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Rebalancing Your PortfolioPresented by:
Carlos OblitesPFM Asset Management
50 California Street, Suite 2300San Francisco, CA 94111
(415) 982-5544
1
Amazing Transformations
2
Amazing Transformations
3
Amazing Transformations
4
Amazing Transformations
5
Before
Inspiring Action
6
After
Inspiring Action
7
Inspiring Action
8
Portfolio Roadmap
• When managing a portfolio, you need a plan
– To have funds available when needed
– To avoid unnecessary risk
– To optimize returns
9
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
10
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
12
Maintain Portfolio Relative to a Target
• Average maturity or duration
• Matching assets to known expenditures
13
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
15
Something Changes: Market Conditions
• Rising rates
• Falling rates
• Shape of yield curve
• Changes of sector yield spreads
16
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
17
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
18
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%
19
-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
20
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
21
Market Conditions: Shape of Yield Curve
Time to Maturity
Yiel
d
3m 2y 5y3y6m
INVERTED
FLAT
POSITIVE
22
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
23
Something Changes: Credit Quality
• Changes in corporate ratings
• Newspaper headlines
24
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
25
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
26
Something Changes: Investment Strategy
• Change in expected cash flow needs
• Change in risk tolerance
• Desire to improve investment income
27
Why Rebalance?
• Maintain portfolio relative to a target
• Something changes– Market conditions– Credit quality– Strategy
How to Rebalance
29
How to Rebalance
• Buy new securities to restructure portfolio
– Cash on hand
– Cash from matured securities
– Cash from sold security
30
$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
31
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
32
$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
34
Why Rebalance?
• Maintain portfolio relative to a target
• Something changes– Market conditions– Credit quality– Strategy
35
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%
36
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
37
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
38
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
39
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
41
Why Rebalance?
•Maintain portfolio relative to a target
•Something changes– Market conditions– Credit quality– Strategy
42
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
43
Rebalancing Trades
Sell Buy
Short term Long term
Long term Short term
Callable Bullet
Deteriorating credit Higher credit
High credit Medium credit
44
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
45
0%
1%
2%
3%
4%
5%
6%
Yiel
d
Maturity
Sector ChoiceYield Curves
October 8, 2009
Source: Bloomberg
46
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%
47
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
48
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
49
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
50
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.
51
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%
52
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
53
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
54
• 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?
55
Why Rebalance?•Maintain portfolio relative to a target
•Something changes– Market conditions– Credit quality– Strategy
56
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
57
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
58
Piece of History
59
Not For Sale
60
Bond PriceJanuary 2007 – October 2008
The Warning Signs – Lehman Brothers
Source: Bloomberg
61
The Warning Signs – Lehman Brothers
Source: Bloomberg
Stock PriceJanuary 2007 – October 2008
62
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
63
$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
64
Why Rebalance?
•Maintain portfolio relative to a target
•Something changes– Market conditions– Credit quality– Strategy
65
Change in Strategy
• Go longer
• Go shorter
66
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
67
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
68
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
69
Questions?
• Thank you!