to 5s have widened in the last 3 years on the fear that we will return to higher rates.
APPA CONFERENCE, 9/21/04
Basic Example
● Buy 2.5 year agency versus 6 month agency discount notes
● Evaluating additional yield for extension risk
● Also, evaluating overall yield if not held to maturity
APPA CONFERENCE, 9/21/04
Invest in a 2.5 yr Fannie Mae NC 6 mo. 1X at a 3.12% yield for 2.5 years? Or invest in 6 month agency discount notes at 1.90%, waiting for higher rates. What’s the breakeven rate that you’d need at the end of 6 months for the last 2 years? 3.426%. Will 2 year agency bullets yield that much 6 months from now? Check the forward curve to get an idea…
APPA CONFERENCE, 9/21/04
Agency forward curve at 3/21/05 indicates a 2 year agency yield of 3.24%. This is below the breakeven rate of 3.426% from last slide. Relying on the forward curve would tell you to go ahead and buy the 2.5 year callable instead of waiting for higher rates.
APPA CONFERENCE, 9/21/04
What if you have to sell the bond after 6 months and rates have risen? You could have earned 1.90% for 6 months in discount notes. At what price can you earn still earn 1.90% if you sell? 99-12+ . This equates to a 75 basis point increase in rates at the end of 6 months; i.e. an increase to 3.45% for a 2 year agency bullet.
APPA CONFERENCE, 9/21/04
Another approach could be to use somewhat more sophisticated bond analytic tools.
Utilizing analysis tools available from your Investment Advisors and/or Investment Broker/Dealers can help you model various scenarios that provide information on expected returns.
The example I’m going to show you is from Citigroup using “Yield Book.”
APPA CONFERENCE, 9/21/04
Assumptions Used for Computer Simulation (Yield Book)
● Maximize Yield subject to a maximum loss constraint of 3%
● A 3% loss on a 2 year is approximately a 160 bp immediate increase in rates and a 325 bp increase in rates after 1 year. Loss constraint does not include coupon interest earned.
● Securities have maximum maturity of 5 years
● Available Securities - Treasuries and Agencies
APPA CONFERENCE, 9/21/04
Four One-Year Scenarios
● 1994 Style Bear Flattener – 2-yr. rises 344 bp and 10-year up 190 bp
● 1999 Style Bear Flattener – Much Tamer than ’94 case. Two-yr. rises to 4.11% and 10-year increases to 5.43%
● Bear Steepener – A prolonged bear steepener is unusual, but is not impossible if the fiscal situation deteriorates while the economy weakens. Two-yr. yield at 2.44% and the 10-year is 5.32%
● 12-month Forwards – 12-month forward curves are realized
APPA CONFERENCE, 9/21/04
Current Rates vs. 12 Month Forward RatesSource: Bloomberg, as of 9/16/04
0.00
1.00
2.00
3.00
4.00
5.00
6.00
3 mo. 6 mo. 1 yr. 2 yr. 5 yr. 10 yr.
Perc
ent Y
ield
Current Rates 12 month Forward Rates
APPA CONFERENCE, 9/21/04
Securities Universe
● Treasuries with maturities less than/equal to 5 years
● Bullet/Callable agencies with maturities less than/equal to 5 years
● Step-up agencies – With a 2007 final maturity
● Floating-rate agencies - Five-yr. floating rate at LIBOR – 9 and Four callable cap floaters – 5 NC1 and 5 NC2 with 5% and 5.5% caps
APPA CONFERENCE, 9/21/04
Next Par MarketDescription Coupon Maturity Call Date Yield DurationConvexityAmount Value PercentFreddie Mac Bullet 2.125 11/15/2005 2.423 1.232 0.021 20,000 20,028 20.0%Freddie Mac Bullet 1.875 2/15/2006 2.374 1.468 0.029 17,426 17,466 17.5%FHLB Callable 2.1 10/13/2006 4/13/2005 3.039 2.014 -0.126 20,000 19,758 19.8%Fannie Mae Callable 3.75 9/15/2008 9/15/2005 3.834 2.762 -0.734 17,499 17,709 17.7%Fannie Mae Callable 3.875 11/17/2008 11/17/2005 3.905 2.904 -0.692 5,000 5,039 5.0%Agency Floater (L - 9) 1.602 8/13/2009 3.803 0.253 0.001 20,000 20,000 20.0%
Totals 2.344 2.9 Yrs 3.137 1.587 -0.18 99,925 100,000 100.0%
Effective
OPTIMAL PORTFOLIO (SELECTED BY COMPUTER MODEL)
$100 Million Portfolio:
Two bullet agencies (38%)
Three callable agencies (42%)
August 2009 Libor Floater (20%)
Yield to mat. is 3.14%, compared to 2-Yr. Treas. yield of 2.44%
Duration is 1.6 years compared to 2 yr. T-note of 1.9 years
APPA CONFERENCE, 9/21/04
One- Year Performance Across Scenarios
Scenario Total Principal Interest1994 Style Bear Flattener -0.42 -3.00 2.581999 Style Bear Flattener 1.50 -0.93 2.43Bear Steepener 3.29 0.92 2.37Forward Curves Realized 2.22 -0.24 2.46
% Return
APPA CONFERENCE, 9/21/04
Scenario Total Principal Interest1994 Style Bear Flattener -0.42 -3.00 2.581999 Style Bear Flattener 1.50 -0.93 2.43Bear Steepener 3.29 0.92 2.37Forward Curves Realized 2.22 -0.24 2.46
% Return
One-year Total Return by Scenario
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
1994 Style BearFlattener
1999 Style BearFlattener
Bear Steepener Forw ard CurvesRealized
Scenario
Tot
al R
etur
n (%
)