TEACHERS’ RETIREMENT BOARD INVESTMENT COMMITTEE …€¦ · Investment Committee – Item 5c September 7, 2011 Page 2 DISCUSSION The Fixed Income Portfolio (Portfolio) continued

TEACHERS’ RETIREMENT BOARD

INVESTMENT COMMITTEE

SUBJECT: Fixed Income – Annual Performance Report ITEM NUMBER: 5c Fiscal Year 2010-11

CONSENT: X ATTACHMENT(S): 1 ACTION: DATE OF MEETING: September 7, 2011 INFORMATION: X PRESENTER(S): Michelle Cunningham

POLICY

The strategic asset allocation and investment structure for the CalSTRS Investment Portfolio are controlled by the Investment Policy and Management Plan (IPMP). The Fixed Income Investment Policy (Policy) governs the management of the fixed income assets and strategies, in order to develop a diversified portfolio of fixed income assets and strategies that meet the System’s objectives within acceptable risk parameters.

BOARD STRATEGIC PLAN GOAL

Goal 4: Ensure a financially sound retirement system

Objective A: Ensure a financially sound retirement system through optimal investment returns.

HISTORY OF THE ITEM

The Fixed Income Unit has presented an annual report since 2002. Prior to that year, reviews of the Fixed Income Portfolio were reported to the Investment Committee on a regular basis.

PURPOSE

In accordance with the California State Teachers’ Retirement System’s (CalSTRS’) Fixed Income Investment Policy regarding monitoring and reporting and the Investment Committee’s (Committee) annual objectives within the current business plan, the Fixed Income Annual Report is provided for the Committee’s information (see Attachment 1).

Annual reports are presented as part of the regular reporting process. This report is intended to inform the Committee of the Portfolio activities for the fiscal year ending June 30, 2011, and to provide an update regarding the status of any objectives established for the Portfolio within the most recent business plan. Included is an overview of the process followed in developing strategies for the Fixed Income Portfolio. The current portfolio structure and sector weightings, along with performance compared to our objectives over varying time periods, are also included.

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Investment Committee – Item 5c September 7, 2011 Page 2

DISCUSSION

The Fixed Income Portfolio (Portfolio) continued to generate strong returns across all of the strategies and sectors, outperforming the performance benchmark by 99 basis points for the twelve months ending June 30, 2011 (see page 7, CalSTRS Debt Portfolio). The outperformance this past year can be attributed in large part to the accommodative policies that continued to support/encourage investor’s risk appetite. Looking forward over the next year, we will be looking for signs that economic growth will become self sustaining, as the monetary and fiscal stimulus is being removed. However, until some of the uncertainties, such as budget deficits here in the U.S. and over in Europe, are addressed, corporate America is likely to hold off on any major business investment and job creation. In this environment, markets are volatile and, while everyone agrees that interest rates are surprisingly low, they could remain low for an extended period of time. As a result, we will continue to focus on higher quality spread sectors (i.e., non Treasury securities) and risk management.

Given the environment, the common theme throughout the Investment Branch Business Plans for the upcoming year was to focus on the core mission of “making money and protecting the assets.” With that in mind, a portion of the existing high yield mandate that has been entirely managed externally will be brought in-house. Updates on the implementation will be included in the Board’s quarterly reports, with an emphasis on portfolio performance and cost savings.

CONCLUSION

The Fixed Income Portfolio has been structured to achieve a long-term total return consistent with the Board-adopted policy benchmark. As demonstrated on page 7 of the report, the internally managed Core assets were able to generate cost-effective returns that exceeded the benchmark over each of the past 1-, 3-, 5- and 10-year time periods. The Opportunistic Strategies, which are comprised of active portfolios with higher risk levels and higher expected returns, also added value over all time periods, as compared to the benchmark. Prepared by: _____________________________ _____________________________ Glenn Hosokawa, CFA Paul V. Shantic Portfolio Manager Portfolio Manager Approved by: Concur: _____________________________ _____________________________ Michelle Cunningham, CFA Christopher J. Ailman Director of Fixed Income Chief Investment Officer

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Self sustaining recovery...or not?

FY10-11 A N N U A L R E P O R T

Fiscal Year 2010-11 Annual Report Fixed Income Portfolio

Self sustaining recovery...or not?

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2 Fixed Income Annual Report—FY 2010-11


Securing the financial future

and sustaining the trust of California’s educators

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3 Self sustaining recovery...or not?


4

5

6

7

8

9

Portfolio Management Team

Director Summary

Portfolio Management Process

Debt Portfolio

Characteristics vs. Benchmark

Glossary

Contents

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Corporates Team Sunny Dhillon; Cathy DiSalvo; Paul Shantic, Portfolio Manager; Stacey Reichen-berg.; and Geetha Arani.

Short Term and Securities Lending Team Glenn Hosokawa, CFA, Portfolio Manager;

John Perez, Portfolio Manager; Debra Ng and Roy Clothier, CFA.

Operations Unit: LEFT TO RIGHT: Wayne Yim, CFA; Melissa Da Ronco; Kim McDonnell; Denny Young; Krista Jackson-Ingram; Carlos Maciel; Laurie Winston; Debra Smith, Operations Director; John Petzold, DCIO; Steve Kruth; Darin Yi; Jermaine Brown; Connie Tyer; Mami Wong; Gilda Ligaya; Michael Law-rence; and Haytham Sharief. NOT PICTURED: Matthew Schroeder, Mary-ann Avansino, Anthony Kennedy, Patrick Rhodes and Brittney Alaníz.

CalSTRS Fixed Income Portfolio—Management Team

Director of Fixed Income and Administrative Support Team Michelle Cunningham, CFA, Director of Fixed Income; Laurie Masters and Jennifer James

Fixed Income External Management Team April Wilcox; Terésa Cutter; and

Deborah Contini, CFA, Portfolio Manager (seated)

Operations Senior Staff: Debra Smith,

Director of Operations, and Wayne Yim, CFA

Interest Rate Products and Currency Management:

Glenn Hosokawa, CFA, Portfolio Manager; Rosie Lucchesini-Jack; Dan Depner.

NOT PICTURED: Roy Clothier, CFA

Structured Products: Josh Diedesch; Ian McCarty; and Margaret Morris, Portfolio Manager

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CalSTRS Fixed Income Portfolio DIRECTOR’S SUMMARY… Last year at this time, we were seeing some cyclical improvements in economic activity as a direct result of the unprecedented monetary and fiscal policy actions and massive injections of capital into the banking system after the financial crisis. These accommodative policies provided support to the investment markets during the fiscal year ended June 30, 2011, and alleviated fears of a double dip recession, encouraging risk-taking activities on the part of investors and resulting in strong absolute returns. Although not as high as the previous year’s double digit returns, the Fixed Income Portfolio (Portfolio) did generate strong returns across all of the strategies and sectors for the second year in a row, ending June 30, 2011 (see page 7, CalSTRS Debt Portfolio). Breaking the performance down by strategy, the internally managed Core assets, which are intended to generate cost-effective market-like returns over time, continued to perform well over each of the past 1-, 3-, 5- and 10-year time periods. The Opportunistic Strategy, which is comprised of active portfolios with higher risk levels and higher expected returns, also added value over each of the pasts 1-, 3-, 5-, and since inception time periods. Looking forward over the next year, we will be looking for signs that economic growth will become self- sustaining as the monetary and fiscal stimulus is being removed. We are not yet seeing significant capital expenditures and job creation. Until some of the uncertainties such as budget deficits here in the U.S. and over in Europe are addressed, corporate America is likely to hold off on any major business investment. In this environment, markets are volatile and, while everyone agrees that interest rates are surprisingly low, until there is clarity on some of these broad issues, they are likely to remain low for an extended period of time. As a result, we will continue to focus on higher quality spread sectors (i.e., non Treasury securities) and develop strategies to protect against the risk of higher interests rates. Given the environment, the common theme throughout the Investment Branch Business Plans for the upcoming year was to focus on the core mission of “Making Money and Protecting the Assets.” With that in mind, one of the key initiatives for the fixed income team this year will be to implement the recommendations of a major study regarding internal asset management that was presented to the Investment Committee this past June. A portion of the existing high yield mandate that has been entirely managed externally since 2002 will be brought in-house. Staff envisions starting with an initial allocation of up to $500 million, and managing to a lower tracking error and active risk. Updates on the implementation will be included in the Board’s quarterly reports, with an emphasis on portfolio performance and cost savings. This report presents the highlights of the CalSTRS Fixed Income Portfolio activities for the fiscal year ending June 30, 2011. Included is an overview of our investment process, the current structure and sector weighting across the Portfolio, and performance as compared to our objectives over varying time periods. Michelle Cunningham, CFA Director of Fixed Income Christopher J. Ailman Chief Investment Officer June 30, 2011

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CalSTRS Fixed Income Portfolio MANAGEMENT PROCESS…

eople

hilosophy

rocess

erformance

Implement Investment Strategy

Asset Manager Selection

Duration Management

Yield Curve Management

Sector Management

Security Selection

Trading/Execution

Analyze / Examine Environment

Fundamental Environment

Technical Environment

Quantitative/Risk Analysis

Credit Research

External Resources

Define Program Framework

Role of Fixed Income

Board Policy/

Benchmark Determination

Portfolio Guidelines

Monitor / Report Portfolio Status

Compliance Reviews

Monthly / Annual Reporting

Credit Committee

Daily Performance

Daily Meetings

P

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C o re P lus$ 2 . 863Special

Situat io ns$ 0 . 428

H igh Yield$ 1. 844

Go vts / A gencies$ 8 . 015

Securit ized A ssets$ 8 . 594

Inv . GradeC o rpo rates

$ 5 . 644

Tota l

Debt

18%

Cash

1%

Abso l ute Return

A l pha

2%

Gl obal

Eq.

53%

Pr i vate Eq. ,

14%

Real

Estate

12%

CalSTRS Fixed Income Portfolio DEBT PORTFOLIO

TOTAL DEBT PORTFOLIO Sector Weightings $ 27.388 (in billions) as of 06/30/2011

The internally managed Core assets, which are

intended to generate cost-effective market-like

returns over time, performed well over each of the past 1-, 3-, 5-, and 10-year time periods as

the markets continued to recover from the financial

crisis.

TOTAL INVESTMENT PORTFOLIO Asset Allocation as of 06/30/2011

TOTAL DEBT PORTFOLIO PERFORMANCE vs. BENCHMARK*

Periods Ending June 30, 2011

TOTAL DEBT 1-Year 3-Year 5-Year 10-Year

CalSTRS 5.44 7.35 6.94 6.33

Benchmark* 4.45 6.82 6.66 6.20

Difference 0.99 0.53 0.28 0.13

CORE STRATEGY 1-Year 3-Year 5-Year 10-Year

Internal Mgmt. 4.13 6.76 6.69 6.12

Benchmark* 3.89 6.44 6.52 6.00

Difference 0.24 0.32 0.17 0.12

OPPORTUNISTIC STRATEGIES

1 Year 3 Year 5-Year Since Inception**

Active Mgmt. *** 11.13 9.71 8.04 8.00

Benchmark* 4.45 6.82 6.66 6.20

Difference 6.68 2.89 1.38 1.80

* BENCHMARK: (95%) Barclays Capital Aggregate Index + (5%) Barclays Capital U.S. High Yield Cash Pay 2% Issuer Constrained (ex-Tobacco) Index

** Inception date April 2002

*** Includes high yield, core plus and debt opportunity funds

___________________

TOTAL: $ 27.388

Opportunistic Strategies, which are comprised of

active portfolios with higher risk levels and

higher expected returns, also continued to reflect a

cautious, yet more confident investment

outlook.

Core Strategy $ 22.253 billion

81.25%

Opportunistic Strategy $ 5.135 billion

18.75%

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CalSTRS Fixed Income Portfolio CHARACTERISTICS VS BENCHMARK…

CalSTRS’ underweight to

AAA securities is consistent with a moderately

higher yield vs. the Benchmark as reflected in

the table above.

PORTFOLIO BENCHMARK COMPARISON as of 06/30/11

CalSTRS Benchmark¹ Difference

# of Issues/Bonds 3,487 9,845 (6,358)

Average Coupon (%) 4.43 4.36 0.07

Average Quality Aa2/AA Aa1/AA+ n/a

Average Yield to Maturity (%) 2.98 2.72 0.26 Option-Adjusted Duration² (Yrs) 4.20 4.46 (0.26)

CalSTRS PORTFOLIO

AAA66.00%

AA4.60% A

9.36%BBB

10.68% BB2.46%B

4.22%Other0.50%

CCC2.18%

BENCHMARK 1

AAA72.23%

AA4.63%

B2.08%

CCC0.75%

Other0.95%

BB1.97%

BBB8.04%

A9.35%

Our investment philosophy is to optimize (as opposed to replicate) our holdings

vs. the Benchmark.

Duration is a quarter-year short versus the benchmark, reflecting our concern over the risk of higher interest

rates.

CalSTRS SECTOR WEIGHTING vs. BENCHMARK 1

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

% o

f P

ort

foli

o

CalSTRSBeginning of FY

30.14% 21.93% 30.95% 4.47% 0.45% 8.50% 3.56%

CalSTRSEnd of FY

30.58% 23.04% 32.45% 3.43% 0.45% 8.06% 1.99%

Benchmark ¹ 37.31% 23.37% 31.01% 2.20% 0.26% 4.91% 0.94%

Difference vs. Benchmark ¹

-6.73% -0.33% 1.44% 1.23% 0.19% 3.15% 1.05%

Government Inv. Grade Credit MBS CMBS ABS High Yield Other ³

¹ BENCHMARK: (95%) Barclays Capital Aggregate Index + (5%) Barclays Capital U.S. High Yield Cash Pay 2% Issuer Constrained (ex-Tobacco) Index

² DURATION: a standard measure of the portfolio’s sensitivity to risk or volatility to interest rates, relative to the benchmark ³ OTHER: Sectors included within the “Other” category include bank loans, emerging market debt, non-dollar bonds, and derivatives

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CalSTRS Fixed Income Portfolio GLOSSARY…

ACTIVE STRATEGY – Objective is to maximize returns above a specified benchmark while minimizing risk exposure. This can be achieved by correctly forecasting broad market trends and/or identifying particular mispriced sectors of a market or securities in a market. Conversely, a Passive Strategy focuses on providing a return that closely mimics the return of a benchmark.

AGENCY SECURITIES – Investments issued by federal corporations and federally sponsored corporations that are able to issue debt at a lower cost to such constituencies as farmers, homeowners, and students.

ASSET-BACKED SECURITIES – Investments that are collateralized by assets such as automobile loans, agricultural equipment loans, and credit card loans. The loans feature credit enhance-ments that lead to high credit ratings and limited investor exposure to the credit of the seller.

BASIS POINT – One hundredth of one percent (.01%); .0001 in decimal form.

BROAD MARKET-WEIGHTED PERFORMANCE BENCHMARK – With a market-weighted bench-mark, the weighting of each asset class within the benchmark may change due to the market capitalization. Conversely, with a fixed-weighted benchmark, the weightings of each asset class are held constant.

CASH FORECAST – The projection provided by CalSTRS’ Operations division of the sources and uses of cash for the System in the immediate future.

COLLATERAL – Securities and other property pledged by a borrower to secure payment of a loan.

COMMERCIAL MORTGAGE-BACKED SECURITIES (CMBS) – Investments that are collateralized by commercial real estate mortgages. Similar to a Mortgage Backed Security where payments to investors are received out of the interest and principal of the underlying mortgages.

COMPETITIVE BIDS/OFFERS – The practice of soliciting more than one bid or offer for a security transaction. It is based on an identifi-able asset in accordance with identified fixed rules for all participants.

CORPORATE BOND – A financial obligation for which the issuer (a company) promises to pay the bondholders a specified stream of cash flows, including periodic interest and a principal repayment.

CREDIT RATING – A relative ranking of timely interest payment and principal repayment, based on past records of debt repayment, current financial status, and future outlook for the company.

DERIVATIVE – A security whose price/return is dependent upon the price/return of some other underlying asset. Futures contracts, forward con-tracts, options and swaps are the most common types of derivatives.

DIVERSIFICATION – Investing in a wide range of securities/or asset classes in order to reduce financial risk.

DURATION – A standard measure of the port-folio’s sensitivity to risk or volatility to interest rates, relative to the benchmark .

(Continued on page 10)

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ENHANCED INDEXING STRATEGY – A technique for making relatively small adjustments to an indexed portfolio in order to increase the return slightly above the return on the index.

FAILED TRADE – Purchased or sold investment securities that are not delivered on the contracted settlement date.

FEDERAL RESERVE – The independent central bank that influences the supply of money and credit in the United States through its control of bank reserves. Also called the Fed.

FISCAL STIMULUS – A fiscal policy of incurring budget deficits to stimulate a weak economy.

FUNDAMENTAL ENVIRONMENT – The economic environment; encompassing interest rates, inflation, gross national product, unemployment, inventories and consumer spending.

HIGH YIELD SECURITIES – A higher-risk debt security that is rated less than Baa3/BBB- by the rating agencies.

INDEX – A defined representative collection of securities used to measure the change in value of the securities market on a monthly basis.

INDEXED PORTFOLIO – A portfolio which replicates a broad market index (benchmark). Objective is to minimize tracking error while providing market returns.

INVESTMENT GRADE SECURITIES – Investment grade is restricted to those bonds rated Baa3/BBB- and above by the rating agencies.

INVESTMENT OFFICER – Any one of the in-house investment professionals in the CalSTRS Fixed Income unit.

LIQUIDITY – The ease with which a bond can be purchased or sold at a fair price in a timely manner.

LIQUIDITY PORTFOLIO – For CalSTRS' purposes, this is the Short-Term Fixed Income Portfolio that provides cash flow for funding transactions for the System, such as benefit payments, investment manager activity, and asset allocation. Examples of short-term investments include U.S. Treasury, Agency, and money market securities (commercial paper, certificates of deposit, Euro-dollar deposits, and repurchase agreements).

MARKET CYCLE – Generally considered to be three to five years.

MONETARY STIMULUS – The Federal Reserve manipulates the money supply either through open market transactions, member bank reserve requirements, or through changing the discount rate.

MORTGAGED-BACKED SECURITY (MBS) – A security that is issued by a federal agency, such as the Federal Home Loan Mortgage Corpora-tion, the Federal National Mortgage Association, or the Government National Mortgage Associa-tion, that is backed by mortgages. Payments to investors are received out of the interest and principal of the underlying mortgages.

PAR VALUE – The underlying stated value of a bond. The par value serves as the basis for calculating coupon payments and settlement details.

PORTFOLIO – A collection of stocks, bonds, or money market securities owned by an investor and segmented by a predefined method.

(Continued from page 9)

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POSITION – The status of securities, futures, and options in an account - long or short.

PRINCIPAL PAYDOWN – The portion of a periodic payment that reduces the amount of the principal.

QUALITY RANGES – Guidelines for the percent-age of market value of a particular credit rating within a portfolio.

QUANTITATIVE ANALYSIS – Applies mathemati-cal and statistical techniques to a single market sector (i.e., equity or debt) or to asset allocation.

RATE OF RETURN – The total income received over a period of time, including interest income, accretion of discount, amortization of premium, and change of market value; usually expressed as a percentage or in decimal format.

SECURITIZED ASSETS – Debt investments that are collateralized by assets. Examples include: Mortgaged-backed securities, Commercial Mortgaged-backed securities and Asset-backed securities.

SETTLEMENT DATE – For each security transaction, a price is established based on the specifics of the security and the payment date. The payment date, or when the security is exchanged for value, is called the settlement date.

SPLIT-RATED – The credit ratings of corporate and other

securities are made by independent services such as Moody's, Standard & Poor’s and Fitch. When a security receives ratings that are different among the rating services, the term “split-rated” is used to signify this difference in relative credit ratings.

TECHNICAL ENVIRONMENT – Evaluates the environment through historical market activity, such as prices and volume, and uses charts to identify patterns that may suggest future activity and/or trends.

TRACKING ERROR – The deviation of the portfolio's rate of return from that of the target index or performance benchmark.

UNITED STATES TREASURY SECURITIES – Debt issues of the U.S. Government, such as Treasury bills, notes and bonds.

WHOLE LOANS – A secondary mortgage market term which refers to an investment in an original mortgage loan, versus a loan which participates in a secured pass-through security.

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California State Teachers’ Retirement System Investments Branch — Fixed Income Unit P.O. Box 163749 Sacramento, CA 95816-3749 916-414-7501 www.CalSTRS.com

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Documents

TEACHERS’ RETIREMENT BOARD INVESTMENT COMMITTEE …€¦ · Investment Committee – Item 5c September 7, 2011 Page 2 DISCUSSION The Fixed Income Portfolio (Portfolio) continued