CUNA – CFO Council Conference | Anaheim, CA What Every …...May 15, 2016 · • Financial...
Transcript of CUNA – CFO Council Conference | Anaheim, CA What Every …...May 15, 2016 · • Financial...
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%
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-10%
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0%
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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%
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%
Time Cash Flow Yield/ Discount Rate PV
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
3 Year 6% Coupon Yielding 5%
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
Yield to Maturity Calculation
3 Year 6% Coupon Yielding 5%
Yield to Maturity Calculation
Time Cash Flow Yield/ Discount Rate PV
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
3 Year 6% Coupon Yielding 7%
Yield to Maturity Calculation
Time Cash Flow Yield/ Discount Rate PV
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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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”
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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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Which is the better risk/reward?
The Money Tables
$200 $200 $0 $100 $100 $100
Which is the better risk/reward?
The Money Tables
$0 $200 $200 $100 $100 $100
Which is the better risk/reward?
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
-200 bps -100 bps 0 bps +100 bps +200 bps
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.
-200 bps -100 bps 0 bps +100 bps +200 bps
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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.