GIOA Workshop : Effective Agency Strategies

1. GIOA Workshop : Effective Agency Strategies Stephen Manning, CFA Director – Institutional Branch Services March 16, 2011

2. Developing Portfolio Strategies Using Agencies • Risk Management Overview • The Portfolio Process • A Brief discussion on Duration and Convexity • Agency Alternatives: • Agency Bullets • Fixed Coupon Callables • Step Ups • Fixed to Float • The Cost of “Waiting” • Useful Bloomberg Tools

3. Risk Management Overview

4. SAFETY LIQUIDITY Investment Policy / Guidelines Interest Rate Social Screens Risk Macroeconomic Yield Curve Trends Risk Implement Market Cash Flow Portfolio Strategy Trends Risk Credit Credit Risk Trends Liquidity Risk Investment Decision Process

5. Interest Rate Effective Duration – Expected Change in Price For every 100bp Shift in Rates Convexity – How will my duration Change as yields change. Risk Yield Curve Risk Partial Durations – Shift a Single Point on the curve to Determine Where on the curve your risk exposure is concentrated. Cash Flow Risk Cash Flow Simulation – Run Cash flows across multiple horizon rate scenarios to ensure there are no liquidity gaps Quantifying Risk

6. Duration Duration is the slope of a line drawn tangent to the price-yield curve and shows the % change in bond price for a given change in yield. • Duration – Expected %Change in Price For a 100bp Shift in Rates • Graphically - The Slope of the Price Yield Function Bond Price Yield

7. Duration • Example: the price of a bond with a duration of 3.0 is expected to: • Fall by 3% when rates rise by 100bp • Increase by 3% when rates fall (rally) 100bp. • However: The price/yield relationship is rarely linear (a straight line). Bond Price Out Performance Yield

8. Convexity • Convexity – Expected Change in Duration For a 100bp Shift in Rates • Positive Convexity - When rates change, the bond outperforms the duration. • Negative Convexity – When rates rally, the bond will underperform its duration. Bond Price *P Bond A **P **P Bond B Duration **Y *Y Yield **Y Bond Price *P *Y Yield

9. Agency Alternatives

10. Ticker Yield Spread to TSY Bullets: No Optionality • Key Features: • Fixed Coupon throughout life • Certainty of Cash Flow • Start with HIGHER Duration than callable. • LOWER Yield/Coupon than callable. • Slight Positive Convexity • Best Performer when rates moving lower (Bullish). • Better Liquidity • Bloomberg: FIT <GO> • Update Market to “Agency” if not the default.

11. Finding Carry: Callable Agencies • Fixed Coupon Callables • 1X Call (Euro): • Higher Coupons than Bullets, and initial Step-Up Coupons. • 1x Calls become bullet alternatives if not called on the call date. • Berm and Cont. Call: • Higher Coupon than 1x Call (Selling more optionality). • Better Convexity Profile. • Duration does not extend as quickly as 1x call, as the “next call” keeps it shorter.

12. Finding Carry: Defensive Step-Ups • Synthetic Premiums • One time step-up, with above market back end coupon. • Increases the probability the bonds will get called, even with rates higher. • 1X Call, with in-the-money back coupon. • Give up some income on the front coupon • Higher probability of call • Price yield off the Maturity, while synthetically keeping your duration much shorter. • 5NC2 Example? • Multi-Step Multi Call

13. Finding Carry: Defensive Step-Ups • Defensive Multi-Step Structures • Starting coupons significantly higher than short cash rates to the first call • Coupons set to step up in line with future expectations in rates, to improve price performance, and keep durations short in rising rate environment.

14. Defensive Strategies • Fixed To Float • ABOVE Market Initial Coupon – Increase Cash Flow • Below market spread on back end floater, but with frequent resets, bond remains near par in back up. • Take on “Basis Risk” of spread widening, which should be much lower than the pure duration risk of a fixed coupon bond.

15. Discount Callables • Euro Calls (1X) • Viewed as Bullet Alternatives • Depending on strike, call date, many already extended in their durations. • Look for Yield Pick-Ups to Bullets • Bermuda / Continuous Calls • Steep Yield Curve / Roll Down means some of the forward call options are still in the money despite discount price. • Look for Pick Up to bullets. • Many trading to the expected call date, as opposed to the maturity, which can make them look rich optically. • Look for opportunities to pick up yield to Maturity, with excellent upside if the market does not back up more, and the bonds are called early.

16. Cost of “Waiting”

17. Buy and Hold – Carry Still Important • With the steep yield curve, look for Carry and Roll down. • Callable agencies such as the one above offer significant pick up to cash, while taking on moderate duration risk. • Over a 1 year time period, the Callable Agency outperforms the theoretical cash pool even in a +100bp rate shift. • If it takes 2 years to sell off, this Callable outperformed even through the +200bp scenario. • Callable Agencies represent a good sector to pick up yield, and reduce duration vs. similar maturity bullets in the agency and credit markets. • Always Keep your Liquidity Needs in mind, and evaluate the full extension risk of callables.

18. Income Break Even • Break Even Income Analysis After 1 Year • The above callable agency generates 840k in interest over 4 yrs • Starting with a cash rate of 23bp for 1 year (1yr Tsy) you would need to reinvest at a rate of 2.72% to break even. • Implies a back up of 94bp in Treasuries to attain that. • 3YR Treasury Rate, 1YR Forward is currently 2.21%, implying just a 100bp Backup over the next year.

19. Useful Bloomberg Tools

20. New Issue Monitor: NIM2 • NIM2 <GO> • Shows all the announced new issue deals, and upsizes in the market. • Ordered by date, and time, newest to oldest

21. Option Adjusted Spreads (OAS1) • OAS is an Extremely useful pricing tool • “Spread” to the CURVE after taking out the value of optionality. • CUSIP Govt OAS1 <GO> • Spread to Treasury Curve (I111). • 14 Vol is standard for street pricing, but does not reveal value.

22. AOAS Screen – Relative Value • “A”OAS – Spread to the Agency Curve • CUSIP Govt AOAS <GO> • Spread to Relevent Agency Benchmark Curve, with Live Volatility • Spread to Treasury Curve (I111). • 14 Vol is standard for street pricing, but does not reveal value.

23. Forward Rates • FWCM <Go> • Can look at US Treasury and Swap Forward Rates

24. Forward Rates • FWCV <GO> • Forward curve for agency bullets is projecting higher yields

25. Forward Rates - Series • FWCV <GO> ; 3 <GO> • Useful to see the path of single rate forward in time.

26. Break Even Analysis • GA3 <Go>

27. Looking at the Complete Picture

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