Davidson Fixed Income Management Deanne Woodring, CFA Managing Director (866) 999-2374
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Davidson Fixed Income ManagementDavidson Fixed Income ManagementDeanne Woodring, CFADeanne Woodring, CFA
Managing DirectorManaging Director(866) 999-2374(866) 999-2374
Benchmarking for Public Fund Benchmarking for Public Fund Investment Guidance and PerformanceInvestment Guidance and Performance
BEST PRACTICESBEST PRACTICES““Safety, Liquidity and Return”Safety, Liquidity and Return”
OMFOA - 2008OMFOA - 2008
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YieldYield
Investment Investment PolicyPolicy Benchmark Benchmark ProcessProcess
Effect:Effect:* Purchase date* Purchase date* Maturity of Portfolio* Maturity of Portfolio
Framework:Framework:* Maturity* Maturity* Asset Allocation* Asset Allocation* Broker Relationships* Broker Relationships* Define Goals* Define Goals
Process:Process:* Control Risk* Control Risk* Manage Return* Manage Return* Accountability* Accountability* Strategy* Strategy
Encompassing Portfolio Management Tools
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Prudent Portfolio Management
“The measure of success in managing public fund dollars lies most appropriately in safety and liquidity, with yield there after.”
Dan Dowell Chief Investment Officer State of California
However, there is a responsibility as public fund steward to manage safety, liquidity and returns through process, discipline and planning.
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Reality 2008 – Public Fund Cash Management Process
Investment Policy
Political and Internal
Environment
Risk Return
Safety
Liquidity
Market Rate of Return
Board
Investment Committee
Staff Turnover
Resources (Experience,
time, software, etc.)
Safety
Liquidity Cash-Flow
Mark to Market
Political
Book Yield & Accrual
Performance (Mark to Market)
Optimizing the Growth of
Funds
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Principles Of Investing
Considerations when:
1. Buying a house
2. Buying a car
3. Investing in retirement
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Principles Of Investing = Growth
Considerations when:1. Buying a house: Timing (Market Conditions)
Location (Where to buy)Objectives (What fits your profile)Time Horizon
2. Buying a car: Type of car Resell Value Objectives
Time Horizon
3. Investing in retirement: Objectives
Best ReturnsGrowth ValueTime Horizon
Each consideration will generate a different outcome or dollar value at the end of period of time.
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Yield versus Return
Yield to maturity: Is an assumption of return based on interest rates at the time the bond is purchased and assumes that all cash flow generated from the bond will be reinvested at YTM rate.
Return: Incorporates what really happens to the investment over a period of time.
Changing Interest rates Impact:1. Value of the bonds2. Reinvestment Rates3. New purchase rates
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Does it matter how you invest?
LETS LOOK AT THIS YEAR 2007:$10,000,000.00 or $100,000,000.00
Pool Funds Average Return for 2007 = 5.10%
$10,000,000.00 = $10,510,000$100,000,000.00 = $105,150,000
0-3 Year Treasury Portfolio - 1.2 year Maturity = 6.635% Book Yield 5%
$10,000,000.00 = $10,663,500$100,000,000.00 = $106,635,000.00
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US Treasury 2 Year Note12/31/97 – 12/31/07
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US Treasury 2 Year Note12/31/07 – 03/04/08
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SAFETYSmoothing Out Interest Earnings
• Assumptions– Current Portfolio Size: $ 50,000,000
• Liquid Portion (50%) $ 25,000,000• Core Portion (50%) $ 25,000,000
– Historical Average Rates for last 10 years (12/31/97 – 12/31/07)
Liquid: 4.0% (Average Pool Funds) Core: 4.43% (US Treasury 0-3 year)
– Benchmark
US Treasury 0-3 year Duration: 1.2 yrs
4.42%3.22%2.00%
4.22%4.22%4.00%
4.02%
$ 1,000,000
$ 3,000,000
$ 2,000,000
6.00%
Stay the Same
Increase 200 bp
Decrease 200 bp $ 2,207,500
$ 2,007,500
$ 2,107,500
$ 1,607,500
$ 2,607,500
$ 2,107,500
5.22%
Rates Liquid Only
12 Months Earnings Due to Given Change in RatesCore SplitCore Split
(Interest Only) (with Price Change)
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Facts of public fund investing
• Interest rates change.
• Your entity’s cash flow requirements change.
• Your investments and earnings are impacted by changing rates.
• Forethought into the investment strategy is important. It can have a substantial impact in your earnings outcome.
• Strategy is important and can be applied to any size portfolio.
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Best Practice Benchmark Considerations Incorporate Objectives
• LIQUIDTY = Cash Flow – Liquidity vs. Core
• SAFETY = Asset Allocation - Diversification
• RETURN = Market Risk Exposure Duration
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A Market Benchmark in Review
• Basket of fixed income securities that reflect your entity’s risk and return profile
• Standard investment management tool
• Provides guidelines for investment decisions and portfolio positioning
• Typically used for funds in excess of liquidity requirements (core funds)
• Effective in managing expectations within your organization
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Strategy Utilizing Benchmarks
STEPS:
1. Evaluate return expectations
2. Determine acceptable risk tolerance
3. Establish appropriate benchmark
4. Establish duration targets
5. Determine guidelines
6. Monitor and report performance
7. Rebalance the portfolio
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1. Evaluate Return ExpectationsBased on Duration
Ending Value and Return - Manage Duration$10,000,000.00 Invested Over the Last 10 Years
Value Raw Return/ Annualized
ML 0-1 Year Treasury Index0.5 duration
$14,748,080
47.58% / 3.97%
ML 0-3 Year Treasury Index 1.2 duration
$15,434,000
54.34% / 4.43%
ML 0-5 Year Treasury Index1.85 duration
$15,880,000
58.80% / 4.73%Source: Merrill Lynch indices
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Evaluate ReturnBased on Duration
Ending Value and Return- Manage Duration$10,000,000.00 Invested Over the Last 5 Years
Value Raw Return/ Annualized
ML 0-1 Year Treasury Index0.5 duration
$11,631,000
16.31% / 3.07%
ML 0-3 Year Treasury Index 1.2 duration
$11,651,000
16.51% / 3.10%
ML 0-5 Year Treasury Index1.85 duration
$11,730,000
17.30% / 3.24%Source: Merrill Lynch indices
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Evaluate Return Based on Asset Allocation
Ending Value and Return-$10,000,000.00 Invested Over the Last 5 Years
Value Raw Return/ Annualized
ML 1-3 Year Treasury Index $11,738,000
17.38% / 3.26%
ML 1-3 Year Bullet Agency Index
$11,786,000
17.86% / 3.34%
ML 1-3 Year Callable Agency Index
$11,618,000
16.18% / 3.04%
ML 1-3 Year AA or Better Corporate
$11,826,300
18.263% / 3.41%Source: Merrill Lynch indices
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Outperforming Asset Classes do not repeat year to year
Year What Happened 2 Year Yield Change (y/y)
– 2007 Spreads widened, rates fell, inflation picked up 4.80% to 3.04% – 2006 Rates rose – curve inverted 4.40% to 4.80%– 2005 Spreads were flat, rates rose, inflation high 3.08% to 4.40%– 2004 Rate rose a little, curve flattened 1.83% to 3.08%– 2003 Yields low, unchanged 1.59% to 1.83%
INDEX 2007 2006 2005 2004 2003
US Treasury 1-3 Year 7.317 3.96 1.67 0.91 1.90
US Agency 1-3 Year Bullet 7.124 4.46 1.72 1.15 2.37
US Agency 1-3 Year Callable 5.768 4.63 1.87 1.26 1.78
TIPS 1-3 Year 8.73 3.08 2.25
1-3 Year Corp A-AAA 6.041 4.62 1.96 1.45 3.82
0-3 Yrs WAL Mortgages 6.948 4.64 2.15 2.80 1.83
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Evaluate Return Based on Yield Curve
Ending Value and Return-$10,000,000.00 Invested Over the Last 5 Years
Value Raw Return/
Annualized
1 Year Sector – Treasury $11,569,000
15.69%/2.96%
2 Year Sector – Treasury $11,660,900
16.60%/312%
3 Year Sector _ Treasury $11,816,900
18.17%/3.39%
5 Year Sector - Treasury $11,917,200
19.17%/3.58%
Source: Merrill Lynch indices
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2. Determine Acceptable Risk ToleranceMark to Market
100bp+/- 200bp+/-
Index Duration
% P Value % P Value
Merrill 0-1 Year
.58 .58% $58,000 1% $116,000
Merrill 0-3 Year
1.2 2% $120,000 2.4%
$240,000
Merrill 0-5 Year
1.85 1.85% $185,000 3.7%
$370,000
$10,000,000 Portfolio$10,000,000 Portfolio
•Value Change Calculation: $100,000,000 (portfolio size) * 1.2 (duration) * .01 (rate move) = $1,200,000
•2 YEAR TREASURY NOTE JUNE 1997 – JUNE 2007•Average annual yield change (high to low) was 153 basis points•Standard Deviation is 51 basis points•One Standard Deviation range (68%) is 102 bp to 204 bp•Two Standard Deviation range (95%) is 51 bp to 255 bp
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2. Determine Acceptable Risk Credit Diversification
ASSET ALLOCATION TARGETS
State Cod
e& Policy Practice
Treasury 100% 5%
Agency Securities 100% 80%
Corporate 35% 15%
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3. Establish Appropriate Benchmark
TWO CHOICES: 1. Customize a benchmark that reflects your practices:
5% Treasury 1-3 Year Duration 1.6560% Agency 1-3 Year Duration 1.6515% Corporate 1-3 Year Duration 1.76 Average Maturity 1.66
years
2. Pick Standard Market Index:1-3 Agency Index Duration 1.65 0-3 Treasury Index Duration 1.2
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Standard Index Comparison to Practice
COMPARISON OF INDEX TO CUSTOM
INDEX 2007 2006 2005 2004 2003
US Treasury 1-3 Year 7.31 3.96 1.66 .907 1.89
US Agency 1-3Year 7.268 4.54 1.58 1.73 2.30
1-3 Year Corp AA-AAA 6.041 4.62 1.96 1.45 3.82
CUSTOM PRACTICE 5% Treasury 1-3
/80% Agency 1-3 / 15% Corporate Duration 1.55 6.69 4.49 1.77 1.18 2.31
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Standard Index versus Custom Index based on Legal Parameters
COMPARISON OF INDEX TO CUSTOM LEGAL 12/31/07
INDEX 2007 2006 2005 2004 200310 Year
US Treasury 0-3 Year 6.635 4.24 2.10 .98 1.66 4.43
US Agency 1-3 Year – Duration 1.65 6.73 4.52 1.77 1.18 2.18 4.97
1-3 Year Corp AA-AAA 6.24 4.56 1.86 1.29 3.18 5.37
Legal Maximum Custom 25% 0-1 / 40% 1-3 Agency /35% 1-3 Corp Duration 1.29 6.24 4.57 2.06 1.21 2.30 4.85
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Standard Index versus Custom Index based on Legal Parameters
COMPARISON OF INDEX TO CUSTOM LEGAL 12/31/07
INDEX 2007 2006 2005 2004 200310 Year
DFIM 0-3 Year Index – 1.29 Duration - OREGON 6.47 4.58 1.98 1.18 2.00 4.76
Legal Maximum Custom 25% 0-1 / 40% 1-3 Agency /35% 1-3 Corp Duration 1.29 6.24 4.57 2.06 1.21 2.30 4.85
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Management
Establish Benchmark Establish Benchmark
Select the Agency/Treasury 0-3 year Index
1. Duration is appropriate 2. Agency exposure appropriate3. Add value when spreads are wide on corporate and agency
issues
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4. Establish Duration Targets
US Treasury
Historical Average Rates Current Rates
5 Year(12/31/02 - 12/31/07)
10 Year(12/31/97 - 12/31/07)
As of: 3/7/08
3 Month 2.90 3.51 1.42
6 Month 3.09 3.65 1.51
2 Year 3.31 3.95 1.48
5 Year 3.82 4.38 2.40
Historical Yield Levels
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Establish Duration Targets
Duration Neutral
Yields RiseDuration (Risk/Reward)Increases
Neutral point – duration is at neutral point when yield is at average
Duration/Yield Relationship
Yields DeclineDuration (Risk/RewardDeclines
2.0%
6.0%
4.20%
1.51..90 1.41.20
Benchmark: DFIM 0-3 Treasury/ Agency 0-3 YearBenchmark duration: 1.2 years (this is your neutral position)10 year Average rate on 2 year note is 3.9%
Strategy: Based on current rates relative to historical rates portfolios should be approaching their neutral positions.
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5. Determine Guidelines
Target size of core balance
Benchmark to control risk and measure return
$75MM- $100MM
DFIM 0-3 year T/Agency
Duration: Approximately 1.2 years
Asset allocation: Within policy
Maturity structure: Within policy
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Guidelines
Duration rage of portfolio relative to +/- 25% or duration benchmark
Minimum .90years
Maximum 1.5years
Asset Allocation Targets Neutral
5% Treasury70% Agency 20% Callable15% Corporate Securities
Strategy and timeline The portfolio will be adjusted periodically to reflect the above guidelines.
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6. Report on Portfolio
Core Component Of Portfolio - 12/31/07
Liquidity Component of Portfolio
Issue Acq Date
Acq Yield
% Holding
Duration
(Years)
Effective
Duration
(Years)
2,000M FFCB 4 1/18/08 5/5/05 3.858 20% .01 .01
1,000M FHLB 5.125 6/13/08 5/31/06 5.25 10% .5 .5
1,000M FFCB 4.125 9/26/08 9/13/05 4.571 10% .75 .75
2,000M FNMA 5.05 1/12/09-1/08 1/27/06 5.09 20% .9 .1
2,000M FHLB 5 5/15/09 6/15/06 5.25 20% 1.2 1.2
1, 000M FHLMC 4.875 2/9/10 2/10/07 5.000 10% 2.4 2.4
1,000M FHLB 5.375 9/8/10-9/08 Callable
6/30/07 5.375 10% 2.8 1.0
10,000,000 4.85 100% 1.08 .74
15MM State Pool or Short Term Money Market Issues – Rate 4.80%
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Monitor Portfolio Compared to Benchmark
Returns Risk Portfolio Benchmark Portfolio
Benchmark1/31/07 .307% .215% 1.35 1.642/28/07 .791% .797% 1.44 1.623/31/07 .356% .384% 1.53 1.684/30/07 .416% .356% 1.43 1.655/31/07 .001% -.074% 1.46 1.726/30/07 .423% .419% 1.51 1.677/31/07 .729% .911% 1.40 1.648/31/07 .637% 1.028% 1.24 1.619/30/07 .848% .708 1.36 1.6410/31/07 .435% .37% 1.26 1.6111/30/07 1.073% 1.718% 1.32 1.6012/31/07 .414% .262% 1.39 1.61
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Monitor Portfolio Compared to Benchmark ($100,000,000 Portfolio)
Returns YTD - 12/07 Since Inception - 12/97
Portfolio Benchmark Portfolio Benchmark
Raw Return
6.618% 7.317% 67.309 59.079%
Annualized 6.618% 7.317% 5.28% 4.75%
VALUE ADDED SINCE 12/31/97
Portfolio $67,309,000
Benchmark $58,079,000
Pools (0-1) $47,580,000
DIFFERENCEPortfolio vs. Benchmark
$9,230,000
DIFFERENCE Portfolio vs. CASH
$19,729,000
Benchmark: US Treasury 1-3
Duration: 1.65
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7. Rebalance the Portfolio
Conditions to Rebalance:• Large change in interest rates
• Large change in asset class valuations
• Time has shorten duration below guideline
• The yield curve has made a large shift
OBJECTIVE OF REBALANCING
To rebalance duration and asset weighting back to guideline levels.
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Rebalance Portfolio – Decision Process
Scenario:Yields have dropped to 2.5% on the two year noteWant to move portfolio out, but remain short to the
benchmark$50,000,000 portfolio with $10,000,000 (20%) in maturing
bond
Neutral Duration 1.2 yearsCurrent duration .75 years Target duration 1.0 years
Question #1: What maturity do you buy?
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Answer – What If Scenario duration
Duration% of Portfolio
Weighted Portfolio
Existing .75 80% .60
Target Buy Issue 2.0 20% 0.40
New Duration 1.0
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Other Scenarios
Want to stay shorter the benchmark
Duration
% of Portfolio
Weighted Portfolio
Existing .75 80% .6
Target Buy Issue 1.0 20% .2
New Duration .80
If want to stay shorter but can’t resist the yield on the 3year 3mth callable
Duration
% of Portfolio
Weighted Portfolio
Existing .75 80% .6
Target Buy Issue 3/3 mth call 20% 0.5
New Duration 1.1
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What do you buy?
Guideline
s Actual Spreads Value
Treasury 5% 0% 0
Agency Bullet 50% 50% Wide ADD
Agency Callable 20% 30% Wide
Corporate 15% 15% Wide
Recommendation: Buy 2 year bullet agency
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BEST PRACTICE BENCHMARK 2008 and Beyond
Comply Comply
Comply
BEST PRACTICE BENCHMARK
SAFETY LIQUIDTY MARKET RETURN
Diversification Requirements Book Yield
Quality Maintenance Benchmark Return
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How to implement?
• Evaluate Internal System and Expertise
• Cost/Benefit Analysis of Outsourcing - Advisors
• Evaluate Value of Improved Process
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Benefits of a Benchmark Strategy
• Clear Sense of Direction
• Focus in Overall Portfolio vs. Yield
• Accountability to Decision Making Process
• Balances Risk and Return
• Communication, Communication, Communication
• Confidence and Peace of Mind
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TOP TEN ISSUES
1. CASH FLOW2. DIVERSIFICATION OF LIQUIDITY AND INVESTMENTS3. DIVERSIFICATION OF MATURITY AND DURATION4. DIVERSIFICATION OF ASSET CLASS5. KNOW THE RISKS IN YOUR PORTFOLIO6. KNOW THE CURRENT MARKET ENVIRONMENT7. HAVE A STRATEGY8. ESTABLISH GUIDELINES9. COMMUNICATE10.MONITOR THE PORTFOLIO
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MARKET OBSERVATIONS
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THE LAST EASE
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Today- Treasuries have lead ease
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Where are Fed Funds Rates and Short Rates Headed?
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YIELD CURVE
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HAVE A PLAN
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THANK YOU