seven steps to higher realized yield - cuna councils€¦ · · 2015-03-08• look forward...

© Copyright 2013. Performance Trust Capital Partners, LLC. All Rights Reserved.

Seven Steps to Higher Realized Yield

Philip M. Nussbaum

Performance Trust Capital Partners, LLC


Philip M. Nussbaum Chairman and Co-Founder Phil has an unmatched passion for applying a disciplined, well-quantified risk/reward decision-making process to bond portfolios. He leads the company’s Analytics Group and often speaks and writes on bank investment portfolio management and regulation. Previously, Phil was a Vice President at Clayton Brown & Associates and a Senior Examiner with the Financial Markets Unit of the Federal Reserve Bank of Chicago. Phil is a Trustee of the PowerShares Exchange-Traded-Funds, where assets under management exceed $20 billion. Phil graduated summa cum laude from Wheaton College with a Bachelor of Science degree in mathematics. He has an MBA in finance from the University of Chicago. 2


7 Steps to Higher Realized Yield 1. Higher yield does not equal higher earnings 2. Higher yield in the long term and not just the short term is

the goal 3. Higher yield is difficult to achieve if risk and reward are

improperly framed 4. Higher yield is more achievable if risk vs. reward is properly

framed 5. Higher yield requires real portfolio management 6. Higher yield requires looking back not just looking forward 7. Higher yield is achievable

3


7 Steps to Higher Realized Yield

1. Higher yield does not equal higher earnings

4


• Or to put it another way: Stated yield does not equal realized yield

• Yield is not what you get

5

Step 1: Higher Yield Does Not Equal Higher Earnings


“YIELD” ON A BOND =

Ending $s

“YIELD” ON A CD =

Rate % # Compounding

Frequency at the Rate% Ending $s

Coupon # Comp. Freq. Semi-Annual at _____% ?

I Don’t Know! 6



Compare Two 5-Year Bonds

UST Corporate Bond 6.50 7.50 6.50 7.50 6.50 7.50 6.50 7.50 6.50 7.50

6.50% “CD Yield” $376,894

7.50% “CD Yield” $445,044

Difference

= $68,150 7



"What You Get" Reinvestment UST 6.5% Corporate 7.50%

Rate $ % $ Diff $ Diff %

3.50% 351,602 6.12% 405,723 6.93% 54,121 0.81%

4.50% 359,727 6.24% 415,098 7.07% 55,371 0.83%

5.50% 368,071 6.37% 424,726 7.21% 56,655 0.84%

6.50% 376,640 6.50% 434,614 7.35% 57,974 0.85%

7.50% 385,440 6.63% 444,767 7.50% 59,327 0.87%

8.50% 394,476 6.77% 455,193 7.65% 60,717 0.88%

9.50% 403,754 6.90% 465,899 7.80% 62,145 0.90%

8



Reinvest Rate

Treasury Realized vs. Purchase

MBS Realized vs. Purchase

Realized Spread

"MBS Realized Yield and Spread"

6.31% 5.38% +.11 6.31% 0 0.93

5.27% 5.27% 0 5.93% -.38 0.66

4.50% 5.19% -.08 5.66% -.65 0.47

3.00% 5.03% -.24 5.13% -1.18 0.10

MBS Alternative Purchase Spread 5-Year Treasury 5.27% Purchase Yield

15-Year MBS 6.31% Purchase Yield 104 BPS

Benchmark

9



10

Lower Yields Can Mean Higher Earnings



This bond was purchased

0bp +300bp +100bp -100bp -200bp -300bp+200bp

11



This is what happened Coupon Allocation as a Percentage of Dollars Invested

7.50 7.00 6.50 6.00 5.50 5.00 4.50 Weighted Coupon

Jun-00 100% 0% 0% 0% 0% 0% 0% 7.50

Dec-00 92% 8% 0% 0% 0% 0% 0% 7.46

Jun-01 65% 35% 0% 0% 0% 0% 0% 7.33

Dec-01 40% 28% 32% 0% 0% 0% 0% 7.04

Jun-02 27% 23% 29% 22% 0% 0% 0% 6.77

Dec-02 15% 15% 19% 19% 0% 33% 0% 6.13

Jun-03 8% 8% 10% 12% 0% 30% 31% 5.49

Dec-03 5% 5% 6% 9% 17% 27% 30% 5.36

Jun-04 4% 4% 4% 7% 29% 24% 28% 5.30

Dec-04 3% 3% 3% 6% 26% 33% 26% 5.23

Jun-05 2% 2% 3% 5% 22% 42% 24% 5.17

Dec-05 2% 2% 2% 14% 19% 38% 23% 5.24

Investment Period Weighted Coupon 6.07 vs. 7.50%

Price Dec-05 104-23 104-09 102-18+ 100-28+ 99-00+ 96-28+ 94-06+ 12



This is what happened Was There a Financial Crime? • Actual pool yield = 6.07%; Projected pool yield = 7.50%;

Actual bullet agency yld = 6.75%; Projected bullet yld = 7.10%

• Look forward income: 5.24% weighted average vs. 7.10% bullet agency (4.5 years left)

• Weighted market value of pools is $97.67 vs. $109.5 for remaining 4.5 year bullet

Net difference: $1,731,000 shareholder value

13



You want higher earnings. Therefore measure dollars, not yield.

14

Step 1 Takeaway:




1. Higher yield does not equal higher earnings 2. Higher yield in the long term and not just

the short term is the goal

15


Which would you rather have? 3% yield or 2.5% yield?

16

Step 2: Higher Yield In The Long Term Is The Goal


CSI

17

Step 2: Higher Yield In The Long Term Is The Goal

Price -300 -200 -100 Unch +100 +200 +300MBS 100 7.26 7.35 7.45 7.53 7.54 7.54 7.54Bullet/Agency 100 7.10 7.10 7.10 7.10 7.10 7.10 7.10

Avg Life/MaturityMBS 1.5 2.1 3.7 8.5 10.2 11.1 11.6Bullet/Agency 10 10 10 10 10 10 10

Comparative Yield Table



1. Higher yield does not equal higher earnings 2. Higher yield in the long term and not just the

short term is the goal 3. Higher yield is difficult to achieve if risk

and reward are improperly framed

18


Do Not Measure Risk & Reward Separately

RISK REWARD

19

Step 3: Higher Yield Is Difficult To Achieve If Risk And Reward Are Improperly Framed


Income Simulation & NEV Example

Which one do you buy?

Asset 1

2-year asset (assume Treasury) with

a 2% coupon at par

Asset 2

5-year asset (Treasury) with a 5% coupon at par

20



2-year Income Simulation (Reward)

0

20,000

40,000

60,000

80,000

100,000

120,000

-200 -100 0 100 200 300 4002 Yr @ 2% 40,000 40,000 40,000 40,000 40,000 40,000 40,0005 Yr @ 5% 100,000 100,000 100,000 100,000 100,000 100,000 100,000

Net Interest Income

Clearly the 5-year rainbows the 2-year

21



Net Economic Value (Risk)

-20.00

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

-200 -100 0 100 200 300 4002 Yr @ 2% 3.98 1.98 0.00 -1.93 -3.81 -5.65 -7.455 Yr @ 5% 9.46 4.62 0.00 -4.38 -8.53 -12.48 -16.22

NEV % Change

22

The 2 year looks like the better choice using this risk metric



• When risk and reward are not properly framed, many decisions are unclear

• Is there a better way to make decisions?

• Is there a way to measure risk vs. reward?

23




1. Higher yield does not equal higher earnings 2. Higher yield in the long term and not just the

short term is the goal 3. Higher yield is difficult to achieve if risk and

reward are improperly framed 4. Higher yield is more achievable if risk vs.

reward is properly framed

24


How Do We Decide Which Bond to Buy?

We need to measure the risk vs. reward trade-off

RISK REWARD

25

Step 4: Risk vs. Reward Properly Framed


THE MONEY TABLES A Shape Management® Game

What is meant by “a good risk/reward”?

26



THE MONEY TABLES

Which is the better risk vs. reward?

A

B

27



$0

$20

$40

$60

$80

$100

$120

$140

$160

1 2 3

Dol

lars

Scenario

Money Tables

Table A

Table B



4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

-200 bps -100 bps Unchanged +100 bps +200 bps

Bond A Bond B

Which is the better risk vs. reward?

Total Return

29



Question: Which fraction is greater?

We need a common denominator

17 265

21 428

38 371

57 1027

2 213

3 347

1 3

1 2 <

>

< + +

30



When evaluating two or more bonds for purchase, a common denominator is needed. Essentially, we need some kind of common

analytical maturity®.

31



We could select the maturity of the longest bond as the common denominator

Horizon Point of Purchase

Security 1

Security 2

Security 3

Maturity

Maturity

Maturity

32



Select a Common Analytical Maturity®


Security 1

Security 2

Security 3

Maturity

Maturity

Maturity

We could select an immediate security

33




Security 1

Security 2

Security 3

Maturity

Maturity

Maturity

We could select a shorter maturity

34





Security 1

Security 2

Security 3

Maturity

Maturity

Current Income Future Income

Current Income

Current Income

MV =

Maturity

MV = Future Income

Total Return is that methodology It counts all income, both current and future

35




Total Return Timeline

36


Total Return = Income + Change in Market Value

= Income + End Price – Beginning Price

= Current Income + Future Income

Scenario total return provides a common denominator to compare unlike cash flows so that risk vs. reward can be properly framed.


Let’s Return to The “CSI” Bond

37


0bp +300bp +100bp -100bp -200bp -300bp+200bp


The Case of Purchase vs. Realized Yield

Look-Forward 3-Yr Horizon: June 2000

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

-300 -150 0 +150 +300

Tota

l Ret

urn

30 Year Pool 7.5 10 Year Bullet Agency

This would have been valuable at purchase

38



39


Income Simulation & NEV Example

0

20,000

40,000

60,000

80,000

100,000

120,000

-200 -100 0 100 200 300 4002 Yr @ 2% 40,000 40,000 40,000 40,000 40,000 40,000 40,0005 Yr @ 5% 100,000 100,000 100,000 100,000 100,000 100,000 100,000

Net Interest Income

-20.00

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

-200 -100 0 100 200 300 4002 Yr @ 2% 3.98 1.98 0.00 -1.93 -3.81 -5.65 -7.455 Yr @ 5% 9.46 4.62 0.00 -4.38 -8.53 -12.48 -16.22

NEV % Change

Which one do you buy?


A Much Clearer Picture of Risk vs. Reward

0.00

2.00

4.00

6.00

8.00

10.00

12.00

-200 -100 0 100 200

2-Year Total Return (%)

2 Yr @ 2% 5 Yr @ 5%

Total Return = Income Simulation + NEV (at horizon)

40



-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

-200 -100 0 +100 +200

Tota

l Ret

urn

1-Year Horizon

5 Year Bullet Agency1 Year Bullet Agency5 Year NC 1


Callable Agencies Are Not

Compelling Today A picture is worth a 1000 words


-6.00

-5.00

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

-200 -100 0 +100 +200

Tota

l Ret

urn

1-Year Horizon

15 Year 3.0 N Pool

5 Year NC 1


Mortgage Product is Very Expensive


-6.00

-5.00

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

-200 -100 0 +100 +200

Tota

l Ret

urn

1-Year Horizon

Intermediate Callable Step-up

5 Year NC 1


Step-ups Are Not Materially Different

From Callables


-12.00

-10.00

-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

-200 -100 0 +100 +200

Tota

l Ret

urn

1-Year Horizon

Intermediate WAL Prem Cpn CMO

Intermediate Pac Stripped Cpn


Decreasing One Risk May

Disproportionately Increase Another Risk


-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

-200 -100 0 +100 +200

Tota

l Ret

urn

1-Year Horizon

Fed Funds

Short WAL Prem Cpn CMO


Cash is Expensive; Other Cash Substitutes

Can Be Attractive


-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

-200 -100 0 +100 +200

Tota

l Ret

urn

1-Year Horizon

15 Year 3.0 N Pool

15 Year NC 7 High Prem General Market (Credit Union)


Some Munis May Make Sense Even For

Credit Unions


7 Steps to Higher Realized Yield 1. Higher yield does not equal higher earnings 2. Higher yield in the long term and not just the

short term is the goal 3. Higher yield is difficult to achieve if risk and

reward are improperly framed 4. Higher yield is more achievable if risk vs

reward is properly framed 5. Higher yield requires real portfolio

management 47


• Don’t eliminate sectors just because there are undesirable outcomes in some scenarios

• Consider combinations

48

Step 5: Higher Yield Requires Real Portfolio Management


THE MONEY TABLES

Which is the better risk/reward?

A

B

49


THE MONEY TABLES


B

C

50


THE MONEY TABLES


D

B

51


50% of A + 50% of C

52

THE MONEY TABLES


Sacrificial Lamb Risk

53



Definition of Sacrificial Lamb That part of your portfolio that might “under perform” in a given scenario.

54



An Example of A Potential Sacrificial Lamb

Some bonds do well in rates up but poorly in rates down while others do well in rates down but poorly in rates up. Instead of eliminating those bonds due to poor performance in a given scenario, consider the combination of the two.

55


-10.00

-5.00

0.00

5.00

10.00

15.00

-200 -100 0 +100 +200

Tota

l Ret

urn

1-Year Horizon

5 Year NC 1Short WAL Prem Cpn CMO15 Year NC 7 High Prem General Market (Credit Union)


Combinations are key

Portfolio Management requires a thorough understanding of combinations of securities. This understanding is essential for long-term outperformance.

56


3.542.81

1.460.78

-0.76

0.96

0.96 0.96

-1.73

-5.41-6.00

-4.00

-2.00

0.00

2.00

4.00

-200 -100 0 +100 +200

Tota

l Ret

urn

1-Year Horizon

70% Short WAL Prem Cpn CMO / 30% 15 Year NC 7 High Prem Gen Mkt (CU)

5 Year NC 1


You Need Sacrificial Lambs to Outperform • Trying to have every bond perform okay in every rate scenario

is a recipe for mediocrity.

• Finding good combinations is the key to outperformance.

• Therefore, you will have some bonds that have lower performance (but not underperformance) in certain rate scenarios.

57



Sacrificial Lambs and the Investment Policy How does the concept of combinations impact policy limits?

• Why have policy limits on sectors related to interest rate risk?

• For example: no bonds greater than X maturity; no prices greater than Y

• Good sacrificial bonds are often explicitly excluded by policies

• Policy limits should be at the aggregate portfolio level but even that has problems – limits refer to risk but what about reward? Total return portfolio constraints may work here.

58




1. Higher yield does not equal higher earnings 2. Higher yield in the long term and not just the short

term is the goal 3. Higher yield is difficult to achieve if risk and reward are

improperly framed 4. Higher yield is more achievable if risk vs. reward is

properly framed 5. Higher yield requires real portfolio management 6. Higher yield requires looking back not just looking

forward

59


60

Step 6: Higher Yield Requires Looking Back Not Just Looking Forward

PROJECTIONS

Invest Calculate

VARIANCES

ADJUSTMENTS REALITIES

Learn Measure

When making investment decisions, we are participating in the upper half of this cycle.

Disciplined Investing Purpose


61


The “money tables” for each investment

available.


62

For example, rates down portfolio return = 40%*4.04 + 30%*4.78 + 20%*4.19 + 10%*6.93 = 4.58

3-Yr Horizon$ % of Port DA DM UN UM UA

Bond 1 40,000,000 40% 4.04 4.58 5.07 5.51 5.85Bond 2 30,000,000 30% 4.78 5.60 5.80 5.24 4.65Bond 3 20,000,000 20% 4.19 4.60 4.96 5.32 5.62Bond 4 10,000,000 10% 6.93 6.11 5.31 4.53 3.76

Portfolio Total Return 4.58 5.04 5.29 5.29 5.24

Total Return shapes are additive! Yields of different securities are not additive, but total returns are additive. Thus, the individual shapes are simply dollar weighted and then added together to arrive at the aggregate portfolio shape.

The Look-Forward®: A Portfolio Strategy



63

3.00

3.50

4.00

4.50

5.00

5.50

6.00

6.50

7.00

-300 -150 0 +150 +300

Tota

l Ret

urn

3-Year Horizon

Bond 1Bond 2Bond 3Bond 4

3.00

3.50

4.00

4.50

5.00

5.50

6.00

6.50

7.00

-300 -150 0 +150 +300To

tal R

etur

n

3-Year Horizon

Portfolio

Total Return is additive

In this case, positions in these 4 bonds…

…would result in this aggregate shape.



64

PROJECTIONS

Invest Calculate

VARIANCES

ADJUSTMENTS REALITIES

Learn Measure


Disciplined Investing

On the other hand, Look-Backs® take place in the lower part of the cycle. Hindsight is 20/20 … only if you look!

Purpose


65


Summary Projected Actual Difference (bps)

Strategic 6.33 6.15 -17

Typical 4.16 4.08 -8

Margin 2.17 2.07 -9

Strategic Portfolio Portfolio Look-Back®

2.00

3.00

4.00

5.00

6.00

7.00

8.00

Tota

l Ret

urn

Non-PLMBS Strategic Portfolio

Typical Portfolio

Actual Non-PLMBS Strategic Return

Actual Typical Return

-300 -150 0 +150 +300



66

1. Higher yield does not equal higher earnings 2. Higher yield in the long term and not just the short term is

the goal 3. Higher yield is difficult to achieve if risk and reward are

improperly framed 4. Higher yield is more achievable if risk vs. reward is

properly framed 5. Higher yield requires real portfolio management 6. Higher yield requires looking back not just looking forward 7. Higher yield is achievable


-1

0

1

2

3

4

5

6

0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 64 68 72 76 80 84 88 92 96

Tota

l Ret

urn

(%)

Percentile (%)

1 Year Total Returns

1Q12

Credit Union Performance All CREDIT UNIONS: 1 Yr Total Return Differential

20th vs 80th Percentile

1Q12: 143 bps

7,073 Credit Unions

67

Step 7: Higher Yield Is Achievable


So For Every $100 Million… 143bps = $1,430,000 Additional Wealth

68



-3

-2

-1

0

1

2

3

4

5

0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 64 68 72 76 80 84 88 92 96

Tota

l Ret

urn

(%)

Percentile (%)


1Q12

Credit Union Performance

1Q12: 165 bps

7,027 Credit Unions

All CREDIT UNIONS: 3 Yr Total Return Differential 20th vs 80th Percentile

69



Investment Portfolio Risk

$(30,000,000)

$(20,000,000)

$(10,000,000)

$-

$10,000,000

$20,000,000

$30,000,000

0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95

Tota

l Ret

urn

Diffe

renc

e fro

m M

edia

n

Percentile Performance All US Credit Unions

3 Year Investment Portfolio ScorecardAny Credit Union

Difference From 50th Percentile

Actual Performance: $250MM portfolio

Do Not Undervalue the Potential of the Bond Portfolio

70



$(30,000,000)

$(20,000,000)

$(10,000,000)

$-

$10,000,000

$20,000,000

$30,000,000

0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95

Tota

l Ret

urn

Diffe

renc

e fro

m M

edia

n

Percentile Performance All US Credit Unions

3 Year Investment Portfolio ScorecardAny Credit Union

Difference From 50th Percentile

Actual Performance: $250MM portfolio

Investment Portfolio Risk Do Not Undervalue the Potential of the Bond Portfolio

71



Credit Union Performance 3 Yr Total Return Differential

All CUs vs CUs with Average Securities > $50MM

-2

-1

0

1

2

3

4

5

6

7

0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 64 68 72 76 80 84 88 92 96

Tota

l Ret

urn

(%)

Percentile (%)


All Credit Unions: 7,027

Avg Sec > $50MM: 532

72



• Higher yields (long-term earnings) are achievable.

• It will take work, but the potential upside is significant.

73



THE MONEY TABLES

How do you play this game if you don’t know how many dollars are in each pile?

A

B

74



75

1. Higher yield does not equal higher earnings 2. Higher yield in the long term and not just the short term is the

goal 3. Higher yield is difficult to achieve if risk and reward are

improperly framed 4. Higher yield is more achievable if risk vs. reward is properly

framed 5. Higher yield requires real portfolio management 6. Higher yield requires looking back not just looking forward 7. Higher yield is achievable

seven steps to higher realized yield - cuna councils€¦ · · 2015-03-08• look forward...

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