Using the Fundamentals Day Two Linda T. Patterson

Using the Fundamentals Day Two Linda T. Patterson

Using the Fundamentals Day Two Linda T. Patterson Patterson & Associates [email protected] The Investment Decision Where do I need money? A: cash flow What can I buy? A: authorized securities Am I diversified? A: policy Where is the market?

Where are the rates going? What has the best yield? A: relative value Relative Value Analysis is = Comparative Shopping Yield is our common denominator to compare alternatives Investments Investments are not just longer term Investments are not locked in Basically all investments can be sold Investments are designed to pay your bills

Every dollar every day is an investment Cash flow planning tells us where market swings become irrelevant once investment is made Investments in place on a ladder creates earnings Strategies Dependent first off on your cash flow Dependent on your risk tolerance Dependent on your policy limits Dependent on your economic view

Will rates go up? When will it go up? How far will it go? What part of the curve will go up? Disciplined Investing Even Infrequent Investors Need It Horizon investing Chose the time period

Month or quarter periods Stay to your horizon Consistently cover next disbursement Create liquidity buffer as you go Create a ladder to pay upcoming liabilities At Todays Rates What do You Do? You have $40mm in Texpool at 0.07% You need $2,500,000 a month You have a safekeeping account at bank You have little time

Evaluating the Choices Sector analysis Spread analysis assuming that similar sectors are similar which issuers are available, wanted which maturity range is best which bond is best in that maturity Yield curve analysis where are rates now

where are rates going Sector Analysis Market sectors are the different types of securities Sectors vary by risk and structure Treasuries, agencies, CP, CD, pools agencies and new agency issues commercial paper taxable municipals Evaluating sectors requires information on that sector

credit decisions and risks Spread Analysis Spread means difference Difference in rate between securities or market sectors 8 Spreads are dynamic Anticipated spreads on credit Current spreads Historical spreads Treas

Agy CP 7 6 3mo 6mo 1yr 2yr Doing a spread analysis means comparing rates You must check the rates at that maturity in various sectors Yield Curve Analysis

Yield curves depict the market conditions Shows the markets expectations and demands Tells a story Illustrates the best value Read in light of current conditions Picking the best place on the curve Your portion of the curve is restricted by policy Your portion is restricted by risk tolerance and cash flow Yield Curve Nuances 7.00 Cheap Steepness

6.00 Flat Value ep 5.00 St e Rich Pick-up 4.00 3.00 3 Mo 6 Mo 1 Yr 2 Yr

5 Yr 10 Yr 30 Yr Relative Value by Yield A core investment out 1.5 years T-Note FNMA FHLMC FHLB Call CD

0.28 % 0.35 % 0.33 % 0.40 % 0.95 % What are your considerations ? How far do you feel safe going? Strategies must change so adjust Jan 2001 Jan 2002 June 2004 June 2005

Overnight rates move from 6.50% to 1.00% Need to lock-in rates as long as reasonable Going long was primary strategy Overnight rates move from 1.00% to 3.00% Need to move up with the rates Staying short was primary strategy Sept 2008 Sept 2009 Overnight rates move from 2.0% to 0% Need to lock in rates and look for alternatives Going long was primary strategy Passive Management Passivity

No unnecessary action: liquid reliance Defensible and easy Will mirror the lowest rates available Passive Conservative Based on facts: cash flow needs/core Conservative with liquid buffers Targets month-by-month needs Usually stays within one year horizon Occasionally given to fits of agony Increases portfolio yields The Pie and the Portfolio Liquid Sector

Provides liquidity Alternatives Bank demand deposits Local government pools Money market mutual funds Overnight repurchase agreements Todays strategy Short-Term Match upcoming known expenditures Alternatives in different scenarios Securities (discount notes, CDs, some liquidity options) The Pie and the Portfolio

Long-Term Ultimately matching known expenditures becomes the short-term Usually 6 to 12 months Alternatives directed by market yields Todays strategy Core Reserves, no planned shorter term use Focus on rate movements and yield May call for different securities Todays strategy

Two Views to the Structure $9.0 $8.0 $7.0 $6.0 Liquid; 20% Long ; 20% $5.0 Core; 10% $4.0 $3.0 Short; 50% $2.0 $1.0 o/ 1- n 3 m

3- o 6 m 6- o 9 m 9o 12 12 mo -1 8 18 mo -2 4 24 mo -3 6 m o $0.0 Liquidity Liquidity funds must provide

Funds availability Reasonable return Ease of use Reporting Used for long term liquidity in rising rate environment Used for short-term liquidity facilitating choice of securities Bank Liquidity Choices A range of choices

non-interest bearing checking interest bearing checking money market accounts sweeps Dependent on risk/access A New Alternative - ICS Insured Cash Sweep Promontory Network (CDARS) Fully insured deposits Online monitoring One monthly statement ICS Sweeps as an Investment Account A Account B Account C

Excess amounts sweep each day not entire amount. Daily Sweep to MMMF Make sure your policy includes MMMF as authorized investment Liquidity Choices Local Pools Money Market Mutual Funds (MMMF) Repurchase Agreements (larger entities) Bank Options checking accounts, interest bearing accounts, money market accounts,

Sweeps to money market funds Risk and return variations on each choice Liquidity Choices Where would you put $2mm? Alternatives: O/N Repo Rate 0.04 MMMF or $1 Pool Rate 0.04 Bank checking 0.01 Bank money market account 0.18 Bank sweep to MMMF 0.00

The 14 extra bps buys you $2,800 a year. Commingled Investments Local Government Pools Money Market Mutual Funds Mutual Funds All offer: Economy of scale Diversification Some extension with liquidity

Reporting Pools vs Funds You are not insured in either Pools require a resolution and certification Are not a security they are a cooperative Funds Need to be in your policy Do not require resolution or certification They are a registered security

Fund/Pool Types Constant dollar funds/pools Strive to maintain $1 asset (share) value Money market equivalent known as 2a-7 funds Net asset value funds/pools Share value fluctuates on market price Mutual fund equivalents potential loss of principal Constant NAV 1

2 3 4 5 6 7 8 9 10 11 12 Pools and Funds Provide

Its all about disclosure Information statements Prospectus Full Information Confirmations Transaction History Reports Monthly History All requirements built on SEC requirements for MMMF Pools and Funds Pools

Based on ILCA Require resolution by Board Rated Unregulated All types Money Market Funds SEC registered No resolution required

SEC oversight and regulation Strict restrictions What do these figures tell you? Know how to read the facts about your pool(s). Pools Know what they are.. Read the information statement Most pools are constant dollar

Texpool I and II Logic Class TASB Liquidity TexStar Some pools are mutual funds Some are a hybrid Its your job to know Have accounts at more than one pool Types of MMMF

MMMF are regulated securities maximum maturity 13 months Maximum WAM of 60 days Types of MMMF Treasury US Treasury Obligations & repo with treasuries Government US treasuries and agencies & repo backed by treasuries and agencies Enhanced Government

Same as Government but including CP Prime treasuries, agencies, CP, BA, or corporate to 5%, repo New SEC Rules for MMMF New regulations are directed towards safety, liquidity and stability Minimum 10% in securities convertible to cash in 1 day Minimum 30% in securities convertible to cash in 1 week Maximum WAM shortened to 60 days Maximum WAL of 120 days weighted average life to reduce use of variables Monthly reporting to SEC on shadow prices

Create procedures for stress tests New Rules for MMMF Repo collateralized with US Obligations or cash only Ability to process at price not $1 Maximum 3% in second tier securities (higher risk securities) from 5% Maximum of 5% in illiquid securities

Know Your Investor requirements added Ability to suspend redemptions to prepare for liquidation Proposed Money Market Rules Sec has turned PRIME money funds into mutual funds Not strive to maintain $1 Fluctuate with market values (price) Can reflect principal loss The ACT requires $1 NAV money market funds

What does your policy say? Money market mutual funds, excluding prime funds. Money market funds which strive to maintain a $1 NAV. MMMF Considerations This is a registered security add as authorized investment to your policy as direct or sweep Safety is that you own and not have pledged securities Get and read the prospectus Check historical rates Check the expense fee Choose the type that fits you risk tolerance

It may add value to go directly to fund Usually will under-perform pools because of expenses/subsidy Know the procedures The Ubiquitous Repo Repurchase Agreements Simultaneous Buy-Sell Transactions Allows full liquidity at market rates Uses DVP and independent custody Margins (102%) monitored constantly

Various types include overnight, open & term Flex is designed for capital projects Established for the entire expenditure period Rate is fixed and normally above issue rate Flexibility on draws with xx/month Interest on semi-annual basis BUY SELL Tri-Party Repo Transactions Public Entity Agreement to buy-sell with $$$ Primary dealer with securities

Instructions $ Third Party NYC Bank Cash Account $$ Securities Securities Account Safeguards for True Repos

Primary dealers only Banks are allowed under law but not competitive Written Master Repurchase Agreement The Bond Market Association Master Repo Agreement Independent Safekeeping Money center bank usually DVP at all times! Mark-to-market daily Collateral Margins (102%) Designated Collateral Danger: Repo Bank Sweeps FDIC has no set procedure for liquidation Losses have occurred Ownership is not clear

Securities are segregated in banks name Securities remain in banks safekeeping account Rates are slightly higher for a reason Beyond Liquidity: Securities Securities Provide stability in rate changes May add yield May not be liquid Liquidity Options

Float, and lag, rates both up and down Always provide short rate Assure liquidity Needed by all but smallest Needed by all entities entities Investments Choices US Treasuries US Agencies/

Commercial Paper corporations, ABS Bankers Acceptances Certificates of Deposit Brokered CD Securities Repurchase Agreements Money Market Mutual Funds Mutual Funds GICs Investment Pools State of Israel bonds Municipal Obligations [Letters of Credit] Best Choices for Infrequent Investors

US Treasuries Treasury Bills and Notes Primarily discount securities US Agencies/Instrumentalities FHLB, FNMA, FHLMC, FFCB Primarily discount structure Certificates of Deposit FDIC and collateralized Depository FDIC Brokered (with controls) Money Market Mutual Funds

Local Government Investment Pools Other alternatives for todays special situation DEPOSITORY Certificates of Deposit Depository agreements Bank relationship Any bank now allowed but primarily Texas Requires paperwork to create a deposit Patriot (Terrorist) Act provisions Funds are left in the bank as a deposit All MUST BE Insured by FDIC or collateralized

Above $250,000 requires agreement and collateral Texas collateral rules protect you under PFCA Different collateral types are legal Controlled by PFIA and depository law (Local Govt Code Ch.105) PFIA Language re CD 2256.010 (a) Texas CD or CU Share Certificate Insured by FDIC or Natl CU Share Insurance Collateralized per PFCA including authorized mortgage backed securities in PFIA Secured in any manner allowed by law (b) Brokered CD Invest through Texas bank or Texas broker (on broker list) Fully insured by US or its instrumentality Includes CDARS spread program

Limited to $250,000 per bank Broker can custody ---conflict with DVP CD Confusion Depository Brokered CD CD A registered security Relationship with bank Paperwork Straight buy/sell involved Can not exceed exceed $250,000 $250,000 Collateralize

No collateral > allowed $250,000 Onlystate Any TEXAS Not on Can be broker spreadlist (CDARS) On broker list MERGER NO MERGER

PROTECTION PROTECTION Brokered CDs Differentiate Brokered CD as securities in policy (Added 2011) Brokered certificate of deposit securities Often sold by brokers or banks Legal in Texas -------but only if FDIC insured A Pool ?? Or?? What does your policy say?? These are brokered CDs bought by a pool, not in Citys name and not in their policy. Policy Language Authorizing Depository CDs

Fully insured or collateralized depository certificates of deposit of banks doing business in Texas, with a maximum maturity of ----- years guaranteed or insured by the Federal Deposit Insurance Corporation, or its successor, or collateralized in accordance with this Policy. Collateralized CD will be created under a written collateral agreement. Policy Language Authorizing Brokered CDs FDIC insured brokered certificate of deposit securities from banks in any US state, delivered versus payment to the Citys safekeeping depository, not to exceed one year to maturity.

Before purchase the Investment Office must verify that the bank is FDIC insured on Controls on Brokered CD The investment officer must monitor On no less than a weekly basis Status and ownership of the issuing bank based on FDIC information If the bank has merged or been acquired where other deposits exist Investment Officer shall immediately liquidate any brokered CD which places the city above the FDIC insurance coverage

CD Accrual and Payments You purchase a CD: Par $ 500,000.00 Principal $ 500,000.00 Interest rate 1.50 % Days-to-Maturity 180 Total Earnings = $ Earning each day = $

3,750.00 20.83 per day ($500,000 x 1.50%) / 360 x 180 Earnings are from accrued interest only Earnings belong on your monthly/quarterly reports Payments will differ (monthly, quarterly, at maturity) Check it! Buying an FDIC CD FDIC coverage is permanent at $ 250,000 Decide on your needed maturity date Phone several banks in Texas for the rate competition

Ask for the maturity ranges (3 mo, 6 mo, 1 year) and compare Get all in APY (annual percentage yield) Clarify dates, agreement and certification requirements Do not use a broker to place a depository CD Chose the best rate and notify the banks Get instructions to send money Send money on settlement date Buying A Collateralized CD Decide on your needed maturity You will need a collateral agreement

Phone several banks for the rates Agree on terms and collateral needs Clarify certification Get all in APY (annual percentage yield) Chose the best rate and notify the banks Get instructions to send money Send money on settlement date Buying a CDARS CD Check for CDARS banks in Texas ( Currently up to $50 million at $10mm per week

Maturities set at 3,6, and 12 months normally They all settle on Thursdays Phone or email several banks for the rates Get all in APY (annual percentage yield) Certification only from entrance bank Chose the best rate and notify the banks Get instructions to send money and agreement for CDARS Standard CDARS Deposit Placement Agreement Send money on settlement date Certificate of Deposit Account Registry Service CDARS Banks in Texas Other CD Options

Virtual Banks doing business in Texas State Farm Insurance Ally Bank USAA Others? Stay under FDIC insurance levels Must make investment directly Check the Rates Current rates survey

(4/7/15): Ally 1-year CD 1.05% State Farm MMA 0.25% State Farm 1 year CD 0.10% State Farm 2-year CD 0.40% Possible for 4a-4b corporations? Rates change normally on Tuesdays all banks Reduce Your Collateral Cost Collateral is expensive for banks and you! Additional FDIC assessments increase costs

On time and demand deposits 10% to 15% possible Certificate of Deposit Account Registry Service (CDARS) could reduce collateral on time deposits Manage your collateral and balances Monitor the alternative rates stay on top of them CDARS: An Edge for Small Banks

No fee to customers CD rates are negotiated as normal Banks must be members Promontory Inter-financial Network (700 banks) Initial test transactions are used City receives consolidated report Reciprocal or non-reciprocal Sample CDARS CD Account ID 1000088888 Product Name 52 week CD

Interest Rate 2.350 % Account Balances $ 195,000 Effective Date 01/15/04 Maturity Date 01/14/05 YTD Interest accrued $ 2,291.25 Average Annual & Earned: 2.377 % CD Issued by Bank X Balances and interest paid/accrued CD Issued by Bank Y Balances and interest paid/accrued $ . $ .

Security Basics Buying Securities At a discount At par At a premium Reporting Securities Amortized value Book value Market value The Money Markets

Loose collection of markets Creativity and innovation Structural variety requires knowledge (embedded options, calls, strips, bullets, etc.) Book entry requires documentation DVP settlement is critical Two Types of Securities You earn only from principal or interest Money market = created only 1 year or less Here you earn solely from accretion of principal US Government > T-Bills

US Agencies > Discount Notes Local Government > BANs, TRANs Corporations > Commercial Paper Fixed income = created only 1 year or more Her you can earn from principal and interest US Government > Treasury Notes/Bond US Agencies > Agency Notes Local Government > Long-term Bonds Corporations > Corporate Notes A Word on Security Earning

Earning come from only: Principal The value of the principal increases Interest A coupon accrued then pays on a schedule Rate accrues then pays on a fund/pool Bought above par moves to par Amount above par is amortized expensed Premium Expense 10

0 Income (par Discount ) Bought below par moves to par Amount below par is accreted earns Issuance Maturity A Word on Security Price PAR means $100 or $1=$1 Buying at par means you pay the face value DISCOUNT means below PAR Buying a discount means you pay less than face

PREMIUM means above PAR Buying at premium means you pay more than face Discount Structures All securities with original maturities < 1 year Treasury bills Agency discount notes Commercial paper Quoted at a discount Often close to yield Ask to be quoted yield for comparison purposes Discount vs. Price Discount securities are often quoted as a discount Shorthand mechanism for price

Larger the discount = lower the price Know the convention but buy on yield Ask the broker to quote the yield for comparisons T-Bill A 1.95 discount 99.5016667 price T-Bill B 1.65 discount 99.5783333 price Discount Securities Agency discount notes always sold below par Quoted at a discount not a price Only two key elements to know Maturity Dec 16 xx

Discount Listing Mat 165 Bid 0.68 Asked 0.66 Chg -0.03 Ask Yld 0.75 Discount Securities Accrete (Gain) Value Over Life Always bought at a price less than 100 Earn daily and only through accretion

100 99 Buying a $100,000 T-Note Price = $ 98,000 You own it 200 days until maturity Discount/# of days 2,000/200 days= $ 10 / day What You Earn 99.5 98.5 u Yo o rb

ok l va ue 98 97.5 97 Purchase You buy it at $ 98,000 it matures at $ 100,000 Maturity Buying at a Discount Discount notes All securities under one year at issue or auction T-Bills, CP, Discount notes

101 100 99 Notes at a discount Securities bought below face Book value increases daily in a straight line Earnings are difference discount to Par (face) A 97 96

E 98 95 Accretio n R N 94 93 92 Purchase Maturity Daily Accretion You purchased a T-Bill 8/6/12 about 0.11% yield:

Par $1,000,000.00 Principal $ 997,695.69 Discount $ 2,304.40 Days-to-Maturity 356 (book value day 1) Ouch ! Daily Accretion $ Earnings only from accretion 6.47

(2,304.40/356) Security Notes Any security is longer than one year when issued or auctioned is a note Notes move to maturity over time An old 30 year could now be a 1 year note All notes have a coupon which is fixed at issuance * *With a few exceptions The rate is based on the then current rates The coupon earns = accrues interest

The principal can earn or can be an expense Notes Bought at a Premium Buying above par ($1=$1) Daily amortization an expense 102 101.5 is 101 100.5 Premium of $20,000 for 180 days = $111.11/day

e x p e n s e Amortization 100 99.5 99 Purchase Maturity Prices and Yields Move Inversely $ % A 5% coupon at par (100) Coupon = 5%

Yield = 5% Prices and Yields If Rates Go UP Ra tes % $ Pr ice A 5% coupon is not worth as much if rates go up so price goes down Coupon = 5 % Yield = 6 % Prices and Yields If Rates Go DOWN ce i r P $ %

es t a R A 5% coupon is worth more if rates go down so price goes up Coupon = 5 % Yield = 4 % Discount or Premium? T-Note 5% Note - yield of 3.22% A premium or discount ? T-Note

5% Note - yield of 6.75% A premium or discount ? US Treasury Obligations Various types Explicit guarantee T-Bills, T-Notes, TIPS, Strips Securities are auctioned regularly If you buy at auction then get auction yield Securities then move to the secondary market Based on taxing ability of the US

The certainty security Strict guidelines control the auctions and forms Treasury Bills Markets hate uncertainty so it loves its certainty and stability Auctions are scheduled with $$ announced Maturities of 1 year or less No coupon Trade at discount to par

3- & 6-month auctioned every Monday* 4-week auctioned every Tuesday* Settlement & maturities on Thursdays* Cash Management Bills one month *Unless a holiday, then next business day Buying A Treasury Bill $100,000 T-Bill maturing 5/27/XX Settling 6/5/xx at 1.11 Discount The discount price translates into a discount from par Par Price Principal Discount Yield

$ 100,000.00 94.83322 $ 94,833.22 $ 5,166.78 1.38 % Notes Notes are created starting at 2 years Notes carry a coupon

The coupon is normally fixed A few securities coupons change on schedules A coupon accrues for the owner as long as owned When you buy a note you also buy the accrued interest Notes can be bought at/above/below par US Treasury Notes The NO-SURPRISES security Semi-annual fixed coupons fixed at time of issuance (auction) Mature on the 15th or last day of month Currents (on-the-runs)= most recently auctioned Interest is actual days/actual days of year basis Price quoted as % of par (99,100,101) Usually quoted as YTM

A note will have coupon accrual during its life in Addition to possible accretion and amortization. Note bought at Premium Coupon coupon coupon 10 0 (par ) Note

bought at Discount Issuance Maturity coupon Buying a Treasury Note Semi-annual coupons Sold at par, discount or premium Price is percent of face Quoted in 32nds Still only two things to attend to: maturity and yield T-Note Listing Rate 1 3/4

Maturity Aug xx Bid 97:26 Asked 97:28 Chg -3 Ask Yld 1.41 Strips Only Treasury strips are authorized by PFIA All coupons have been stripped away

Only the principal is purchased No payment until maturity Straight line accretion Creates a long-term discount note Good for targeting specific dates in future Usually start at 5-10 year maturities Other Treasury Structures Callables Treasury has a right to call them Strips (US Government securities) Separate Trading of Registered Interest& Principal zero coupon, wireable, like a long T-Bill

TIPS (a NEGATIVE yield TIPS in 10/10!!) inflation adjusted Where to find the Treasuries: On the Yield Curve 7 A normal yield curve 6 5 3 mo 6 mo T-Bills 1 yr 2 yr 5 yr

T-Notes 10 yr 30 yr T-Bond Treasury Rates Abound US Agencies Short term agencies Called discount notes Some are regularly issued and some as needed Non-standard dates created to fill investor needs

Longer term agencies Called debentures or agencies Some are set maturities many are not Different structures created to fit investor or US Agencies The investors advantage in lower credit Treasuries give markets standardization Agencies offer more to get your business Advantages

All good day maturities Flexible maturity date choices Flexible structures More yield to take risk of lower credit Federal Agencies Agencies most often in the marketplace FHLB Federal Home Loan Bank FHLMC in conservatorship Freddie Mac Home Loan Mortgage Corp FFCB Farm Credit Farm Credit Bank

FNMA in conservatorship Fannie Mae National Mortgage Assoc. Government Agencies Non-standard, semi-annual coupons Varying middle dates Agency Listing Rate Maturity 0.75 4-xx Bid Asked

92:20 92:24 Yield 1.88 Callable Securities Issuers Agencies, corporations, public entities Callable is two securities 1. Issuer sells fixed income security to investor Value = present value of stream of cash flows 2. Investor sells option to call to issuer Value = probability of being exercised based upon current yield curve, a rate of volatility, and time to

exercise date Lock-out period Call protection; initial period during which issuer cant call bonds Callable Structures Various structures 3/1; 5/2; 10/3 2YNC6 Berm European one-time call Bermuda Discrete call, callable only on interest payment dates American Continuous call, callable anytime with specified # of days notice Step-up callables Fixed coupon to next call date At call date, bonds either called or coupon steps up/increases to structured higher coupon Can have multi-step ups Not the same as floating rate notes

Valuation of Callable Securities Priced at spread to Treasuries Yield to Worst (YTW) Which is lesser: Yield to Maturity or Yield to Call Option Adjusted Spread (OAS) Creates synthetic bullet Compare spread from OAS analysis to historical spread for non-callable securities from same market sector Structured or Floating-Rate Notes

Floaters reset rates periodically Index Spreads Reset Periods Day Count Periods Payment Periods

Maturity Valuation difficulties (accounting variations) Agencies Come in 2 Varieties Agencies issue debentures to get funds to buy mortgages Agency Notes debentures of the agency backed by the credit of the agency Issued like regular discount notes and notes Mortgage Backed Agencies

Created by pools of and backed by home mortgages affected by interest rates and mortgage pay-downs Some More Securities Additional types of securities They are legal if in your policy Not used by most public entities You might want specificity in definitions Chose your policy securities carefully Bond Mutual Funds

Structure is key not liquid securities Moves on market prices not a straight accrual Must have a maximum WAM of 2 years Not permitted for bond funds because of risk Not much reason to use especially now Potential of principal loss in rising rates Check the fee Use no-load funds total expense ratio Know the earnings history Read the prospectus Size Goals and policy restraints Bond Funds

Must be treasury and agency Bond Proceeds are prohibited by law!! Too much risk of principal loss. Maximum WAM of 2 years Short term bond mutual funds What would that make the maximum maturity?? Only safe when rates are falling Rising rates may limit your liquidity or lose principal Look for Morningstar Four Stars ****

Watch for rates to turn Watch and check for liquidity terms Reporting will be different Restrict the amount used primarily for reserves Corporate Bonds Only for Higher Education and ISD >50,000 Credit required AA- but higher may be safer Monitoring required Mortgage Backed Securities

Built from pools of home mortgages Pass-through securities Passes through P&I from homeowner Stated maturity and expected maturity Performance of pool dependent on mortgage payments Dependent upon interest rates Subjective pricing Basic Mortgage Backed Security (MBS) Homeowner gets pools Mortgage mortgages As

homeowne r pays P&I monthly Company sells the mortgage Payments flow through agency investor to investor It all hinges on the Agency like Derivative Mortgage Backed Created for investors clamoring for yield Pool of mortgages is divided

Collateralized Mortgage Obligations (CMO) Each piece (tranche) is structured differently CMO differ in risk CMO Collateralized mortgage obligations Noble laureates puzzle over some of this math Pools of mortgages split into pieces

Each piece is structured differently Some carry more risk (and therefore yield) Certain CMO are unauthorized in TX Municipal Obligations Current value over other securities Taxable and non-taxable issuers In any US state Rated A or above (you may want higher!)

Various structures Credit and liquidity issues Arbitrage safe haven Commercial Paper Unsecured promissory note of a corporation Credit Considerations

Corporation is borrowing short term funds Using the low rates of the short term market Often used by municipalities then rolled to longer term debt Dual rating is better market-wise Law allows single rating with LOC Cautions: Stay to known names Consider the situation (like European bank debt!) Stay short and high quality Available out 270 days Stay within 90 days set your policy as such Sample CP Policy Language Commercial paper rated A1/P1 or equivalent by two nationally

recognized rating agencies with a maturity not longer than 90 days. Could stipulate domestic CP only Asset Backed Commercial Paper Know what backed the securities Based on underlying securities or assets Originally backed by receivables Not based on credit of the company

Short-term debt used to finance long term risk High concentrations threaten funds/pools Florida, Montana, Washington State Bankers Acceptances Bankers Acceptances International trade primarily Defined as 270 maximum Restrict to 90-120 days in policy Illiquid

Measure spread vs CP Credit issues Foreign versus domestic? Israeli Bonds Issued, assumed or guaranteed by the State of Israel Assumed backing by US Currently 1.20% on 2-year Denominated in US dollars Longer term Illiquid Limited-Use Securities

GIC Guaranteed Investment Contracts Basically insurance contracts Specialized funds [IRS Code Sec 501(f)] Institutions of Higher Education Municipal utilities Distributing electricity or natural gas Hedging contracts Decommissioning Trust Fund Mineral Rights Funds Alternate uses for mineral right (gas) funds Barnett Shale impetus Securities Lending

Authorized after 9/1/03 Reverse repo without buy/sell Banks and some primaries 50% of income to entity (10-15 bps) Collateralized Treasuries (primarily) and agencies only Larger portfolio use primarily: must have securities to lend

Requires a strategy Securities Lending Must be at least 100% collateralized with treasuries, agencies and munis letters of credit from bank rated not less than A commercial paper, mutual funds, or pools Must allow for termination at any time Collateral must be pledged to public entity and held in its name deposited at time of the loan Loan must be with primary or bank in Texas Contract may not be for term longer than 1 year

Can extend Special Use PFIA Securities Guaranteed Investment Contracts (GICs) Nuclear De-commissioning funds Primarily housing authorities Detailed restrictions on use & collateral Long life requires differentiation Higher Education variations

Corporate notes, equities, stock mutual funds NOT for school districts Securities in General Current Issues Round lot purchases may be better prices Odd lot purchases to buy and hold Watch for credit warnings and esoteric structures When it sounds too good to be true.. BUT When in Doubt - Dont! Portfolio Reporting

To show risk Volatility risk (change in market value) To provide accounting/archiving Detail for holdings and summary for information To illustrate compliance Compliance with policy parameters (SLDY) To judge performance Yield Benchmark comparison Accounting and Reporting Concepts Two types of securities Discount securities Fixed income securities (with a coupon)

Two values Market value = price of you sell it changes daily Book value = your value net of amortization changes daily Three computations Interest accrual (coupons) Accretion (earnings) Amortization (expense) What Did I Earn? Earnings = accrual plus (net amortization + accrued) Amortization from notes bought above par decreases earnings

Accretion from notes bought below par increases earnings Accounting for the Portfolio Buying securities Accounting for securities At par = $1 for $1 face (price of 100) at par Below par = below $1 or 100 at a discount Above par = above $1 or 100

at a premium All affect the principal only The book value at maturity must equal face value (100) Straight line amortization/accretion Earnings from securities are from: Earning from the changes in principal (premium/discount) Earning from interest accrued in a coupon (accrued interest) Market Value Changes Daily Market value is quoted as principal only Market value equals:

Current price x face value 101.22 x $100,000 = $101,220 98.3 x $100,000 = $ 98,300 Certificates of Deposit always priced at 100 Market will always equal face amount 100 x $100,000 = $100,000 Fair Market Value When do I report it? What is change in market value? Pricing

Require an independent source Gains and Losses realized and unrealized Structured securities can be tricky Calls, step-ups, floaters, indexed, TIPS, pools Mortgage backed securities need more particularly subjective/judgmental pricing Prepayment speed assumptions, PSA rates Small issue pricing comparables Earnings

Earnings = amortization + accrued Note bought at a premium 1. 2. Monthly amortization = daily amort. * # days plus Coupon earnings = coupon rate * face/12 Note bought at a discount 1. Monthly accretion = daily accretion * # days plus What did I earn? Income equals: Total Accrued + Net Amortization

Investment Earnings recognizes coupon flow (accrued) recognizes original price of security (principal) Accrual basis does not include cash coupons Reporting Issues

Accuracy Timeliness Compliance Risk Identification Pricing Value Representation Formats Information A Cardinal Reporting Rule Weighting the Information Recognizes the impact of Dollar value Maturity

Yield $ 10,000 CD $ 500,000 CD 100 days 10 days = 12 day WAM Weighted Average Maturity This measure is useful in determining the degree of market or interest rate risk. The longer the WAM, the more exposure to the market and more potential for capital gains and loses. More risk. Portfolio managers typically shorten or lengthen average maturities depending on their interest rate outlook. If rates are expected to drop we ------- ?

If rates are expected to rise we -------- ? Calculating Weighted Average Maturity Multiply book value by days remaining to maturity Divide Sum by total book value of portfolio Current Value Book Remaining Days Maturity to Book x Days 6,568,777 14 91,962,878

3,211,222 48 154,138,656 5,999,158 300 1,799,747,400 1,425,177 540 769,595,580 1,920,575 270 518,555,250 19,124,909 3,333,999,764/19,124,9

09 Equals WAM = 3,333,999,764 174.3 days Weighted Average Yield The weighted average yield will accurately describe the performance of a buy-and-hold portfolio. Weighted yield is a measure against your benchmark. This measure does not consider market value impact. This measure reflects the price at which you bought the securities. Calculating Weighted Average Yield

Multiply book value by purchase yield Divide Sum by total book value of portfolio Book Value Purchase Yield Book x Yield 6,568,777 2.25 147,797 3,211,222 2.10 67,435 5,999,158 1.99 119,383

1,425,177 2.75 39,192 1,920,575 3.20 61,458 19,124,909 435,265 / 19,124,909 Equals WAY = 435,265 2.27 % To Commingle or Not to .. Interest Distribution

How to effectively distribute interest to various funds Replaces separate portfolios May help your overall yield Distributed on a pro rata basis by percent of fund Accuracy Ease Timeliness Distributing Interest Total interest to be distributed = $10,000 Fund/ Project Avg* Bal

Fund Fund Fund Fund $ 150,000 50.49 % $ 40,000 13.40 % $ 101,500 34.43 % $ 5,000 1.68 % A B C D % of Total $ 296,500 Interest Received $ 5,049.00 $ 1,340.00

$ 3,443.00 $ 168.00 $10,000.00 *Use either month-end balance or average balance Specific Report Requirements Compliance statement and signature Detail Information

Report was prepared in compliance with the Act and our policy Each investment position (including bank accounts) with maturity date Book and market values of each position at end of period Portfolio/fund investment belongs to Summary Information Beginning and ending market value of portfolio Earnings for the period Report Mirror Policy Parameters Key report parameters reflect your policy

Maximum maturity limitations Maximum average maturity limitations Diversification goals and limits Performance benchmarks Philosophy (Strategy) on the portfolio Volatility (change in market value) not required by PFIA as of 2011 Reports should reflect risk tolerances Looking in Reports for Risk Liquidity risk Extension risk

Volatility risk Credit risk Diversification Detail Description Elements Description of the holding

Type (T-Bill, T-Note, FNMA, CD Bank XX, etc.) Par (face amount) Coupon rate Purchase yield Purchase date )settlement not trade date) Maturity Date (and call date if applicable) Book value amortized value of the security Market value price it could be sold for today Earnings for the period Accrued + Net Accretion/Amortization Inventory Report Sample Inventory Report As of xx-xx-xx Purchase Date Beginning Book Beginning

Market Ending Book Ending Market Mo. Earnings Security Coupon Maturity Yield T-Bill T-Bill T-Bill T-Note 0% 0%

0% 5% 1-16-xx 2-22-xx 5-15-xx 8-15-xx 4.22% 4.35% 4.52% 4.75% 101,486 251,488 190,025 354,898 102,100 252,980 194,020 355,390 102,570 251,999 192,005

354,300 102,100 253,005 192,401 366,980 1,084 511 1,980 860 FNDN FHLB 0% 5% 3-7-xx 6-4-xx 4.41% 5.25% 107,642 104,567

107,666 104,750 107,999 104,850 107,000 106,010 357 1,766 BankOne BankTwo 4% 3% 3-5-xx 1-8-xx 4.00% 3.00% 98,000

95,454 98,000 95,454 98,327 95,691 98,327 95,691 327 237 Pool #1 0% xx-xx-xx 4.37% 120,123 102,123

120,999 120,999 876 1,412,483 1,428,740 1,442,513 7,998 Treasuries 4-5-xx 5-10-xx 2-4-xx 7-9-xx Agencies 11-20-xx 7-3-xx CDs 3-5-xx 7-8-xx

Pools xx-xx-xx TOTALS 1,423,683 Diversification by Sector By Market Sector Shows diversification Illustrates Risks 70 60 50 40

30 Treas Agency CD Pool 20 10 0 Too short Too long Barbelled Diversification by Maturity 35 30 O/n 0-3 mo

20 3-6 mo 6-9 mo 15 9-12 mo 25 10 5 0 By maturity breakdown Shows coverage of liabilities Funds concentration on near-by liabilities

Plus use of longer opportunities Pool/Fund Reporting Pools and Funds price and value Constant dollar (money market equivalents) designed to show risk to investor Price is always $1 Days-to-maturity is always 1 day Mutual fund equivalents

Price is the net asset value or share price that day Days to maturity is the WAM of the underlying portfolio Benchmarks Purpose Risk or performance? Selection with yield versus rate of return Comparability Sector recognition Comparable treasury versus index Always compare same periods

Benchmarks Measure Risk and Performance Sample Benchmarks Comparable Treasury Yields 3-Mo, 6-Mo, 1 Yr Fed Funds Pools or S&Ps LGIP Index GFOA Public Investor Benchmarks Government Bond Indexes Summaries Tell the Story

Beginning Book Value Beginning Market Value Beginning WAM 10,100,000 10,400,000 240 days Ending Book Value Ending Market Value Change in market value Earnings for Period Ending WAM

10,150,000 10,500,000 100,000 4,160 280 days Period Average Yield Period Average Benchmark Yield 2.40 % 2.10 % If you are more than 0.75% from your benchmark you should know why! Annual GASB Reporting GASB focus is on risk Displays fiduciary responsibility and public trust

Annual risk disclosure Collateral risk Safekeeping risk Volatility risk Credit risk Government Accounting Standards Board GASB 31 Fair Market Evaluation Designed to show change in market value Annual reporting only Entry is made and reversed Too much volatility equals volatility risk Discloses risk created by change of market price Only used for securities > one year only

GASB 40 Disclosure is aimed at: Credit risk including credit quality from rating agencies Interest rate risk Interest rate sensitivity disclosure including WAMs and specific derivatives Primarily on structured notes Foreign exchange (currency) risk

Texas PFIA Makes GASB 40 Reporting Easy All areas are covered by policy and approved by governing body Reporting Credit Exposures: All Agencies are AAA Credit ratings critical on CP, BA, Corporates Procedure to monitor credit in policies Reporting Interest Rate Exposures: % Callables or other structured notes Requires listing of callable and structured notes only Reporting Interest Rate Exposures: Maximum Maturity Weighted Average Maturity

Benchmarks So what do I do about reporting Recognize amortized book value Recognize accretion and amortization Get independent pricing source Report monthly if possible quarterly required Holdings report for detail Management reports/information for summary view

How Do I Buy a Security? Security Transactions Banks Broker/Dealers Can sell depository CD or be a broker Can sell securities of different types Advice and Management Investment Advisers

Find, competitively bid and purchase for you Can not sell anything Act as your investment officer Buying A Security Set the time horizon and amount Get competitive bids/offers Award the winner Inform the losers Write the trade ticket Access to the Market Brokers/dealers access the markets Market distribution process

A broker puts buyer and seller together A dealer sells securities fromCorporate an US Treasury US Agencies entities inventory - Primary dealer structure - -Selling groups - - banks and investment bankers Purchases and Sales Settlement Cash (same day) Regular (next day) Bid (sale) vs. Offer (buy)

Independent safekeeping Settlement Parties involved: YOU Broker Banks Timing is critical Documents are critical Settlement Require delivery versus payment (DVP)

Send every broker your delivery instructions It is the law No broker safekeeping Get the instructions from your bank Instructions are your ABA number and account Document by trade ticket and confirmation ? Clearing confirmation shows security arrived Safekeeping receipt shows bank is holding the security ABA 11-12345611 for account of ------ District

Delivery and Settlement Language Federal Reserves FedWire DTC (Depository Trust Corporation) PTC (Participatory Trust) Delivery versus Payment Free Delivery DK (Dont know the trade) Bankers Bankers selling a traditional depository CD

Banks acting as a broker If your bank holds your securities they can not be your broker Banks are not advisers Does not perfect DVP Still need multiple brokers for competition New factors for depository CD: Terrorism Act documentation Collateralized versus FDIC funds

Bank CD Trade Settlement Getting yields from multiple banks Check for details Day count, coupon pay dates, good maturity Get Policy Certification If not FDIC, need Depository Collateral Agreement Terrorism documentation takes time Broker or Dealer

Broker No inventory Transaction based FINRA Regulation Capitalization Retail Institutional Dealer Maintains

inventory FINRA Regulation Primary Dealer Reports to NY Fed Capital monitored Open market Primary Dealer List Broker/Dealer vs. Adviser Broker/Dealers sell a security

Advisers SEC registered as advisers Must have a CRD # Can not charge on a transaction/security Portfolio perspective Only an adviser can do competitives for you Advisers SEC registered under 1940 Act A money manager who advises and can not sell a security

Discretionary vs non-discretionary management public is always non-discretionary because of cash flows A broker can not be an adviser A broker can not do your competitive bidding Where is Your Protection What danger do you really have????? Peer Experience and References Credit Lines Capital Adequacy

A standard not a guarantee Government Security Dealer Act 1986 (structure) Government Securities Act 1993 (standards) SIPC INSURANCE ONLY APPLIES FOR BROKER HELD SECURITIES DO NOT ASK FOR OR DEMAND SIPC FINRA (Financial Institutions Regulatory Authority) Self regulatory body FINRA

Selecting a Broker Determined by portfolio needs Local versus non-local Primary versus secondary Banks How many brokers? What due diligence? NEVER use broker safekeeping Your policy and the law say DVP settlement

move securities to your depository bank Certification in Texas 2256.005(k) This is not a guarantee it affords little or no protection Policy must be given to any person offering to engage in an investment transaction execute a written instrument in a form acceptable to the investing entityand the business organization substantially to the effect that Brokers and bankers (including pools and advisers)

Firm has received and reviewed the policy Firm has established controls to sell only approved securities Nothing relieves the entity from responsibility for monitoring for policy compliance Some brokers view of certification POLICY CERTIFICATION FORM as required by Texas Government Code 2256.005(k) ________________ (the Entity) ________________ (the Firm)

I AM A BROKER. I HAVE PERUSED THE POLICY. I WILL TRY KINDA, SORTA, MAYBE, PERHAPS ATTEMPT TO NOT SELL YOU ANY OF THE FUNKY, *&$^%% SECURITIES MY DESK OFFERS. Firm: _______________________________________ Signature _______________________________________ Annual Broker/Dealer List PFIA requires an annual adoption of list List is for broker/dealers only

Investment committees can adopt list Any firm on list must have provided certification Banks may change as CD rates are found Pools are already authorized by Board action May list banks and pools for information Documents for Your Broker Before Selection Questionnaire Investment Policy Certification After Selection CAFR Trading Authorization

Your delivery instructions Tax identification number No account application (safekeeping agreement) Broker Dealer Questionnaires Differentiate between brokers and primary brokers All brokers: firm information contact broker information delivery instructions public client references Non-Primary Brokers:

market sector involvement Basic Questionnaire Info Name of Firm: __________________ CRD #___________________ Address: ___________________________________________________ Primary Representative on account: ___________________________________ Telephone: ________________ Fax: _______________________________ E-Mail: ______________________________________________ Broker CRD# ___________________________ Backup representative or trading assistant: ______________________________ Telephone: ___________________________________________ E-mail: ___________________________________________ Branch Manager: ___________________________________________ Telephone: ______________________________________ Fax: ____________________________________________ E-Mail: ____________________________________________

Questionnaire Is the firm designated as a Primary Dealer by the Federal Reserve? __________________ Is the firm registered with the tx State Securities Board? __________________________ Is the firm and representative registered with FINRA? ___________________________ How long has the designated representative been an institutional fixed income broker at this firm? ____________________ In total? _____________________ In what market sectors does the account representative specialize? Treasuries ? _________ Agencies? _________ MBS? _________ Delivery instructions: ___________________________________________________ Non-Primary Information

FINRA Registration and CRD Report State Securities Registration Market Involvement Public Sector Involvement References Audited Financial Statements provided annually So what do I do? Finding brokers to use Peer group ideas and references Use at least 3 bank/broker Feel comfortable with the person

Use at least one primary and all institutional brokers Its a telephone market no need to meet Establishing a relationship Talk about your policy and limits Get basic information Backup person and numbers Delivery instructions Send your policy and certifications Modified certifications

And then what? Making an investment Set your time horizon Tell the brokers what you need/want I need the best rate not past xx/xx/xx in an agency or treasury Wait for them to do the research Set the maximum maturity date

They will bring back alternatives for you to chose from Make the decision Inform them all what you bought (the cover) Feedback is important And then.? You chose on date and yield Do not go past your due date if it is set Chose the highest yield (true or govt yield) Settling the security

The broker has your delivery instructions Tell your bank it is coming (trade ticket) Broker will send the bond to the bank Investment Steps Set your maximum date (your time horizon) Set your maximum money to invest Have a general idea of where rates are Look at value in all markets available Look at them all !

Check the alternatives authorized for you: CD T-Bill FNMA disco FNMA note FHLMC note SLMA note TVA note 3.01 % 3.85 % 4.01 % 4.00 % 4.07 %

4.09 % 4.12 % What are your considerations? The Buying Decision Determine the maximum maturity (time horizon) Offers will differ in maturity and type Do not go beyond that maturity Request offers short of or on that date Are they all authorized? Do they fit diversification?

Do I know what they are? Chose the best yield Active Strategies Expand on the Same Basics Advantages Improved yields Utilize market opportunities Techniques

yield curve analysis (rate anticipation) riding the curve spread and sector analysis market timing swaps Larger Entities Some core cash Fund types provide additional opportunity Annual review required Rewards and responsibilities One or more constant dollar pools Bank sweep accounts Flex for large bond funds Ladder of securities matching liabilities

Steps in Developing Market View 1. Perspective on world and geo-political situation 2. View of business environment 3. Market and economic conditions Yield curve movement Relative value 4. Your unique situation a So what do I do about all this Do your cash flow Write your policy Choose at least two brokers and qualify them Create a short term ladder

Create a longer term ladder Out to 4-6 months if rates are favorable to go further If not move extra funds to the high point in rates Do competitive bidding Do delivery versus payment Get started! Be careful Get started Good luck! Linda T. Patterson Patterson & Associates Austin, TX [email protected]

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