Public Investment Strategy in the Current Environment

1. Public Investment Strategy in the Current Environment GFOAZ Conference Sedona, AZ March 2006

2. Stra’-te-gy • Macro Strategy: • Set by policy to outline goals and objectives on liquidity, quality, applicability to fund type, credit quality, diversification, and yield. • Based on fundamentals of cash flow and risk tolerance. • Re-evaluate at least annually. • Market Strategy: • Set by the conditions in the market at the current time and unique cash flow restraints. • Established by market conditions within overall strategy guidelines. • Re-evaluate continuously.

3. Your job as an investor: • Meet known asset/liability requirements. • Prepare for unexpected liabilities. • Use your resources. • Be a strategist more than a tactician. • Balance yield, liquidity, and flexibility. • Read major market trends for applicability and rate direction. • Strategize for incremental income

4. What is the current environment? • What makes it the same? • Fundamental business cycles • Elections • Fundamental market cycles • Risks – internal and external • Your fiduciary responsibilities • What makes it different? • Oil and gas prices • Productivity • Global growth • Terrorism • Deficits • New Fed Chairman • Housing • Global outsourcing

5. Some things don’t change • Risk management • Public investing is risk management • Direct correlation of risk to reward • No risk – no reward • Know risk – know reward • Controls • Technological advances/opportunities • On line investing pros and cons • Expedited funds and remote deposit changes

6. The Foundation Doesn’t Change PORTFOLIO POLICY AND PROCEDURES MARKET ANALYSIS SECURITY REPORTING CASH FLOW RISK STRATEGY ANALYSIS ANALYSIS ANALYSIS

7. Different Funds – Different Flows Cash Flow Analysis General Fund Utility Fund

8. Macro Net Balance Cash FlowsPaint a Portfolio Portrait core • Sets maximum maturity limits • Sets maximum weighted average maturity • Sets your benchmarks • Develops a strategy • where to invest • where not to invest • when comes from the market

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

10. 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 • Today’s strategy • Core • Reserves, no planned shorter term use • Focus on rate movements and yield • May call for different securities • Today’s strategy

11. The special strategy on capital projects • A large nonrecurring expenditure • A unique cash flow • Like projects often create trends • Preliminary work with departments for an expenditure plan before $$ arrives • Bond document plans • Updates on ongoing basis with department heads and engineers to modify plans • Explaining the importance of cash flow helps generate support • Impact of additional earnings • Arbitrage impacts

12. Project Trends Streets - 1995 Use multiple historical issues of the same type fund streets water mains land acquisition Trend often appear over the time frame of the total project Use for projections on the same type projects in the future Streets - 2000 Streets Projection 2006

13. Maturity – A Major Factor • The average maturity of the portfolio is arguably the single greatest determinant of investment performance • Yield enhancement accomplished by: • extending maturities • increasing credit risk • reducing liquidity • Capital appreciation Paid for risk taken

14. Rates tell a story.. Today’s story is flat… • Yield curve: • compilation of the expectations of everyone in the marketplace • Overall view: • Projection of slow and steady growth and rate increases continue • Sector view: • sector steepness evident only on close inspection Investment Sector for Majority of Governmental investors

15. Your view and strategy… • Your strategy is dependent on your expectations • Your strategy is dependent on your portion of the curve Long end pop – normal curve Curve inversion

16. Strategies must change • Jan 2001 – Jan 2002 • Overnight rates move from 6.50% to 1.00% • Need to lock-in rates as long as reasonable • Going long was primary strategy • June 2004 – June 2005 • Overnight rates move from 1.00% to 3.00% ?? • Need to move up with the rates • Staying short was primary strategy

17. Trade strategiesWhich do you chose? Does it matter? S M T W T F S 2 3 4 5 6 7 8 FNDN 3.4% ? 9 10 11 12 13 14 15 16 17 18 19 20 21 22 CD 3.2% ? T-Bill 3.0% ? payroll 23 24 25 26 27 28 29

18. “Strategic” Results InvestmentInterestReinvestmentGross • FNDN 245,750 4,250312 4,562 • T-Bill 246,250 3,750 20 3,770 • CD 250,000 4,000 0 4,000 • On a $250,000 payroll - 24 times a year - the additional earnings are $ 562 x 24 = $13,488

19. Risk/Return of Various Benchmarks 10 Years Ended March 31, 2000 Overall Duration Yield 3-Month Treasury Bill $8,315,201 5.21% .25 Years $8,499,138 6-Month Treasury Bill 5.44% .49 Years $9,497,797 6.62% 1-3 Year Treasury Index 1.64 Years $9,985,291 7.16% 1-5 Year Treasury Index 2.19 Years 7.62% 3-5 Year Treasury Index $10,424,264 3.37 Years $10,957,156 5-7 Year Treasury Index 8.15% 4.73 Years $11,273,458 8.46% 7-10 Year Treasury Index 6.36 Years Returns Come Only from Risks Taken Cumulative Return Risk

20. Interpreting Today’s News • Soft patch or slowing economy? • Dollar weakness • Oil and energy impacts • Labor growth and wage pressure • Housing – can it continue? • Inflationary pressures • Fiscal policy • Monetary policy (with and without Greenspan) • Rates increasing or flattening? Curve steeper or inverted? • What part f the curve is moving and where?

21. The Fundamental View – Federal Funds Rate Effective Fed Funds from 01/01/01 to present Fed fights inflation/growth Fed tries to boost economy

22. The Fundamental View – Payroll Non-farm Payrolls – 01/01/01 to present

23. The Fundamental View – Producer Price Index PPI – YOY 01/01/01 to present

24. The Fundamental View – Capacity Utilization Capacity Utilization - 01/01/01 to present

25. The Fundamental View – Oil Three month oil contract from 01/03 to present

26. “Conundrum”

27. Manage Risk - Not Return • Identify the appropriate level of risk for portfolio • Risk can not be avoided – but can be managed • Structure the risk profile of the portfolio • to meet objectives • to comply with constraints • To match risk tolerances • Manage risk to increase the value of the portfolio as much as possible, given the portfolio’s risk parameters

28. Quarterly Rate Moves • - Clear movement on short end • - Danger of leap frog Fed move • Investors target steepness in a curve • Curve directives from market participants • What is keeping the long end down?

29. Use the available curve Only steepness on curve MAR DEC SEPT JULY

30. Possible Bear Market Strategies • Shorten durations • Shorter maturities • Higher coupon securities • Ride the yield curve • Evaluate Spread products • Identify trading ranges • Callable securities??? Floaters?? Indexed?? • Barbell term structure • Portfolio realignments – loss payback swaps

31. A Bearish Strategy • Graph shows rate increases between 4/1, 10/1 and 04/05 plus what another 6 months could do • 2-year in April ‘04 = 1.75% o/n in April ’05 = 2.75% • 2-year in Oct ’04 = 2.75% o/n in May ’05 = 3.00% • Stay ahead of rates by 3-6 months investments to generate extra revenue and ride up on rates 04/01/04 10/01/04 04/08/05 03/03/06

32. Security Impact • Callables • Floaters • Indexed • Bullets • Full information and analysis

33. Issuers Agencies, corporations, public entities Callable is two securities Issuer sells fixed income security to investor Value = present value of stream of cash flows 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 can’t call bonds Callable Securities

34. Various structures – 3/1; 5/2; 10/3 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 Callable Structures

35. Uncertain cash flows and risk is difficult to measure 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 Valuation of Callable Securities

36. Continuous Call Description

37. Continuous Call OAS

38. Floating-Rate Notes • “Floaters” reset rates periodically • Know the details and their impact • Index • Spreads • Reset Periods • Day Count Periods • Payment Periods • Maturity • Valuation

39. Yield Curve Nuances CHEAP STEEP FLAT % RICH TIME

40. Yield Curve Maneuvers • Interest rates anticipation not projection • Direction • Magnitude • Timing • Macro curve expectation • “the compilation of expectations” • Implement strategy to address the curve • Current and future • Disciplined investment will outperform speculation over time

41. Actual Yield Curve Changes Curve indicates slowly rising rates 2 1

42. Actual Yield Curve Changes Rates rose and now indicate a drop 3 4 2 1

43. Actual Yield Curve Changes Rates drop precipitously 3 4 2 5 1 6

44. Summarizing • Some 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