The Merits of Diversification in Portfolio Management April 14, 2016 Ellis Phifer, CFA, CMT Managing Director (901) 579-4831 Ellis.Phifer@raymondjames.com Intended for Institutional Clients Only See Page 43 for Important Disclaimers & Disclosures FIXED INCOME RESEARCH
Objectives Broad Understanding of Diversification Theory Implication for Public Sector Portfolio Diversification Within the Agency Sector Broader Asset Class Diversification 2
Diversification 3
1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT Stock Portfolio 6000 Stocks 5000 4000 3000 Stocks Return 9.92% St Dev 15.53% MaxDD -50.95% $100 becomes $ 4,868 2000 1000 0 Stocks 4
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT Stock Portfolio 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% Annual Returns Stocks 5
1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT Bond Portfolio 3000 Bonds 2500 2000 1500 1000 Bonds Return 8.04% St Dev 8.36% MaxDD -15.79% $100 becomes $ 2,394 500 0 Bonds 6
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT Bond Portfolio 50% Annual Returns 40% 30% 20% 10% 0% -10% -20% Bonds 7
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT Stocks and Bonds 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% Annual Returns Stocks Bonds 8
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT Blended Portfolio 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% Annual Returns Stocks Bonds Blend 9
1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT Blended Portfolio 6000 5000 4000 3000 2000 1000 0 Stocks Bonds 10
11 0 1000 2000 3000 4000 5000 6000 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Stocks Bonds 0 1000 2000 3000 4000 5000 6000 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Stocks Bonds Blend Blended Portfolio THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Blended Portfolio Stocks Bonds Blend Return 9.92% 8.04% 9.37% St Dev 15.53% 8.36% 9.14% MaxDD -50.95% -15.79% -23.11% $100 becomes $ 4,868 $ 2,394 $ 3,961 12
1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT Fully Diversified 7000 6000 5000 4000 3000 2000 1000 0 Stocks Bonds Blend Full Diversified T-Bills, S&P, Small Caps, Foreign Stocks, Emerging Markets, Treasuries, Corporates, Commodities, REIT, Long Treasuries, Gold, Foreign Bonds 13
Diversified Portfolio Stocks Bonds Blend Diversified Return 9.92% 8.04% 9.37% 10.36% St Dev 15.53% 8.36% 9.14% 7.98% MaxDD -50.95% -15.79% -23.11% -29.74% $100 becomes $ 4,868 $ 2,394 $ 3,961 $ 5,738 T-Bills, S&P, Small Caps, Foreign Stocks, Emerging Markets, Treasuries, Corporates, Commodities, REIT, Long Treasuries, Gold, Foreign Bonds 14
Diversification Not designed to increase returns, but sometimes that occurs. Intended to reduce volatility and drawdowns. By adding uncorrelated assets. Not by adding less risky assets, though that helps. Keep in mind, correlations are not constant. In times of crisis, correlations increase among asset classes, reducing the benefits of diversification. 15
Objectives Broad Understanding of Diversification Theory Implication for Public Sector Portfolio Diversification Within the Agency Sector Broader Asset Class Diversification 16
Simple Portfolio Comparison A vs. B 17
Portfolio A 18
Portfolio B 19
Goal of Public Sector Portfolio Diversification Fixed income products are all very correlated. Most volatility is driven by interest rate sensitivity. Lack of uncorrelated investments means you have to diversify by focusing on: Liquidity Cash Flow o Maintain enough cash flow so that you are not forced to sell securities. o Spread out maturity to reduce reinvestment risk. 20
Objectives Broad Understanding of Diversification Theory Implication for Public Sector Portfolio Diversification Within the Agency Sector Broader Asset Class Diversification 21
Diversification Factors Maturity Call Date Call Type Issuer Dollar Price Deal Size Coupon Type (Fixed/Floating/Step) Coupon Payment Dates 22
Callable Portfolio 23
Call Type One Time (1x) or European Call Callable once after a specified lockout period. For example, a 5-year bond which is callable one-time after 2 years. Continuous or American Call Callable anytime with a specified period of notice (usually 10 or 30 days). Discrete or Bermuda Call Callable on interest payment dates only by a predetermined call schedule. Canary Call A hybrid between a Bermuda call and a European call. 24
Issuer November 2013 25
Issuer June 2009 26
Federal Home Loan Banks The Federal Home Loan Bank system was organized in 1932 under the Federal Home Loan Bank Act. Organized Prior to Fannie Mae (1938) or Freddie Mac (1970). The Act was designed to restore confidence in the U.S. banking system and revive the post-depression housing market. The Act also created the need for a credit system to ensure the availability of funds to finance home loans. Thus, the primary purpose of the FHLB is to lend funds in the form of collateralized advances to member institutions for making home loans. Super Lien Authority. State Tax advantage keeps demand high. 27
FHLB Debt Highlights Joint and several obligations of the system banks. Not guaranteed by the Federal Government. Typically not subject to State income taxes. Issued as senior debt. Senior debt rated AA+/Aaa. Website: www.fhlb-of.com 28
Farm Credit Federal Farm Credit Bank FFCB Oldest of the GSEs Co-operative Structure Over $275 Billion in Assets Debt Issuance Growing Fast Becoming Player in Daily AA+/Aaa GSE Debt Issuance Net Income of over $3.5 Billion in each year over past 5 years. Regulatory Oversight o Farm Credit Administration Executive Branch Added Protection o Farm Credit System Insurance Corp 29
Other Large U.S. GSEs Tennessee Valley Authority (TVA) Federal Agriculture Mortgage Corporation ( Farmer Mac ) Alternative Issuers in Agency Market Private Export Funding Corporation (PEFCO) Financing Corporation (FICO) U.S. Agency for International Development (USAID) Overseas Private Investment Corporation (OPIC) 30
TVA Tennessee Valley Authority TVA Nation s Largest Public Power Producer Wholly Owned by Federal Government o Does Not Issue Stock Sole Discretion to Set Power Rates o Directed by TVA Act to Set Rates to Cover Debt Costs Diversified Power Production o Coal-Fired Units o Operating Nuclear Units o Hydro Units o Combustion-Turbine Units o Green Power Facilities 31
TVA Table II Comparison to Two of the Largest GSEs, Fannie Mae and Freddie Mac TVA Fannie Mae and Freddie Mac 1938 (FNMA) Federal Charter 1933 1970 (FHLMC) Federal Ownership Shareholders Government Financial Objective Profit Neutral For Profit Primary revenue source Electricity Sales Mortgages Explicit guarantee by the U.S. Gov. No No Rating of senior unsecured securities AA+/Aaa AA+/Aaa Business type Public Power Utility Financial Services Approximate level of outstanding debt securities $25 Billion $450 Billion each State and local income tax exemption Yes No Source: Tennessee Valley Authority, Bloomberg 32
Farmer Mac provides a secondary market for agricultural and rural utility loans through the mobilization of external capital. Created by Congress in response to the agricultural credit crisis in the mid-1980s. Farmer Mac is a Government Sponsored Enterprise (GSE) and an institution of the Farm Credit System (FCS). Farmer Mac is regulated by the Farm Credit Administration (FCA), an independent agency in the executive branch of the United States government. Farmer Mac has $1.5 billion U.S. Treasury backstop supporting guarantees. 33
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Other Diversification Factors Dollar Price Discounts and Premiums (Cushion) Deal Size Larger deal size are more liquid. Global deals greater than $1Billion have the most liquidity. Smaller auction deals are not as liquid but offer higher yields. Coupon Type Fixed/Floating/Steps. Step alternatives to floaters currently attractive. Coupon Payment Dates Structure coupon payments months just like you would maturity and call dates to reduce reinvestment risk. 35
Objectives Broad Understanding of Diversification Theory Implication for Public Sector Portfolio Diversification Within the Agency Sector Broader Asset Class Diversification 36
Asset Class Diversification Introducing additional asset classes can boost returns and provide further diversification. Mortgages Agencies 37
Treasury vs Swaps 38
Mortgage Backed Securities Compare to 3Year NC 6Month 1X @ 1.15% 3-year Avg Life, 2.48 Effective Duration 39
MBS vs Callables 40
Taxable Municipal New York St Urban Dev 1.38% 3/15/2018 - Rev Aa1/AAA Yields 1.308%, +40bps to Agency Bullets FHLMC 0.875% 3/07/2018 0.90% California State 6.20% 10/1/2019 AA3/AA Yield 1.88%, +66bps to Agency Bullets FHLMC 1.25% 10/02/2019-1.22% 41
Question & Answer 42
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