Public Investment Strategy Public Investment Strategy in the Current Environmentin the Current Environment

GFOAZ ConferenceGFOAZ ConferenceSedona, AZSedona, AZMarch 2006March 2006

Stra’-te-gyStra’-te-gy

Macro Strategy:Macro Strategy: Set by policy to outline goals and objectives on liquidity, quality, Set by policy to outline goals and objectives on liquidity, quality,

applicability to fund type, credit quality, diversification, and applicability to fund type, credit quality, diversification, and yield.yield.

Based on fundamentals of cash flow and risk tolerance.Based on fundamentals of cash flow and risk tolerance. Re-evaluate Re-evaluate at leastat least annually. annually.

Market Strategy:Market Strategy: Set by the conditions in the market at the current time and Set by the conditions in the market at the current time and

unique cash flow restraints. unique cash flow restraints. Established by market conditions within overall strategy Established by market conditions within overall strategy

guidelines.guidelines. Re-evaluate Re-evaluate continuouslycontinuously..

Your job as an investor:Your job as an investor:

Meet known asset/liability requirements.Meet known asset/liability requirements.Prepare for unexpected liabilities.Prepare for unexpected liabilities.Use your resources.Use your resources.Be a strategist more than a tactician.Be a strategist more than a tactician.Balance yield, liquidity, and flexibility.Balance yield, liquidity, and flexibility.

Read major market trends for applicability and rate Read major market trends for applicability and rate direction.direction.

Strategize for incremental incomeStrategize for incremental income

What is the What is the currentcurrent environment? environment?What makes it the same?What makes it the same?

Fundamental business cyclesFundamental business cycles ElectionsElections Fundamental market cyclesFundamental market cycles Risks – internal and externalRisks – internal and external Your fiduciary responsibilitiesYour fiduciary responsibilities

What makes it different?What makes it different? Oil and gas pricesOil and gas prices ProductivityProductivity Global growthGlobal growth TerrorismTerrorism DeficitsDeficits New Fed ChairmanNew Fed Chairman HousingHousing Global outsourcingGlobal outsourcing

Some things don’t changeSome things don’t change

Risk managementRisk management Public investing is risk managementPublic investing is risk management Direct correlation of risk to rewardDirect correlation of risk to reward

No risk – no rewardNo risk – no rewardKnow risk – know rewardKnow risk – know reward

ControlsControls

Technological advances/opportunitiesTechnological advances/opportunities On line investing pros and consOn line investing pros and cons Expedited funds and remote deposit changesExpedited funds and remote deposit changes

The Foundation Doesn’t ChangeThe Foundation Doesn’t Change

PORTFOLIO

POLICY AND PROCEDURES

SECURITY REPORTING

CASH FLOW RISK STRATEGY

ANALYSIS ANALYSIS ANALYSIS

MARKET ANALYSIS

Different Funds – Different FlowsDifferent Funds – Different Flows

020

4060

80

Sept Dec Mar June

0

20

40

60

Sept Dec Mar June

General Fund

Utility Fund

Cash Flow Analysis

Macro Net Balance Cash FlowsMacro Net Balance Cash FlowsPaint a Portfolio PortraitPaint a Portfolio Portrait

0

20

40

60

80

0

10

20

30

Sets maximum maturity limitsSets maximum maturity limitsSets maximum weighted average maturitySets maximum weighted average maturitySets your benchmarksSets your benchmarksDevelops a strategyDevelops a strategy

where to investwhere to invest where not to investwhere not to invest when when comes from the marketcomes from the market

core

The Pie and the Portfolio The Pie and the Portfolio

Liquid SectorLiquid Sector Provides liquidity Provides liquidity AlternativesAlternatives

Bank demand depositsBank demand depositsLocal government poolsLocal government poolsMoney market mutual fundsMoney market mutual fundsOvernight repurchase agreementsOvernight repurchase agreements

Today’s strategyToday’s strategy

Short-Term Short-Term Match upcoming known expendituresMatch upcoming known expenditures Alternatives – in different scenariosAlternatives – in different scenarios

Securities (discount notes, CDs, some liquidity options)Securities (discount notes, CDs, some liquidity options)

The Pie and the Portfolio The Pie and the Portfolio

Long-TermLong-Term Ultimately matching known expendituresUltimately matching known expenditures

becomes the short-termbecomes the short-term Usually 6 to 12 monthsUsually 6 to 12 months Alternatives directed by market yieldsAlternatives directed by market yields Today’s strategyToday’s strategy

Core Core Reserves, no planned shorter term useReserves, no planned shorter term use Focus on rate movements and yieldFocus on rate movements and yield May call for different securitiesMay call for different securities Today’s strategyToday’s strategy

The special strategy The special strategy on capital projectson capital projects

A large nonrecurring expenditure A large nonrecurring expenditure A unique cash flow A unique cash flow Like projects often create trendsLike projects often create trends

Preliminary work with departments Preliminary work with departments for an expenditure plan before $$ for an expenditure plan before $$ arrivesarrives

Bond document plansBond document plans

Updates on ongoing basis with Updates on ongoing basis with department heads and engineers to department heads and engineers to modify plansmodify plans

Explaining the importance of cash Explaining the importance of cash flow helps generate support flow helps generate support

Impact of additional earningsImpact of additional earnings Arbitrage impactsArbitrage impacts

Project Trends Project Trends

0200

400600

800

1 2 3 4 5 6 7 8 9

0200

400600

800

1 2 3 4 5 6 7 8 9

Use multiple historical issues of the same type fund

streets water mainsland acquisition

Trend often appear over the time frame of the total project

Use for projections on the same type projects in the future

Streets - 1995

Streets - 2000

0200

400600

800

1 2 3 4 5 6 7 8 9

Streets Projection 2006

Maturity – A Major FactorMaturity – A Major Factor

The average maturity of the portfolio is arguably the single greatest The average maturity of the portfolio is arguably the single greatest determinant of investment performancedeterminant of investment performance

Yield enhancement accomplished by:Yield enhancement accomplished by: extending maturitiesextending maturities increasing credit riskincreasing credit risk reducing liquidityreducing liquidity Capital appreciationCapital appreciation

0

1

2

3

4

5

6

7

8

9Paid for risk taken

Rates tell a story..Rates tell a story..Today’s story is flat…Today’s story is flat…

Yield curve: Yield curve: compilation of the compilation of the expectationsexpectations of everyone in the marketplace of everyone in the marketplace

Overall view: Overall view: Projection of slow and steady growth and rate increases continue Projection of slow and steady growth and rate increases continue

Sector view: Sector view: sector steepness evident only on close inspectionsector steepness evident only on close inspection

3

3.5

4

4.5

5

5.5

6

o/n 3mo 6mo 1yr 2yr 3yr 5yr

Investment Sector for

Majority of Governmental investors

Your view and strategy…Your view and strategy…

0%

5%

10%

0%

2%

4%

6%

Your strategy is Your strategy is dependent on dependent on your your expectationsexpectations

Your strategy is Your strategy is dependent on dependent on youryour portion of the curveportion of the curve

Long end pop – normal curve

Curve inversion

Strategies must changeStrategies must change

Jan 2001 – Jan 2002Jan 2001 – Jan 2002 Overnight rates move from 6.50% to 1.00%Overnight rates move from 6.50% to 1.00% Need to lock-in rates as long as reasonableNeed to lock-in rates as long as reasonable Going long was primary strategyGoing long was primary strategy

June 2004 – June 2005June 2004 – June 2005 Overnight rates move from 1.00% to 3.00% ??Overnight rates move from 1.00% to 3.00% ?? Need to move up with the ratesNeed to move up with the rates Staying short Staying short waswas primary strategy primary strategy

Trade strategiesTrade strategiesWhich do you chose? Does it matter?Which do you chose? Does it matter?

S M T W T F S

payroll

2 3 4 5 6 7 8

9 10 11 12 13 14 15

16 17 18 19 20 21 22

23 24 25 26 27 28 29

FNDN

3.4% ?

T-Bill

3.0% ?

CD

3.2% ?

““Strategic” ResultsStrategic” Results

InvestmentInvestment InterestInterest ReinvestmentReinvestment GrossGross

FNDNFNDN 245,750 4,250245,750 4,250 312 312 4,5624,562

T-BillT-Bill 246,250 3,750 20 3,770 246,250 3,750 20 3,770

CD 250,000 4,000 0 4,000CD 250,000 4,000 0 4,000

On a $250,000 payroll - 24 times a year - the additional earnings are On a $250,000 payroll - 24 times a year - the additional earnings are $ 562 $ 562 x 24 = x 24 = $13,488$13,488

Returns Come Only Returns Come Only from Risks Takenfrom Risks Taken

Risk/Return of Various Benchmarks

10 Years Ended March 31, 2000

3-Month Treasury Bill3-Month Treasury Bill

6-Month Treasury Bill6-Month Treasury Bill

1-3 Year Treasury Index1-3 Year Treasury Index

1-5 Year Treasury Index1-5 Year Treasury Index

3-5 Year Treasury Index3-5 Year Treasury Index

5-7 Year Treasury Index5-7 Year Treasury Index

7-10 Year Treasury Index7-10 Year Treasury Index

Duration

.25 Years.25 Years

.49 Years.49 Years

1.64 Years1.64 Years

2.19 Years2.19 Years

3.37 Years3.37 Years

4.73 Years4.73 Years

6.36 Years6.36 Years

Overall

Yield

5.21%5.21%

5.44%5.44%

6.62%6.62%

7.16%7.16%

7.62%7.62%

8.15%8.15%

8.46%8.46%

$8,315,201

$8,499,138

$9,497,797

$9,985,291

$10,424,264

$$10,957,156

$11,273,458

Cumulative Return

Risk

Interpreting Today’s NewsInterpreting Today’s News

Soft patch or slowing economy?Soft patch or slowing economy?Dollar weaknessDollar weaknessOil and energy impactsOil and energy impactsLabor growth and wage pressureLabor growth and wage pressureHousing – can it continue?Housing – can it continue?Inflationary pressuresInflationary pressuresFiscal policyFiscal policyMonetary policy (with and without Greenspan)Monetary policy (with and without Greenspan)

Rates increasing or flattening? Curve steeper or inverted? Rates increasing or flattening? Curve steeper or inverted? What part f the curve is moving and where?What part f the curve is moving and where?

The Fundamental View – Federal Funds Rate The Fundamental View – Federal Funds Rate

Effective Fed Funds from 01/01/01 to present

Fed tries to boost economyFed fig

hts infla

tion/growth

The Fundamental View – Payroll The Fundamental View – Payroll

Non-farm Payrolls – 01/01/01 to present

The Fundamental View – Producer Price Index The Fundamental View – Producer Price Index

PPI – YOY 01/01/01 to present

The Fundamental View – Capacity Utilization The Fundamental View – Capacity Utilization

Capacity Utilization - 01/01/01 to present

The Fundamental View – Oil The Fundamental View – Oil

Three month oil contract from 01/03 to present

““Conundrum” Conundrum”

Manage Risk - Not ReturnManage Risk - Not Return

Identify the appropriate level of risk for portfolioIdentify the appropriate level of risk for portfolio Risk can not be avoided – but can be managedRisk can not be avoided – but can be managed

Structure the risk profile of the portfolio Structure the risk profile of the portfolio to meet objectives to meet objectives to comply with constraints to comply with constraints To match risk tolerancesTo match risk tolerances

Manage risk to increase the value of the portfolio as Manage risk to increase the value of the portfolio as much as possible, given the portfolio’s risk parametersmuch as possible, given the portfolio’s risk parameters

- Clear movement on short end- Clear movement on short end- Danger of leap frog Fed move- Danger of leap frog Fed move- Investors target steepness in a curveInvestors target steepness in a curve- Curve directives from market participantsCurve directives from market participants- What is keeping the long end down?What is keeping the long end down?

Quarterly Rate MovesQuarterly Rate Moves

3

3.5

4

4.5

5

o/n 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 10 yr 30 yr

09/01/05 12/31/05 3/3/2006

Use the available curveUse the available curve

3

3.2

3.4

3.6

3.8

4

4.2

4.4

4.6

4.8

5

o/n 3 mo 6 mo 2 yr 3 yr

DEC

SEPT

JULY

Only steepness on curve

MAR

Possible Bear Market StrategiesPossible Bear Market Strategies

Shorten durationsShorten durations Shorter maturitiesShorter maturities Higher coupon securitiesHigher coupon securities

Ride the yield curveRide the yield curve

Evaluate Spread productsEvaluate Spread products

Identify trading rangesIdentify trading ranges

Callable securities??? Floaters?? Indexed??Callable securities??? Floaters?? Indexed??

Barbell term structureBarbell term structure

Portfolio realignments – loss payback swapsPortfolio realignments – loss payback swaps

A Bearish StrategyA Bearish Strategy

Graph shows rate increases Graph shows rate increases between 4/1, 10/1 and 04/05 between 4/1, 10/1 and 04/05 plus what another 6 months plus what another 6 months could docould do

2-year in April ‘04 = 1.75% 2-year in April ‘04 = 1.75% o/n in April ’05 = 2.75% o/n in April ’05 = 2.75%

2-year in Oct ’04 = 2.75% 2-year in Oct ’04 = 2.75% o/n in May ’05 = 3.00%o/n in May ’05 = 3.00%

Stay ahead of ratesStay ahead of rates by 3-6 by 3-6 months investments to months investments to generate extra revenue and generate extra revenue and ride upride up on rates on rates

0

1

2

3

4

5

04/01/04 10/01/04 04/08/05 03/03/06

Security ImpactSecurity Impact

CallablesCallables

FloatersFloaters

IndexedIndexed

BulletsBullets

Full information and Full information and analysisanalysis

Callable SecuritiesCallable Securities

IssuersIssuers Agencies, corporations, public entitiesAgencies, corporations, public entities

Callable is two securitiesCallable is two securities

1.1. Issuer sells fixed income security to investorIssuer sells fixed income security to investor

Value = present value of stream of cash flowsValue = present value of stream of cash flows

2.2. Investor sells option to call to issuerInvestor sells option to call to issuer

Value = probability of being exercised based upon current Value = probability of being exercised based upon current yield curve, a rate of volatility, and time to exercise dateyield curve, a rate of volatility, and time to exercise date

Lock-out periodLock-out period Call protection; initial period during which issuer can’t call bondsCall protection; initial period during which issuer can’t call bonds

Callable StructuresCallable StructuresVarious structures – 3/1; 5/2; 10/3Various structures – 3/1; 5/2; 10/3

EuropeanEuropean – one-time call – one-time call BermudaBermuda – “Discrete call”, callable only on interest payment – “Discrete call”, callable only on interest payment

datesdates AmericanAmerican – “Continuous call”, callable anytime with specified # – “Continuous call”, callable anytime with specified #

of days noticeof days notice Step-up callablesStep-up callables

Fixed coupon to next call dateFixed coupon to next call date

At call date, bonds either called or coupon “steps At call date, bonds either called or coupon “steps up”/increases to structured higher coupon up”/increases to structured higher coupon

Can have multi-step upsCan have multi-step ups

Not the same as floating rate notesNot the same as floating rate notes

Valuation of Callable SecuritiesValuation of Callable Securities

• Uncertain cash flows and risk is difficult to measureUncertain cash flows and risk is difficult to measure

• Priced at spread to TreasuriesPriced at spread to Treasuries

Yield to Worst (YTW) Yield to Worst (YTW) Which is lesser: Yield to Maturity or Yield to CallWhich is lesser: Yield to Maturity or Yield to Call

Option Adjusted Spread (OAS)Option Adjusted Spread (OAS) Creates synthetic “bullet” Creates synthetic “bullet” Compare spread from OAS analysis to historical spread for Compare spread from OAS analysis to historical spread for

non-callable securities from same market sectornon-callable securities from same market sector

Continuous Call DescriptionContinuous Call Description

Continuous Call OASContinuous Call OAS

Floating-Rate NotesFloating-Rate Notes

““Floaters” reset rates periodicallyFloaters” reset rates periodically

Know the details and their impactKnow the details and their impact IndexIndex SpreadsSpreads Reset PeriodsReset Periods Day Count PeriodsDay Count Periods Payment PeriodsPayment Periods MaturityMaturity ValuationValuation

Yield Curve Nuances Yield Curve Nuances

TIME

%

STEEPFLAT

RICH

CHEAP

Yield Curve ManeuversYield Curve Maneuvers

Interest rates anticipation not projectionInterest rates anticipation not projectionDirectionDirectionMagnitudeMagnitudeTimingTiming

Macro curve expectationMacro curve expectation““the compilation of expectations”the compilation of expectations”

Implement strategy to address the curveImplement strategy to address the curveCurrent and futureCurrent and future

Disciplined investment will outperform Disciplined investment will outperform speculation over timespeculation over time

Actual Yield Curve ChangesActual Yield Curve Changes

4.25

4.75

5.25

5.75

6.25

3 Mo 6 Mo 1 Yr 2 Yr 5 Yr 10 Yr 30 Yr

Mar-99Sep-991

2

Curve indicates slowly rising rates

Actual Yield Curve ChangesActual Yield Curve Changes

4.25

4.75

5.25

5.75

6.25

3 Mo 6 Mo 1 Yr 2 Yr 5 Yr 10 Yr 30 Yr

Mar-99Sep-99Mar-00Sep-00

1

2

3

4

Rates rose and now indicate a drop

Actual Yield Curve ChangesActual Yield Curve Changes

4.25

4.75

5.25

5.75

6.25

3 Mo 6 Mo 1 Yr 2 Yr 5 Yr 10 Yr 30 Yr

Mar-99Sep-99Mar-00Sep-00Dec-00Mar-01

1

2

3

4

5

6

Rates drop precipitously

SummarizingSummarizingSome things never change

Fundamentals define your portfolio Cash flow Risk profiles and tolerance levels

Look at the fundamentals

Develop a market view Economic fundamentals by sector Macro investment strategy Avoid “tactical” moves

Study the curve Develop a long range view of rates Rates will go up or they will go down…but maybe not today

Maintain your discipline