Rebalancing Your Portfolio - California State Treasurer...2009/10/22  · Rebalancing Your Portfolio...

Rebalancing Your PortfolioPresented by:

Carlos OblitesPFM Asset Management

50 California Street, Suite 2300San Francisco, CA 94111

(415) 982-5544

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Amazing Transformations

2

Amazing Transformations

3

Amazing Transformations

4

Amazing Transformations

5

Before

Inspiring Action

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After

Inspiring Action

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Inspiring Action

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Portfolio Roadmap

• When managing a portfolio, you need a plan

– To have funds available when needed

– To avoid unnecessary risk

– To optimize returns

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Effect of Time on Portfolio

$0

$5

$10

$15

$20

$25

$30

Cash 1 Day to12 Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

Mill

ions

• If you do nothing, the portfolio will change

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What Is Rebalancing?

Bringing the portfolioback in line with the

strategy

11

Why Rebalance?

• Maintain portfolio relative to a target

• Something changes

– Market conditions

– Credit quality

– Investment strategy

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Maintain Portfolio Relative to a Target

• Average maturity or duration

• Matching assets to known expenditures

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Target: Average Maturity or Duration

0.75

1.25

1.50

1.75

2.00

Time

year

s

High Average Maturity Band

Low Average Maturity Band

Target

14

$0

$2

$4

$6

$8

$10

Under 6Months

6 to 12Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

5 Yearsand Over

Mill

ions

$0

$2

$4

$6

$8

$10

Under 6Months

6 to 12Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

5 Yearsand Over

Mill

ions

$0

$2

$4

$6

$8

$10

Under 6Months

6 to 12Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

5 Yearsand Over

Mill

ions

Target Investments to Spending Dates

AssetsKnown Expenditures

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Something Changes: Market Conditions

• Rising rates

• Falling rates

• Shape of yield curve

• Changes of sector yield spreads

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0.5%

1.5%

2.5%

3.5%

4.5%

5.5%

Mar 07 Sep 07 Mar 08 Sep 08 Mar 09 Sep 09

Market Conditions: Rates Drop2-Year U.S. Treasury Yield History

March 2007 – October 2009

5.03%

1.35%

Source: Bloomberg

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0.5%

1.5%

2.5%

3.5%

4.5%

5.5%

Mar 07 Sep 07 Mar 08 Sep 08 Mar 09 Sep 09

Market Conditions: Rates Rise2-Year U.S. Treasury Yield History

March 2007 – October 2009

5.03%

1.35%

3.04%

Source: Bloomberg

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0.5%

1.5%

2.5%

3.5%

4.5%

5.5%

Mar 07 Sep 07 Mar 08 Sep 08 Mar 09 Sep 09

Market Conditions: Rates Drop Again2-Year U.S. Treasury Yield History

March 2007 – October 2009

Source: Bloomberg

0.74%

5.03%

1.35%

3.04%

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-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Oct 99 Oct 01 Oct 03 Oct 05 Oct 07 Oct 09

Source: Bloomberg

Spread Between 2-Year and 10-Year U.S. Treasury Note YieldsOctober 1, 1999 – October 8, 2009

Yield Curve Is Extremely Steep

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Yield CurveU.S. Treasury Yield Curve

December 31, 2008 versus October 8, 2009

Source: Bloomberg

0%

1%

2%

3%

4%

5%

3m

6m

1y

2y

3y

5y

10y

30y

Yiel

d

Maturity

October 8, 2009December 31, 2008

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Market Conditions: Shape of Yield Curve

Time to Maturity

Yiel

d

3m 2y 5y3y6m

INVERTED

FLAT

POSITIVE

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0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

Oct 04 Oct 05 Oct 06 Oct 07 Oct 08 Oct 09

Changes in Sector Yield Spreads

Source: Bloomberg

Spread Between 2-Year U.S. Treasury and Federal Agency NotesOctober 2004 – October 2009

Rebalance into Agencies

Rebalance into

Treasuries

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Something Changes: Credit Quality

• Changes in corporate ratings

• Newspaper headlines

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Credit Quality: Corporate DowngradeBear Stearns Credit Default Spread

January 2007 – October 2008

11/15 –Downgraded by S&P from A+ to A

3/14 –Downgraded by S&P from A to

BBB

Source: Bloomberg

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Credit Quality: Newspaper Headlines

“CIT Group Inc. said it was forced to defer a $22 million interest payment due next month after failing to meet some conditions in the debt agreement.”"There has to be some concern about the

growth of the portfolios, because that's where the risk is.” 9/13/09

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Something Changes: Investment Strategy

• Change in expected cash flow needs

• Change in risk tolerance

• Desire to improve investment income

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Why Rebalance?

• Maintain portfolio relative to a target

• Something changes– Market conditions– Credit quality– Strategy

How to Rebalance

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How to Rebalance

• Buy new securities to restructure portfolio

– Cash on hand

– Cash from matured securities

– Cash from sold security

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$0

$2

$4

$6

$8

$10

$12

Cash 1 Day to12 Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

Mill

ions

Rebalance with Cash on Hand

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RebalancingOne Year Later with No Rebalancing

Rebalance with Cash from Maturity

Portfolio with Laddered Maturity Structure

Mill

ions

$0

$2

$4

$6

$8

$10

$12

Cash 1 Day to12 Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

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$0

$2

$4

$6

$8

$10

$12

Cash 1 Day to12 Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

Mill

ions

$0

$2

$4

$6

$8

$10

$12

Cash 1 Day to12 Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

Mill

ions

Rebalance with Cash from Sale

$0

$2

$4

$6

$8

$10

$12

Cash 1 Day to12 Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

Mill

ions

$0

$2

$4

$6

$8

$10

$12

Cash 1 Day to12 Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

Mill

ions Sell

Sell

Purchase

Purchase

Purchase

Sell$0

$2

$4

$6

$8

$10

$12

Cash 1 Day to12 Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

Mill

ions

$0

$2

$4

$6

$8

$10

$12

Cash 1 Day to12 Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

Mill

ions

$0

$2

$4

$6

$8

$10

$12

Cash 1 Day to12 Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

Mill

ions

$0

$2

$4

$6

$8

$10

$12

Cash 1 Day to12 Months

1 to 2Years

2 to 3Years

3 to 4Years

4 to 5Years

Mill

ions

Time Passes…

Rebalancing to Maintain the Target Structure

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Why Rebalance?

• Maintain portfolio relative to a target

• Something changes– Market conditions– Credit quality– Strategy

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Mechanics of a Trade

$1million

Year 1 Year 2

Buy 2-year investment

@ 2.20%

Sell investment at

1.19% six months later

$1,020,000 $1,044,000

NET GAIN:$20,000

Buy 2-year investment

@ 2.20%

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Trade to Extend Duration in Rising Rate Environment

$1.7 million

Year 1 Year 2 Year 3

Buy 3-year FNMA Notes

@ 2.55%

Sell FNMA Notes at a loss

Buy 3-year FHLB Notes

@ 5.88%

NET GAIN:$3,900

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Trade to Extend Duration in Rising Rate Environment

Sale Purchase

Security FNMA Notes FHLB Notes

Time to Maturity 0.6 years 3.0 years

Par $1.7 million $1.7 million

Yield on Cost 2.55% 5.88%

Gain/(Loss) ($28,900) -

Income to Original Maturity ($26,100) $58,900

Net Earnings Impact to Maturity of Sold Security $3,900

• Extend duration• Capture attractive yield

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Trade to Swap Sectors and Extend Duration in Falling Rate Environment

$5.5 million

Year 1

Buy 1.2-yearFHLMC Notes

@ 3.16%

Buy 3-year U.S. Treasury

Notes @ 1.25%

NET GAIN:$16,500

Sell FHLMC at a gain

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Trade to Swap Sectors and Extend Duration in Falling Rate Environment

Sale Purchase

Security FHLMC Notes U.S. Treasury notes

Time to Maturity 0.5 years 3 years

Par $5.5 million $5.5 million

Yield on Cost 3.16% 1.25%

Gain/(Loss) $73,500 -

Income to Original Maturity ($95,000) $38,000

Net Earnings Impact to Maturity of Sold Security $16,500

• Extend duration• Realize market value appreciation• Trade into sector with best relative value

Rebalancing to Respond to a Change

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Why Rebalance?

•Maintain portfolio relative to a target

•Something changes– Market conditions– Credit quality– Strategy

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Changing Market Conditions2-Year U.S. Treasury Yield History

October 1999 – October 2009

Source: Bloomberg

0%

1%

2%

3%

4%

5%

6%

7%

Oct 99 Oct 01 Oct 03 Oct 05 Oct 07 Oct 09

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Rebalancing Trades

Sell Buy

Short term Long term

Long term Short term

Callable Bullet

Deteriorating credit Higher credit

High credit Medium credit

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Sector ChoiceYield Curves

November 28, 2008

Source: Bloomberg

0%

2%

4%

6%

8%

10%

2 yr 5 yr 10 yr 30 yr

Yiel

d

Maturity

U.S. Treasury

AA Corporate

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0%

1%

2%

3%

4%

5%

6%

Yiel

d

Maturity

Sector ChoiceYield Curves

October 8, 2009

Source: Bloomberg

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Picking the Best Maturity Range• Considering yields are low and may rise, but

the yield curve is very steep, should you buy short or long?

– Which would you buy?

• 1-year investment @ 0.40%

• 3-year investment @ 1.47%

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Breakeven Analysis

• Frame the question differently

– What rate do you have to earn for the last two years to breakeven?

Time=0 1 year Time=3 years

0.40% ??

1.50%

2 years

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Breakeven Analysis

1.50 * 3 years = (0.40 * 1 year) + (x * 2 years)4.50 = 0.40 + 2 x

4.10 = 2 x2.05 = x

1.50% for 3 years

Time=0 1 year Time=3 years

0.40% for 1 year

2 years

2.05% for 2 years?? for 2 years

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Breakeven Analysis• Do you think that rates will rise more than 100 basis

points in the next year?– If no, buy the 3-year investment– If yes, buy the 1-year

1.50% for 2 years

Time=0 1 year Time=3 years

0.40% for 1 year 2.05% for 2 years

2 years

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Breakeven Analysis• How could you know if rates will rise more than

100 basis points in the next year?

– Frame the question differently

• There are 8 Fed meetings in the next year.

• Is it likely that the Fed will raise rates 25 basis points at 4 of the 8 meetings?

– If no, interest rates will remain low and the 3-year is a good choice.

– If yes, then the 1-year is a good choice.

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Your Turn: Breakeven Analysis

• Considering yields are low and may rise, but the yield curve is very steep?

– Which would you buy?

• 1-year Agency @ 0.36%

• 2-year Agency @ 1.10%

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Your Turn: Breakeven Analysis

• What rate do you have to earn for the last year to breakeven?

Time=0 6 months Time=2 years

0.36% ??

1.10%

1 year 1½ years

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Breakeven Analysis

1.84% for 1 year

1.10 * 2 years = (0.36 * 1 year) + (x * 1 year)

2.20 = 0.36 + x

1.84 = x

1.10% for 2 years

Time=0 6 months Time=2 years

0.36% for 1 Year

1 year 1½ years

?? for 1 year

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• The second step in breakeven analyses is determining if you think that the breakeven rate will come to be.

– But how can you know?

1. Yield curve analysis• The yield curve reflects the market’s

expectations of future rates.2. Federal Reserve monetary policy

• Federal Reserve has indicated it will keep rates low for an “extended period of time.”

How Quickly Will Rates Rise?

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Why Rebalance?•Maintain portfolio relative to a target

•Something changes– Market conditions– Credit quality– Strategy

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Follow the News

Dollar Falls After Australia Unexpectedly Raises Interest Rates –Bloomberg News, October 6, 2009

MBIA Downgrade Brings Up Its 'Overlooked‘ Commercial ExposureReuters, September 28, 2009

Bank Failures Tally Tops 98 In 2009-CNNMoney.com, October 2, 2009

B. of A. To Pay $425 mln To End Government Asset Guarantee-CBS MarketWatch, September 21, 2009

Bernanke Blasts AIG For 'Irresponsible Bets' That Led to Bailouts-Washington Post, March 4, 2009

U.S. Debates Fate of CIT, a Small-Business LenderThe New York Times, July 14, 2009

At Lehman, Allaying Fears About Being the Next to Fall-The New York Times, March 18, 2008

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September 11, 2008Lehman searches for

buyer after stock drops 40%

Monitor News in Corporate Sectors in Your Portfolio

Lehman Brothers: A Cautionary TaleTimeline of the Bankruptcy

August 22, 2008Lehman stock up 5% on possible buy-out

news

September 9, 2008Lehman announces $3.9 BB

loss prompting sale of Neuberger Berman

September 15, 2008

Lehman declares bankruptcy

August 2007 to June 2008Lehman losses due to

subprime increase

September 16, 2008Lehman memorabilia on EBay appreciate in

value

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Piece of History

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Not For Sale

60

Bond PriceJanuary 2007 – October 2008

The Warning Signs – Lehman Brothers

Source: Bloomberg

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The Warning Signs – Lehman Brothers

Source: Bloomberg

Stock PriceJanuary 2007 – October 2008

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The Warning Signs – Lehman Brothers

Credit Default SpreadJanuary 2007 – October 2008

1

1.Sep. 9 – Put on negative credit watch by S&P

2.Sep. 15 –Downgraded from A to CCC- by S&P

3.Sep. 16 –Downgraded from CCC- to D by S&P

2

3

Source: Bloomberg

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$0$10$20$30$40$50$60$70$80

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09

Warning Signs

$0$10$20$30$40$50$60$70

Sep-07 Dec-07 Mar-08 Jun-08 Sep-08

* Ratings: S&P and Moody’s respectively. Source: Bloomberg

$0

$10

$20

$30

$40

$50

Sep-07 Dec-07 Mar-08 Jun-08 Sep-08

$0

$10

$20

$30

$40

$50

Sep-07 Dec-07 Mar-08 Jun-08 Sep-08

Down 91%

Down 100%

Down 81%

Down 100%

Lehman Brothers Stock Price (NR, B3)*September 2007 – September 2008

Washington Mutual Stock Price (D,Caa2)*September 2007 – September 2008

MBIA Stock Price (BB,Ba3)*January 2007 – September 2009

CIT Stock Price (A-,Baa1)*September 2007 – September 2008

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Why Rebalance?

•Maintain portfolio relative to a target

•Something changes– Market conditions– Credit quality– Strategy

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Change in Strategy

• Go longer

• Go shorter

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Change Strategy for Market Reasons

• Waiting for changes to the current trend.

Source: Bloomberg

2-Year U.S. Treasury YieldsMarch 2007– October 2009

0.5%

1.5%

2.5%

3.5%

4.5%

5.5%

Mar 07 Sep 07 Mar 08 Sep 08 Mar 09 Sep 09

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Risk and Return Increase With Duration

Common Total Return Benchmarks10 Years ended September 30, 2009

Merrill Lynch U.S. Treasury Index Duration

Overall Return

Cumulative Value of $50

Million

Quarters With Negative Returns

LAIF 0.50 Years 3.54% $70,802,199 0 out of 40

1-3 Year 1.93 Years 4.54% $77,944,010 4 out of 40

1-5 Year 2.67 Years 5.02% $81,639,103 9 out of 40

3-5 Year 3.89 Years 6.00% $89,574,805 14 out of 40

Source: Bloomberg-Merrill Lynch Global Bond Indices and LAIF website

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1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Past 10 Years

LAIF 5.35% 6.39% 4.95% 2.69% 1.74% 1.66% 3.05% 4.74% 5.25% 3.19% 3.88%

ML 1-Yr TSY 4.03% 7.32% 7.28% 3.28% 1.45% 0.81% 2.36% 4.32% 5.95% 4.75% 4.13%

ML 1-3 Yr TSY 3.06% 8.00% 8.30% 5.76% 1.90% 0.91% 1.67% 3.96% 7.32% 6.61% 4.71%

LAIF and Merrill Lynch U.S. Treasury Index Returns

Yield on 2-Year U.S. Treasury Note1998 - 2008

Source: Bloomberg—Merrill Lynch Indices and LAIF website

Securities with Longer Maturities Outperform

0%

1%

2%

3%

4%

5%

6%

7%

Dec 98 Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08

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Questions?

• Thank you!