Download Reinvestment Risk

Managing
Portfolios Without
Getting in Over
Your Head
April 26, 2006
Kay Chandler, CFA
President, Chandler Asset Management
© 2006. Chandler Asset Management, Inc.
The Topic—Investment Ideas for
Smaller Portfolios

Smaller?

Fewer Resources
2
A Comparison

City of Los Angeles

A Medium-sized City
•
$5 billion +
•
$300 million
•
Treasurer
•
Finance Director
•
Treas…

CIO

3 PMs
•
Active strategies
•
Daily Trading
3
Small vs. Large Portfolios?

More vs. fewer available staff

Budget for portfolio management resources,
e.g., Bloomberg, BondEdge, independent
credit research

Ability to provide continuity of program
management
4
Regardless of Portfolio Size and
Available Resources


Safety—maintain appropriate level of exposure
to risk
Liquidity
• Sufficient short-term investments
• Marketable securities
• Targeted maturities
• Extra layer

Yield (Return,Growth)
•
•
Income
Long-term growth
5
Every Portfolio Needs an
Overriding Strategy

When resources for management are scarce
• Long-term strategy must predominate
• Passive strategies may be preferred



Eliminate short-term trading
Minimize interest rate forecasting
Hold to maturity
• Risk management may look quite different
6
Portfolio Management Is
Risk Management
 The greater an investor’s exposure to
properly diversified risk, the higher the
expected return over time.
 The greater an investor’s exposure to risk,
the higher will be the volatility of return from
period to period.
 The objective of “safety” requires
establishing risk constraints.
7
Tips for Managing Risk

Market Risk

Liquidity risk

Reinvestment risk (Callables)

Credit Risk (Non-governmental Issuers)

Other—political, job, etc.
8
Exposure To Interest Rate
Fluctuations—Market Risk

Market risk
• Securities prices change as interest rates
change—in the opposite direction
• Market risk is best measured as modified
duration
• Measure effective duration instead when
securities have a call feature
9
What Is Duration, Anyway?

Modified duration measures the percent change in
price of a security for a 1 percent change in yields.

Since market prices decline when yields rise, and
rise when yields decline, duration is multiplied by –1
and then multiplied by the change in yield.

We can’t predict interest rates, but, using duration,
we can calculate exactly how much the portfolio
market value will change with a given, instantaneous
change in interest rates
10
What Is Duration, Anyway?








Portfolio size = $50 million
Portfolio duration = 2
Interest rate Δ = +2.25%
Portfolio MV Δ = $50 million x
.02 x 2.25% x -1
MV Δ = ($22,500)
Interest rate Δ = -2.25%
Portfolio MV Δ = $50 million x
.02 x (2.25%) x -1
MV Δ = +$22,500








Portfolio size = $50 million
Portfolio duration = 1
Interest rate Δ = +2.25%
Portfolio MV Δ = $50 million x
.01 x 2.25% x -1
MV Δ = ($11,250)
Interest rate Δ = -2.25%
Portfolio MV Δ = $50 million x
..01 x (2.25%) x -1
MV Δ = +$11,250
11
An Aside Regarding
Interest Rate Forecasting

Can all the following be forecast in a way that results
in superior performance?
•
•
•
Direction
Magnitude
Timing

FRB St. Louis: Professional forecasters do not
outperform “random walk”

The longer the horizon, the worse the error statistics
12
Greater Exposure To Market Risk Leads
To Higher Return Over Time
Higher Duration Portfolios Offer Greater Returns Over Time
$1.70
LAIF
$1.60
1-3 Year Treasury Benchmark
1-5 Year Government Benchmark
Growth in millions
$1.50
$1.40
$1.30
$1.20
$1.10
$1.00
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Source: Index return information provided by Merrill Lynch
Value on 12/31/2005 of $1 million invested 12/31/1995
LAIF
1-3 Year Treasury Benchmark
1-5 Year Government Benchmark
12/31/2005
$1,525,924
$1,596,461
$1,646,268
Annualized Return
4.32%
4.79%
5.11%
13
Greater Exposure To Market Risk Means
Higher Volatility
Higher Duration Portfolios Have Greater Volatility of Return
Quarterly Change in Value
2.50%
2.00%
Quarterly Total Rate of Return
1.50%
1.00%
0.50%
0.00%
-0.50%
-1.00%
-1.50%
LAIF
1-3 Year Treasury Benchm ark
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-2.00%
1-5 Year Governm ent Benchm ark
LAIF is a LGIP managed by the California State Treasurer for California local agencies which invests primarily in short-term securities and seeks to pay $1 dollar out
for every $1 dollar invested. The 1-3 Year and the 1-5 Year benchmarks are unmanaged index portfolios with durations of _____ and ______ respectively as of 12/31/05.
.
14
Laddering Can Be a Substitute
for Targeting Duration

Stagger maturities evenly to desired final
maturity
• Short-term investments sufficient to meet cash
needs
• When ladder securities mature, roll the funds out
to the end of the ladder
• Collect the interest and wait for maturities
15
Managing Liquidity Risk
Liquidity risk (2 definitions)

1.
The risk that the portfolio won’t provide
adequate cashflow for the agency
2.
The risk that a security can’t be sold, if
necessary, at a good price

Measured by such factors as the difference
between bid and ask and the number of market
makers for the issue

This definition is not so important for passive
investors
16
Managing Liquidity Risk
Definition 1
Definition 1

Determine short-term investment needs
through cash flow forecasting and other
techniques

Maintain sufficient investments in vehicles such
as LAIF, money market funds, individual shortterm securities

Invest remainder in strategies with higher
expected yields
17
Reinvestment Risk

Reinvestment risk: cashflows from a
bond must be reinvested at the
market rate at the time the cashflow
occurs
•
•
•
Interest payments
Paydowns from mortgage securities
Principal from called bonds
18
Value in Callable Securities
135
In a period of falling rates,
bullet securities, with higher
duration and positive
convexity, provide more growth
than callables.

130
125
120
115
110
105
100
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95
1-3 Non-Call Agency
103.5
1-3 Callable Agency
103.0
102.5

102.0
101.5
101.0
100.5
100.0
99.5
Dec-03
Mar-04
Jun-04
Sep-04
Dec-04
1-3 Non-Call Agency
Mar-05
Jun-05
Sep-05
Dec-05
But when rates are stable or rising,
callables, with their generally
higher coupons, tend to outperform
bullets, especially after the initial
duration extension is complete.
1-3 Callable Agency
19
Risk in Callable Securities

The investor takes on the risk of a long-term
security, but may end up without the reward

Callable securities are difficult to value, since
the duration is ultimately unknowable

Cash flows are uncertain—in a way that
works against the investor
20
Credit Risk—the Opportunity
$1.85
Assuming additional credit risk
should result in higher returns
over time
1-5 Yr "A" Rated Corps
1-5 Yr Agencies
$1.75
$1.65
$1.55
Growth in millions

$1.45
$1.35
$1.25
$1.15
$1.05
$0.95
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Monthly Change in Value
2.50%
2.00%

1.00%
0.50%
0.00%
-0.50%
With a similar pattern of
volatility of return
-1.00%
-1.50%
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-2.00%
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Monthly Total Rate of Return
1.50%
1-5 Yr Agencies
21
Credit Risk—the Tradeoff

Assuming credit risk requires that additional
resources be devoted to the investment program
•
•
Moody’s/S&P ratings, watch lists, outlook

At time of purchase and

On a regular basis
Supplemented by

Third party sources

Internally generated credit research
22
Outsourcing The Investment
Management Function to an Adviser

An investment firm with demonstrated expertise
in the management of investment portfolios

Acts as a fiduciary for client assets

Registered with and regulated by the SEC under
the Investment Advisers Act of 1940

Compensated on the basis of assets under
management, not transactions
23
Benefits of Using an Adviser

Enhanced returns net of fees

Reduced risk

Better information—reporting, program
evaluation

Internal staff free to perform other duties
24
Are There Any Risks?

Third party custodian is essential—an outside
adviser should never have custody of assets

The client must monitor
• Compliance with Government Code
• Compliance with Policy
• Performance relative to appropriate benchmarks
25
Enjoy the Benefits, Manage the Risks

Cash is king—sufficient short term investments to
meet expected, and even some unexpected,
requirements

Exposure to market risk through laddering in all
market environments

Do you have sufficient resources to analyze and
monitor credit risk

An outside investment adviser can bring expertise
to portfolio structuring and risk management at a
reasonable cost
26