Liability Matching And Benchmarks

CHANDLER ASSET MANAGEMENT Cash Flow, Asset/Liability Matching And Benchmarks CAJPA Fall Conference September 18, 2014 Martin Cassell, CFA CEO and Ch...
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CHANDLER ASSET MANAGEMENT

Cash Flow, Asset/Liability Matching And Benchmarks CAJPA Fall Conference September 18, 2014

Martin Cassell, CFA CEO and Chief Investment Officer 6225 Lusk Boulevard

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San Diego, CA 92121

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Phone 800.317.4747

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Fax 858.546.3741

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www.chandlerasset.com

SECTION 1

Cash Flow Analysis

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Liquidity and Reserve Balance Over Time

60 55 50 45

$Millions

40 35 30 25

Total Portfolio

20 15 10 5 0

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Cash Flow Model Sample

Sample Cash Flow Projections 2010

2011

2012

2013

2014

Maxim um Portfolio Bal

45,700,000

47,700,000

49,500,000

51,700,000

54,400,000

Minim um Portfolio Bal

39,500,000

42,800,000

44,400,000

47,600,000

48,400,000

6,200,000

4,900,000

5,100,000

4,100,000

6,000,000

Difference

Target Liquidity Portfolio Bal Target Liquidity Portfolio Range

10,000,000 7,000,000 to 13,000,000

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Segmenting Portfolio

Total Portfolio Reserve

Liquidity



Meets specific liquidity need such as administrative costs and current claims to be paid



Reserve funds - for case reserves, IBNR, and pool equity



Target to a duration approximating the duration of the liabilities



Local Government Investment Pool



Commercial Paper



Diversified asset allocation



Discount Notes



Treasuries, Agencies, Corporate Notes



Money Market Securities 5

Cash Flow Model Sample Sample Cash Flow Projections Beg. Balance

Projected Total

Mar-14

Jun-14

Sep-14

Dec-14

51,470,000

49,610,000

49,220,000

50,300,000

Inflow Member Payments/Premiums Assessments Other Revenues Total Inflow s

3,000,000 0 30,000 3,030,000

3,000,000 0 30,000 3,030,000

3,000,000 0 30,000 3,030,000

3,000,000 0 30,000 3,030,000

12,000,000 0 120,000 12,120,000

Outflow s Salaries & Benefits Administration Expenses Rent Professional Services Pooled Losses/Insurance Total Expenses Net Change

210,000 120,000 18,000 12,000 1,200,000 1,560,000 1,470,000

210,000 120,000 18,000 12,000 6,000,000 6,360,000 (3,330,000)

210,000 120,000 18,000 12,000 1,200,000 1,560,000 1,470,000

210,000 120,000 18,000 12,000 1,200,000 1,560,000 1,470,000

840,000 480,000 72,000 48,000 9,600,000 11,040,000 1,080,000

Cum ulative Net Change

1,470,000

(1,860,000)

(390,000)

1,080,000

1,080,000

Ending Balance

51,470,000

48,140,000

51,080,000

50,690,000

11,270,000 40,200,000

7,739,000 40,401,000

10,476,995 40,603,005

9,883,980 40,806,020

Fund Balances

Liquidity Investment Pool Reserve investment Pool

50,000,000

10,000,000 40,000,000

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Liquidity and Reserve Balance Over Time

60 55 50 45

$Millions

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Liquidity Portfolio

35 30 25 20

Reserve Portfolio 15 10 5 0

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SECTION 3

Asset Liability Matching

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Asset/Liability Matching Manages Risk

What maturity/duration structure will balance the Portfolio with its liability structure?

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A/L Matching – Single Liability

$25 million principal payment due in 20 years

$9,422,000

20 Years

$25,000,000 Risk Eliminated

Invest $9.4 million at 5%; it grows to $25 million in 20 years.

$25,000,000

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A/L Matching – Multiple Liabilities

Debt Service on $25 Million Bond Issue

$30,000,000 $20,000,000 Investm ent

Amount

$10,000,000

Liability

$$(10,000,000) $(20,000,000) $(30,000,000) Period

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Matching A/L Duration Is More Efficient

■ Cashflow matching works perfectly ■ But is sometimes expensive ■ And sometimes there are no suitable securities available to match the date cashflow is needed ■ Furthermore, cashflows may not be certain

■ So it is common practice to match the duration of the investments to the duration of the liabilities

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Asset/Liability Matching Manages Risk

If FV of assets ends up lower than FV of claims, more reserves will be needed

$40,000 Claims Shortfall

$1,060,000

$1,020,000

A S S E T S

Interest Rate Drop

C L A I M S

Duration of Assets Duration of Claims If interest rates drop 2%, a $1 million investment will produce a $40,000 shortfall in claims funding.

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SECTION 2

Duration

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Facts About Duration ■ Duration is a direct measure of exposure to market risk in a fixed maturity bond ■ Duration is a better measure of the sensitivity to changes in interest rates than term-to-maturity ■ Duration is a close approximation of the percent change in the price of a bond for a one-percentage-point change in yield ■ Change in market value for one-percentage-point change in yield is equal to (-1) x (modified duration) ■ Securities with equal maturity dates may not have equal interest rate risk - duration quantifies the difference

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Calculating Price Changes Using Duration ■ Portfolio size = $25 million

■ Portfolio size = $25 million

■ Portfolio duration = 2

■ Portfolio duration = 1

■ Rates Increase

■ Rates Increase

■ Interest rate ∆ = +1.00%

■ Interest rate ∆ = +1.00%

■ Portfolio MV % ∆ = 2 x 1.00% x -1 = -2.00%

■ Portfolio MV % ∆ = 1 x 1.00% x -1 = -1.00%

■ Portfolio MV $ ∆ = $25 mln x -2.00% = -$500,000

■ Portfolio MV $ ∆ = $25 mln x -1.00% = -$250,000

■ Rates Decline

■ Rates Decline

■ Interest rate ∆ = -1.00%

■ Interest rate ∆ = -1.00%

■ Portfolio MV % ∆ = 2 x -1.00% x -1 = +2.00%

■ Portfolio MV % ∆ = 2 x -1.00% x -1 = +1.00%

■ Portfolio MV $ ∆ = $25 mln x 2.00% = +$500,000

■ Portfolio MV $ ∆ = $25 mln x 2.00% = +$250,000 16

SECTION 4

Benchmarks

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What Makes a Good Benchmark?

■ An unmanaged portfolio that includes the types and maturities of securities that are permitted in the investor’s policies. ■ Representative of assets in which the fund may invest. ■ Constructed in a disciplined and objective manner. ■ Formulated from publicly available information. ■ Exhibit similar risk characteristics as the investment objectives. ■ The information derived from both the benchmark and the portfolio should use the same calculation methods. ■ Known in advance.

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Examples of Common Fixed-Income Benchmarks

■ There are several providers of fixed income market indices such as Barclays (formerly Lehman Brothers), Bank of America Merrill Lynch, and Citigroup ■ Index of 91 day T-bill Security ■ Index of 1 Year T-bill Security ■ Index of 1-3 Year Treasury Securities ■ Index of 1-3 Year Government Securities ■ Index of 0-5 Year Treasury Securities ■ Index of 1-5 Year Government Securities ■ Index of 1-5 Year Corporate (A and above)/Government Securities ■ Index of 1-10 Year Government Securities

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What a Benchmark Does

■ Replicates entity’s selected risk profile for portfolio ■ Keeps you focused on managing risk in entire portfolio ■ Provides guidance for investment decisions ■ Controls exposure to: ■ Market risk (duration; weighted average maturity) ■ Credit risk (sector allocation)

■ Improves expectations in all market environments ■ Provides clarity of strategy communication to board

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Bond Market 101: Higher Risk Higher Return Potential Comparison of LAIF, 1-3 Yr Government Benchmark and 1-5 Yr Government Benchmark $1.40

LAIF $1.35

1‐3 Yr Government Benchmark 1‐5 Yr Government Benchmark

$1.30

Growth in millions

$1.25

$1.20

$1.15

$1.10

$1.05

$1.00

$0.95

Source: Index return information provided by Bank of America Merrill Lynch; California State Treasurer Local Agency Investment Fund (LAIF). Index returns assume reinvestment of all distributions and unlike mutual funds, do not reflect fees or expenses. It is not possible to invest directly in an index.

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Bond Market 101: Higher Risk Higher Variability Comparison of Benchmark Index Return Volatility Quarterly Change in Value 2.5%

LAIF 2.0%

1‐3 Yr Government Benchmark 1‐5 Yr Government Benchmark

Quarterly Total Rate of Return

1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0%

Source: Index return information provided by Bank of America Merrill Lynch; California State Treasurer Local Agency Investment Fund (LAIF). Index returns assume reinvestment of all distributions and unlike mutual funds, do not reflect fees or expenses. It is not possible to invest directly in an index.

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Yield to maturity

■ Yield refers to the income you receive on your bond. ■ There are many different ways of calculating yield. ■ Yield to maturity is the most common yield measure used to determine the expected return of a coupon paying bond ■ Measures the average rate of return that will be earned on a bond bought now and held to maturity ■ Assumes all coupon payments will be reinvested at the same interest rate as the yield to maturity ■ This is an unrealistic assumption and makes it likely that the actual realized return will differ from the yield to maturity at time of purchase

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Evaluating return

■ Yield: income from current and new investments + projection of income from reinvestment ■ Used to project income for line item in next years budget ■ Does not reflect the outcome of portfolio decisions ■ Realized return: Actual income plus realized gains and losses ■ Used to measure the realized level of income from the portfolio ■ No realized yield benchmark ■ Return information can be distorted

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Total rate of return

■ Total rate of return (TRR) measures the outcome of the portfolio ■ Incorporates all three elements of return ■ Interest income ■ Market value gains and losses – realized and unrealized ■ Reinvestment of interest ■ Agreed upon industry standard ■ Uniformly applied to all portfolios ■ To provide comparable, consistent results

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Calculation of total return

(Ending Market Value) – (Beginning Market Value) Beginning Market Value Ending MV = MV on the last day of measurement period including accrued interest Beginning MV = MV of the FIRST day of the measurement period plus accrued interest

(24,999,044*) – (24,787,352) 24,787,352

=

0.85%

*If there are contributions or withdrawals during the measurement period, they must be accounted for in the calculation. Most investors rely on computer systems to make accurate TR calculations. 26

Total rate of return aids portfolio management

■ Always puts your performance in perspective, given market conditions

■ Can manage the governing body’s expectations

■ Demonstrates how the interest rate environment is impacting the portfolio

■ Is consistent with GASB 31 reporting

■ Are our objectives in alignment with our tolerance for market volatility?

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The Earnings Rate Matters

■ The earnings rate helps to estimate the growth of the portfolio ■ The growth of the portfolio helps to pay for future liabilities

■ Underestimating the earnings rate can create a funding shortfall

■ What is the appropriate time period for earnings?

■ Does history have a roll in forecasting future returns?

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Rolling Return Estimates Using the 5 year US Treasury constant maturity yield does not provide a very accurate estimate of the 5 year rolling Total Rate of Return. Actual 5 Yr TRR, 5 Yr US Treas Yield 8.00% 7.00% 6.00% 5.00% Thru August

4.00% 3.00% 2.00% Thru August

1.00% 0.00%

5 Yr Treas CM Yld to est future return

Actual 5 yr TRR 29

Developing A Rolling Return Estimate  Incorporating historical return information and future earnings estimate

 Seeking an effective estimate of future returns

1 Yr Total Rate of Return 3 Yr Total Rate of Return 5 Yr Total Rate of Return Purchase Yield Market Yield Future Earnings Estimate

Portfolio 2.87% 3.29% 5.06% 2.09% 0.83% 1.46%

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Required Future Return

 For a given discount rate, what do we need to earn in the future?

Discount Rate 3 Year Historical Total Rate of Return Required  2 year return to meet discount rate

3.50% 3.29% 3.82%

2.50% 3.29% 1.33%

1.50% 3.29% ‐1.13%

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Finding an Reasonable Discount Rate The 3 year historical return and the 2 year future return estimate have an expected return of about 2.50%

Historical 3 Year TRR Future Return Estimate 5 year Rolling Return Estimate Reasonable Discount Rate 

3.29% 1.46% 2.55% 2.50%

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Rolling Return Estimates Estimate of the future 5 year rolling Total Rate of Return using a combination of Purchased Yield, Market Yield, and historical 3 year Total Rate of Return. Estimated 5 year TRR 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00%

2 Yr Est Portfolio avg Purch/Mkt Yld & 3 yr TRR 33

Rolling Return Estimates The combination of historical returns and estimated future earnings may help provide a relatively stable and effective tool to help a pool manage funding estimates for future liabilities. Estimated 5 year TRR, Actual 5 Yr TRR, 5 Yr US Treas Yield 8.00% 7.00% 6.00% 5.00% Thru August

4.00% 3.00% 2.00% Thru August

1.00% 0.00%

2 Yr Est Portfolio avg Purch/Mkt Yld & 3 yr TRR

5 Yr Treas CM Yld to est future return

Actual 5 yr TRR

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Conclusions

■ Forecasting is an estimate, not an absolute ■ Known facts can help improve your forecast - better than a SWAG ■ Segmentation of the portfolio can help meet objectives of sufficient liquidity and long term returns ■ Matching the duration of assets and liabilities reduces the chance of having funding shortfalls ■ An appropriate performance

benchmark

helps

control

risk

and

evaluate

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More conclusions

■ Rule of Thumb: higher risk creates higher return and higher volatility ■ Return ■ Yield gives you information about income ■ Total rate of return includes information about income as well as realized and unrealized gains and losses ■ Total rate return provides information about portfolio outcomes

■ Incorporate a discount rate that reflects reasonable return expectations and adjust as market conditions change ■ Past performance does not guarantee future results

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A/L Management Investment Program

Establish A/L Management as Objective Monitor, Review, Adjust

Identify Risks, Set Policy, Determine Benchmark, Strategy

Match Investments to Liabilities

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SECTION 5

Biography and Disclosures

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Biographies

Martin Cassell, CFA CEO, Chief Investment Officer

Martin Cassell is the chief executive and investment officer at Chandler Asset Management and is a principal of the firm. Mr. Cassell is responsible for defining, planning, and directing company programs. He heads implementation of the firm’s investment strategies and portfolio risk management. He designed the proprietary quantitative models that drive our investment process, establishing duration, structure, and asset allocation throughout client portfolios. Mr. Cassell joined Chandler Asset Management in 1991 from the City of San Diego where he managed a $1 billion fixed income portfolio. He began his investment career in 1987 managing portfolios at World Savings and Loan. Mr. Cassell received his B.S. in finance from California State University, Hayward. He is a member of the CFA Society of San Diego and holds the designation of Chartered Financial Analyst. He is also a member of the California Association of Joint Power Authorities (CAJPA) finance committee.

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Disclosures Past performance is not indicative of future results. The information herein is provided for informational purposes only and should not be construed as a recommendation of any security, strategy or investment product, nor an offer or solicitation for the purchase or sale of any financial instrument. References to investment indices are for informational purposes and do not imply that managing portfolios to those styles will achieve comparable returns. Indices do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical performance results. Indices are unmanaged, and one cannot invest directly in an index. Any forecasts, forward-looking statements and assumptions are inherently limited and should not be relied upon as an indicator of future results. Any opinions and views constitute judgments made by the author at the date of this presentation and may become outdated or superseded at any time without notice. Any statements concerning financial market trends are based on current market conditions, which will fluctuate. Economic factors, market conditions and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark. The data contained in this presentation is the property of those providers, which were obtained from sources believed to be reliable, but are subject to change at any time at the provider’s discretion. Unless otherwise noted, Chandler is the source of illustrations, performance data, and characteristics contained in this presentation. This presentation contains the current opinions of the author, which are subject to change without notice. Any statements concerning financial market trends are based on current market conditions, which will fluctuate. Forecasts and assumptions are inherently limited and should not be relied upon as an indicator of future results. Unless otherwise noted, Chandler is the source of the tables, graphs, performance data and characteristics contained in this presentation.

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