the massachusetts alm program

The Massachusetts ALM ProgramReducing Risk from a Global Balance Sheet Perspective

June 2014

This presentation has been prepared by the Commonwealth of Massachusetts to provide summary information relative to the general obligation credit of the Commonwealth. The presentation is incomplete. The presentation is not part of the Commonwealth’s Information Statement (Information Statement) and is qualified in all respects by reference to the most recently updated Information Statement that has been filed with the Municipal Securities Rulemaking Board through its Electronic Municipal Market Access (EMMA) system.

Investment decisions relating to Commonwealth general obligation bonds and notes should be based only upon the most recently updated Information Statement and the Official Statement of the Commonwealth relating to such bonds or notes. The provision of access to this presentation does not constitute an offer to sell or the solicitation of an offer to buy any bonds or notes that may be described or mentioned in the presentation. Commonwealth bonds and notes are sold only by means of an Official Statement and through registered broker-dealers.

The information set forth herein includes information obtained from non-Commonwealth sources that are believed to be reliable, but such information is not guaranteed as to accuracy or completeness and is not to be construed as a representation by the Commonwealth. All information and expressions of opinion herein are subject to change without notice. The Commonwealth undertakes no obligation to provide any additional information or to update any of the information or the conclusions contained herein or to correct any inaccuracies that may become apparent.

This presentation contains certain forward-looking statements that are subject to a variety of risks and uncertainties that could cause actual results to differ from the projected results, including without limitation general economic and business conditions, conditions in the financial markets, the financial condition of the Commonwealth and various state agencies and authorities, receipt of federal grants, litigation, arbitration, force majeure events and various other factors that are beyond the control of the Commonwealth and its various agencies and authorities. Because of the inability to predict all factors that may affect future decisions, actions, events or financial circumstances, what actually happens may be different from what is set forth in such forward-looking statements. Forward-looking statements are indicated by use of such words as “may,” “will,” “should,” “intends,” “expects,” “believes,” “anticipates,” “estimates” and others.

Table of Contents

1) Executive Summary2) Balance Sheet Risk3) Asset/Liability Management4) The Pro Forma Massachusetts Five-Year ALM Program5) Program Risk6) Series 2014 C Financing7) Conclusion

Executive Summary

Executive Summary

• Like every state, the Commonwealth of Massachusetts (the “Commonwealth” or the “state”) has significant assets and liabilities that are exposed to changes in market interest rates

• To proactively reduce interest rate risk, the Commonwealth has adopted Asset/Liability Management (or “ALM”) as its long-term strategy for debt financing and balance sheet management

• ALM is a bedrock interest rate risk management framework utilized by insurance companies, banks, and other large financial institutions for the last three decades

• Massachusetts’ goal is to reduce interest rate risk proactively, like its private sector peers, by following ALM and creating a natural hedge between assets and liabilities to reduce interest rate risk and significantly reduce cash flow volatility with respect to the state’s operating budget

5

Executive Summary

• To create a naturally hedged balance sheet, the Commonwealth will prudently add variable-rate bonds – instead of 100% fixed-rate bonds – to its debt portfolio over the next five years to offset the interest rate risk of its floating-rate assets

• While risk reduction is the purpose and outcome of implementing the ALM program, the act of reducing interest rate risk does not inherently mean that the state is accepting reduced revenues/income/returns

• In fact, the Commonwealth expects the implementation of the ALM program to provide a number of long-term credit positives: Reduce cash flow volatility significantly, improving budget performance through

all business cycles Reduce interest costs due to the use of additional variable-rate debt in an

upwardly sloping yield curve environment Return control of the balance sheet to Commonwealth managers Instill an enhanced level of interest rate risk measurement, monitoring and

reporting by Commonwealth managers

6

Balance Sheet Risk

Introduction• The Commonwealth of Massachusetts’ goal is to be proactive in managing and

strengthening its balance sheet so that its ability to provide services to its citizens, and its ability to maintain its strong credit, is sustained over the long-term

• Like other large governments, Massachusetts has billions of dollars in assets and liabilities that are exposed to changes in interest rates that can ultimately impact the state’s operating budget Assets include operating cash and the reserve fund’s short-term investments Liabilities include debt obligations used to fund the capital budget

• One widely understood lesson of the recent financial crisis has been that governments and financial institutions should avoid explicit bets on the direction of interest rates which could magnify the interest rate exposure to their balance sheets

• Equally important, though not as obvious, is the need to avoid implicit bets on interest rates caused by the structure of their asset and liability portfolios

• Over the next five years, Massachusetts is taking steps to ensure that its balance sheet is not explicitly or implicitly “betting” on the direction of interest rates

8

Global Balance Sheet Risk: Assets• On the asset side of the state’s balance sheet, interest rate risk is the risk to the operating budget

arising from a decline in interest rates• Should interest rates decline, investment income would also decline, affecting the amount of revenues

available to support the budget• With annual revenues of nearly $35 billion, the Commonwealth maintains a significant portfolio of

cash and short-term investments that provides liquidity to the operation of state government• Average monthly operating cash balances in FY 2014 are projected to be nearly $1.5 bn• Over the last ten years, the state’s annual year-end balance of cash and short-term investments has

averaged more than $3.2 billion*

9

* Source: Government Fund Balance Sheet in the Comprehensive Annual Financial Report FY2004-2013 representing core operating cash and investments; totals do not include assets of the MSBA; the balance for FY2014 is projected

FY($’s

in Billions)2004 $3.5462005 3.7482006 4.3242007 3.6122008 3.8472009 2.2422010 1.6622011 3.1432012 3.2652013 2.953

2014 (Proj.) 3.169Average $3.228

Invested Cash Balance Invested Cash Balance

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 (Proj.)

($'s

in B

illion

s)

Fiscal Year

---0.1 0.1

--- --- 0.1

0.20.3

0.4 0.40.5

0.8

1.2

1.4

1.61.7

0.9

0.6

1.1

1.7

2.2

2.3

2.1

0.8

0.7

1.4

1.71.6

1.4

0.0

0.5

1.0

1.5

2.0

2.5

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

($'s

in B

illio

ns)

Fiscal Year

Global Balance Sheet Risk: Assets• In addition to operating funds, the state maintains a Budget Stabilization Fund that currently has one

of the highest balances in the country Since its creation in 1986, the average annual balance of the Budget Stabilization Fund is nearly

$1 bn Over the last ten years, the average balance is close to $1.6 bn

• The fund is a long-term reserve with asset balances that will remain exposed to interest rate risk

10

Stabilization Fund Balance (at FY End)

(Proj.)

Global Balance Sheet Risk: Assets• The Commonwealth’s cash and short-term investments are invested in the

Massachusetts Municipal Depository Trust (“MMDT”), as well as in local banks

11

Structured like SEC 2a-7 fund Diversified portfolio of high quality

money market instruments Seeks to maximize current income while

preserving capital investment Aims to maintain sufficient liquidity to

meet reasonably foreseeable participant redemption activity

Portfolio Composition− CP/Notes: 44.8%− Bank Instruments: 21.8%− Variable-Rate Instruments: 18.6%− Repos: 14.8%

Credit Quality Composition− First Tier: 96.8%− Second Tier: 3.2%

Weighted Average Maturity: 41 Days Current Daily Gross Yield: 0.23% Current Daily Net Yield: 0.18%

MMDT Cash Portfolio

Approximate Current Balance:$2.96 Billion

Invested in bank account Facilitates daily business transactions Provides daily liquidity

Cash on Hand

Approximate Avg. Daily Balance:$300.0 Million

Diversified portfolio of investment grade short-term fixed income securities

Seeks to generate long-term performance exceeding the Barclays 1.5 Year Gov’t/Credit Bond Index

Fixed income alternative with longer-term horizon than the MMDT Cash Portfolio

Portfolio Composition− AAA: 61.1%− A: 15.3%− BBB: 15.1%− AA: 5.9%− Cash/Cash Equivalents: 2.6%

Weighted Average Maturity: 2.4 Years Weighted Average Coupon: 1.8% Weighted Average YTM: 0.9%

MMDT Short-Term Bond Portfolio

Approximate Current Balance:$260.0 Million

Recent initiative to shift state deposits to qualifying Massachusetts banks to promote small business loans

Approximately 8,300 current loans from 54 participating banks

Current Yield: 0.23%

Small Banking Business Partnership

Approximate Current Balance:$358.8 Million

Note: Portfolio stats as of April 30, 2014 Note: Portfolio stats as of April 30, 2014

** Current balances as of May 31, 2014

Global Balance Sheet Risk: Assets• Both operating and reserve funds are invested by the Commonwealth in an

appropriately conservative manner• The goals of the Commonwealth’s investment team are to:

1) Protect principal,2) Maintain liquidity for the Commonwealth, and3) Earn yield

• As a result, most of the Commonwealth’s investments are kept short and fairly liquid• This makes the state’s asset portfolio very sensitive to changes in interest rates• For example, since FY2004 the largest annual investment return to the budget

generated by the asset portfolio in a single fiscal year was an estimated $224.9 mm (FY2006)

• Annual investment income dropped significantly, however, to an estimated $5.7 mm only four years later when the economy entered recession

• Why? In FY2010, market interest rates were lowered by the Fed and the state spent-down

a portion of its cash reserves as a result of a decline in revenue collections The decline in investment revenue between FY2006 and 2010 was nearly 100%

12

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

Jan-90 Mar-92 May-94 Jul-96 Sep-98 Nov-00 Jan-03 Mar-05 May-07 Jul-09 Sep-11 Nov-13

Global Balance Sheet Risk: Assets

• For all states with short-term assets, the exposure to interest rates is an asymmetric risk• Looking at Massachusetts data over the last two recessions, there is a strong correlation

between when short-term interest rates decline significantly and when the state experiences sharp declines in tax revenue collections

• The decline in tax revenues during the last two recessions also led to draw-downs of reserves• The combination of lower rates and lower asset balances led to lower investment income for

the operating budget at the at the worst possible time – during a recession

13

0%

1%

2%

3%

4%

5%

6%

7%

10

12

14

16

18

20

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1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

3M L

IBO

R

Budg

etar

y Ta

x C

olle

ctio

ns ($

's in

Mill

ions

)

Fiscal Year

Budgetary Tax Collections3M LIBOR

3M LIBOR vs. MMDT 3M LIBOR vs. Budgetary Tax Collections

Global Balance Sheet Risk: Liabilities

• On the opposite side of the balance sheet, the state has outstanding billions of dollars of debt liabilities to investors who have purchased state bonds that are used to fund Massachusetts’ public infrastructure needs

• For the debt liabilities, the state’s interest rate risk is the risk to the operating budget that arises from an increase in interest rates – the exact opposite of the interest rate risk facing the asset portfolio

• Should interest rates increase, debt service costs on unhedged variable-rate bonds would increase, affecting the budget by enhancing the amount of expenditures the state must make in a given fiscal year

14

Global Balance Sheet Risk: Liabilities

• As of May 31, 2014, the Commonwealth had $19.1 bn in General Obligation (G.O.) bonds outstanding

• Over the last 30 years, debt managers have tried to be conservative in how they structure debt liabilities by selling mostly fixed-rate bonds that pose no interest rate risk to the state following the issuance

• For example, of the total amount of G.O. bonds outstanding, only $917.7 mm is unhedged variable-rate debt

• This represents only 4.8% of all outstanding G.O. bonds outstanding

15

Global Balance Sheet Risk: Liabilities• The Commonwealth has used variable-rate debt in its capital program since 1990• Because of the risk associated with these structures, the variable-rate portfolio is

proactively managed• Since 2008, the portfolio has become more diversified in terms of bond structure,

and less reliant on third-party liquidity support, with stronger liquidity providers

16

• The variable-rate portfolio includes seven different bond structures, with no single product making up more than 25% of the overall portfolio

• “Put” risk and the reliance on third-party liquidity has been intentionally reduced by nearly $2.4 bn since 2008

9.7%5.3%

10.7%

20.3%23.7%

18.3%

12.0%

Variable-Rate Debt Portfolio by Product (Post-Series 2014 C Issuance)

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

ARS CPI Bonds Direct Purchases LIBOR IndexBonds

SIFMA IndexBonds (HardMaturities)

SIFMA IndexBonds (Step-Up)

VRDBs

($'s

in M

illion

s)

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2014 2015 2016 2017 2018

Unh

edge

d Va

riabl

e-R

ate

Deb

t as

% o

f Tot

al D

ebt

Unh

edge

d Va

riabl

e-R

ate

Deb

t ($'

s in

Milli

ons)

Fiscal Year

Global Balance Sheet Risk: Liabilities• Compared to the state’s interest rate-sensitive assets, the amount of unhedged variable-rate debt liabilities is

relatively small Over the last decade, the largest balance of unhedged variable-rate debt outstanding in a fiscal year was

roughly $1.1 bn (FY2006 to 2008) For FY2014, the amount of unhedged variable-rate debt is a projected $917.7 mm

• Further, the existing variable-rate portfolio is very short If the Commonwealth does not issue additional variable-rate bonds over the next five years, the amount of

unhedged variable-rate debt outstanding as a percentage of total debt will decline to just 3.2%

17

Projected Unhedged Variable-Rate Debt through FY2018

4.7%

4.2%3.9%

3.8%

3.2%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

($'s

in B

illion

s)

Fiscal Year

Invested Cash BalanceUnhedged Variable-Rate Debt

• In looking at the two portfolios from a global perspective, it is clear that the Commonwealth’s balance sheet is exposed to interest rate risk

• Over the last decade, assets have averaged $3.2 bn per fiscal year while the amount of unhedged variable-rate debt outstanding has averaged only $747 mm

• In the graph below, the imbalance between cash balances and unhedged variable-rate debt is pronounced

Global Balance Sheet Review

18

Invested Cash Balance vs. Unhedged Variable-Rate Debt


• How does this imbalance occur? • Over time, investment and debt managers have likely structured their respective

portfolios independently in the most conservative way Cash is invested in short-term investments to minimize principal risk and

provide sufficient liquidity to support the government’s operations Debt is structured as 100% fixed-rate, or nearly 100%, to eliminate interest rate

risk• While each manager is trying to be prudent and conservative, the combined set of

decisions is actually very risky for a government• In short, the duration of short-term assets (investments) is mismatched to the

duration of long-term liabilities (fixed-rate debt)• This is not unique to Massachusetts state government

19


• If each of the two portfolios have been structured conservatively, why is there any risk for the state?

• The combination of the structure of these two portfolios creates an unintended, implicit bet that interest rates will always continue to rise

• If rates were to rise, investment income would also rise and debt service costs would remain stable since the interest costs are fixed or mostly fixed

• However, if interest rates were instead to fall, the state would experience reduced interest income while debt service costs would remain stable

• Though the interest rate risk is unintended, given the size the balance sheet, the public dollars at stake can be large and can have a significant budgetary impact

20

Note: Analysis utilizes 3M LIBOR as the taxable investment index for assets, SIFMA + 30 bps as the tax-exempt index for the state’s unhedged variable-rate debt, and the 10-year average of 20-year MMD + 30 as the tax-exempt index for the state’s fixed-rate debt

Assets LiabilitiesOutstanding Balance Interest Cost

FY

Invested Cash

Balance Earnings

Fixed-Rate & Hedged

Variable-Rate Debt

Unhedged Variable-Rate Debt Total

Fixed-Rate & Hedged

Variable-Rate Debt


NetCash Flow

2004 3,546,988$ 57,655$ 15,476,348$ 485,078$ 15,961,426$ 650,007$ 7,435$ 657,441$ 599,786$ 2005 3,747,939 134,041 15,640,262 768,164 16,408,426 656,891 21,238 678,129 544,089 2006 4,324,356 224,932 16,066,184 1,116,148 17,182,332 674,780 41,832 716,612 491,680 2007 3,611,729 191,261 16,374,858 1,113,353 17,488,211 687,744 43,658 731,402 540,141 2008 3,846,883 112,840 15,084,673 1,110,228 16,194,901 633,556 28,196 661,752 548,911 2009 2,242,429 15,471 16,844,160 401,804 17,245,964 707,455 2,851 710,305 694,834 2010 1,661,871 5,707 17,466,048 416,179 17,882,227 733,574 2,351 735,925 730,219 2011 3,142,586 10,642 18,393,301 427,108 18,820,409 772,519 2,048 774,567 763,925 2012 3,264,656 14,032 18,293,357 558,181 18,851,538 768,321 2,587 770,908 756,875 2013 2,952,581 7,895 18,240,843 899,396 19,140,239 766,115 3,525 769,640 761,746 2014 3,169,000 7,420 18,187,998 917,667 19,105,665 763,896 3,258 767,154 759,734

Total 781,896$ 7,814,857$ 158,979$ 7,973,836$ 7,191,940$


• Using average annual interest rates for each year, the table below approximates annual net cash flow for the Commonwealth’s two balance sheet portfolios

• As interest rates declined, the state sustained a decline in investment income that was not offset by decreased interest cost on unhedged variable-rate debt

21

Actual Net Cash Flow ($’s in 000s)Average Annual Rates

FY

Investments (3M

LIBOR)

Variable-Rate Debt

(SIFMA + 30 bps)

2004 1.63% 1.23%2005 3.58% 2.46%2006 5.20% 3.45%2007 5.30% 3.62%2008 2.93% 2.24%2009 0.69% 0.41%2010 0.34% 0.27%2011 0.34% 0.18%2012 0.43% 0.16%2013 0.27% 0.09%2014 0.23% 0.06%

Note: Analysis utilizes 3M LIBOR as the taxable investment index for assets, SIFMA + 30 bps as the tax-exempt index for the state’s unhedged variable-rate debt, and the 10-year average of 20-year MMD + 30 as the tax-exempt index for the state’s fixed-rate debt

• Using average annual interest rates for each year, the table below approximates annual net cash flow assuming the Commonwealth’s unhedged variable-rate debt had hedged its invested cash

• The lost opportunity to Massachusetts of a naturally hedged balance sheet is estimated at over $1 bn since FY2004


22

Net Cash Flow Comparison: Actual vs. Assuming Perfect Hedge ($’s in 000s)Average Annual Rates

FY

Investments (3M

LIBOR)

Variable-Rate Debt

(SIFMA + 30 bps)

2004 1.63% 1.23%2005 3.58% 2.46%2006 5.20% 3.45%2007 5.30% 3.62%2008 2.93% 2.24%2009 0.69% 0.41%2010 0.34% 0.27%2011 0.34% 0.18%2012 0.43% 0.16%2013 0.27% 0.09%2014 0.23% 0.06%

Assets Liabilities Assuming Perfect HedgeOutstanding Balance Interest Cost

FY

Invested Cash

Balance Earnings

Fixed-Rate & Hedged

Variable-Rate Debt


Fixed-Rate & Hedged

Variable-Rate Debt


NetCash Flow Assuming

Perfect Hedge

Actual Net Cash Flow

Cost of Unbalanced

Portfolio

2004 3,546,988$ 57,655$ 10,745,267$ 5,216,159$ 15,961,426$ 451,301$ 79,945$ 531,246$ 473,591$ 599,786$ 126,195$ 2005 3,747,939 134,041 10,896,751 5,511,675 16,408,426 457,664 152,387 610,051 476,010 544,089 68,079 2006 4,324,356 224,932 10,822,985 6,359,347 17,182,332 454,565 238,341 692,906 467,975 491,680 23,705 2007 3,611,729 191,261 12,176,845 5,311,366 17,488,211 511,427 208,277 719,705 528,443 540,141 11,698 2008 3,846,883 112,840 10,537,720 5,657,181 16,194,901 442,584 143,671 586,255 473,414 548,911 75,497 2009 2,242,429 15,471 13,948,274 3,297,690 17,245,964 585,828 23,395 609,222 593,752 694,834 101,083 2010 1,661,871 5,707 15,438,299 2,443,928 17,882,227 648,409 13,808 662,217 656,510 730,219 73,709 2011 3,142,586 10,642 14,198,959 4,621,450 18,820,409 596,356 22,165 618,521 607,879 763,925 156,046 2012 3,264,656 14,032 14,050,573 4,800,965 18,851,538 590,124 22,251 612,375 598,342 756,875 158,533 2013 2,952,581 7,895 14,798,208 4,342,031 19,140,239 621,525 17,017 638,542 630,647 761,746 131,098 2014 3,169,000 7,420 14,445,371 4,660,294 19,105,665 606,706 16,544 623,250 615,830 759,734 143,904

Total 781,896$ 5,966,489$ 937,801$ 6,904,290$ 6,122,394$ 7,191,940$ 1,069,546$

Asset/Liability Management

Expected Benefits of the ALM Program

• Massachusetts has spent the last two years analyzing its portfolio of rate-sensitive assets and liabilities, measuring how they interact and how best their singular risks could be hedged by taking a global view of interest rate risk as debt financing structures are considered for the state’s new-money needs

• Ensuring that the state’s balance sheet is protected from movements in interest rates is a primary goal within the state’s bond financing program

• Instead of focusing on an interest rate forecast, or trying to time the market, the Commonwealth will structure its debt liabilities going forward to achieve Asset/Liability Management (or “ALM”)

• What is ALM? ALM is the continuous process of actively managing assets, liabilities and

financial risks together in an effort to maximize cash flow, limit cash flow variance, and limit risk

24

Reduce Risk Through an ALM Program

• Achieving a balance between rate-sensitive assets and liabilities does not occur organically

• It will require the Commonwealth to utilize variable-rate bonds on a regular basis as it funds the state’s capital plan through FY2018, rather than issue 100% fixed-rate bonds

• Although it is somewhat counterintuitive that adding variable-rate exposure to one side of the balance sheet reduces interest rate risk, from a global balance sheet perspective that is exactly what happens

• ALM allows the state to incrementally improve its balance sheet over time through how bond structuring, with the goal of reducing cash flow volatility over the long-term

25

• For the ALM program, what does it take to achieve a natural hedge?• The first step in the ALM program is to calculate the state’s interest rate exposure to the operating budget

Assets: Includes interest rate-sensitive assets like cash and short-term investments, but does not include assets like physical plant

Liabilities: Includes variable-rate bonds, but does not include fixed-rate bonds or hedged variable-rate bonds

• When in an ALM balance, both sides of equation C should be equal• Without the ability to “fix-out” its assets to reduce risk, the state has to instead increase the amount of variable-rate

debt in the liability portfolio

Reduce Risk Through an ALM Program

26

∆ AssetEarnings = ∆ Debt Service

on Liabilities

= ∆ BorrowingCostLiabilities X∆ Earnings

RateAssets X

AssetsLiabilities

=∆ Borrowing Cost∆ Earnings Rate

Measuring ALM

A

B

C

Reduce Risk Through an ALM Program• How much variable-rate exposure must be added to achieve ALM balance?• The second step in determining how a hedged balance sheet can be achieved is to control for the basis

differential between taxable and tax-exempt interest rates • Because tax-exempt borrowing rates on bonds are generally lower than taxable rates on investments, to

produce a more effective hedge the state likely needs to have outstanding more variable-rate liabilities than floating-rate assets

• Using ten-year averages of asset balances and the tax-exempt-to-taxable ratio, the Commonwealth would need to target a level of approximately $4.7 bn of unhedged variable-rate exposure to be in ALM balance by FY2019

27

Variable-Rate Exposure Sensitivity

SIFMA 3M LIBORSIFMA/

3M LIBORTargeted Variable-

Rate ExposureCurrent 0.100% 0.220% 45.5% $7,040,000,0005-Year Average 0.187% 0.348% 53.8% $5,952,940,71310-Year Average 1.377% 2.036% 67.7% $4,729,711,18320-Year Average 2.149% 3.291% 65.3% $4,901,118,762Note: Current rates as of May 7, 2014

Commonwealth Assets (10-Year Average) $3,200,000,000SIFMA/3M LIBOR Ratio Multiplier (10-Year Average) 1/.68 = 147.1%Targeted Variable-Rate Exposure for Asset/Liability Hedge $4,729,711,183

Calculation of Targeted Variable-Rate Exposure

$4.7 bn is the state’s five-year ALM

target

Borrowing Scenarios for the FY2014-18 CIP

• The Commonwealth has thoroughly tested the impact of more variable-rate debt in the context of its five-year CIP, which totals approximately $10.7 bn

• Two scenarios were evaluated: (i) borrow 100% fixed-rate bonds vs. (ii) borrow $3.6 bn of variable-rate bonds in accordance with ALM, with the remainder done as fixed-rate bonds

28

FY

Scenario (i):100% Fixed-Rate Bonds

Scenario (ii):Include $3.6 Billion of Variable-Rate Bonds

Fixed-Rate Bonds

Variable-Rate Bonds Total

Fixed-Rate Bonds

Variable-Rate Bonds Total

2014(Completed)

$1,227,495,000 $--- $1,227,495,000 $1,227,495,000 $--- $1,227,495,000

2014(Remaining)

600,000,000 --- 600,000,000 100,000,000 500,000,000 600,000,000

2015 2,125,000,000 --- 2,125,000,000 1,350,000,000 775,000,000 2,125,000,0002016 2,250,000,000 --- 2,250,000,000 1,475,000,000 775,000,000 2,250,000,0002017 2,250,000,000 --- 2,250,000,000 1,475,000,000 775,000,000 2,250,000,0002018 2,250,000,000 --- 2,250,000,000 1,475,000,000 775,000,000 2,250,000,000Total $10,702,495,000 $10,702,495,000 $7,102,495,000 $3,600,000,000 $10,702,495,000

Summary of Borrowing Scenarios for the FY2014-2018 CIP

Note: The $3.6 bn of new variable-rate debt issuance assumes the $500 mm expected to be issued with the 2014 Series C financing; in addition to the $3.6 bn of variable-rate issuance detailed above, we have also assumed the Commonwealth exercises its right in 2017 to cancel an existing floating-to-fixed interest rate swap at no cost on the Series 2007 A LIBOR Index Bonds

Reduce Cash Flow Volatility• The table below stress-tests the cash flow impact of a change in rates assuming the state

has achieved an ALM balance by FY2019• Once ALM is achieved, the state’s budget/cash flow volatility is reduced significantly

For a 400-basis point movement in either direction, the net impact to the operating budget is nearly zero

29

FY2019 Net Debt Service Analysis

Volatility is reduced by $108 million

Current RatesSensitivity

#1Sensitivity

#2Sensitivity

#3Increase to 1M & 3M LIBOR N/A +100 bps +200 bps +400 bpsIncrease to SIFMA N/A +68 bps +136 bps +272 bpsScenario (i): 100% Fixed-Rate BondsFY 2019 Net Debt Service $2,096,890,951 $2,069,489,471 $2,042,087,991 $1,987,285,030Absolute Change in Cash Flow N/A $27,401,480 $54,802,960 $109,605,921Scenario (ii): Include $3.6B of Variable-Rate DebtFY 2019 Net Debt Service $1,967,838,082 $1,967,485,859 $1,967,133,636 $1,966,429,190Absolute Change in Cash Flow N/A $352,223 $704,446 $1,408,892

Note: Includes debt service on existing and new fixed-rate and variable-rate bonds, as well as the net cash flow of existing interest rate swaps and investment earnings

** Magnitude of the interest rate stress tests are based on guidance provided in The Comptroller of the Currency’s “Interest Rate Risk: Comptroller’s Handbook,” dated January 12, 2012

Reduce Interest Costs

• It is well-documented that over time, interest costs on variable-rate debt have been lower than interest costs on fixed-rate debt

• Over the long-term, with the yield curve upwardly sloping, replacing 100% fixed-rate debt with $3.6 bn of variable-rate debt (and thus only $7.1 bn of fixed-rate debt) is expected to reduce the Commonwealth’s interest costs

• As part of its five-year plan, the Commonwealth is targeting the use of variable-rate debt to fund its long-term borrowing needs; fixed-rate bonds are expected to be used in the intermediate part of the curve over this period

• Therefore, as it moves towards ALM balance, the state can achieve both budget savings and a reduction in volatility by matching assets and liabilities

30

• For example, assuming current rates and ratios, incorporation of variable-rate debt into the near-term capital plan could reduce average annual debt service by $78.2 mm and save over $2.7 bn through final maturity

• Assuming current rates, debt service savings through FY2018 total $289.0 mm

Note: Analysis includes debt service on existing and new fixed-rate and variable-rate bonds, as well as the net cash flow of existing interest rate swaps; FY 2014 debt service reflects remaining payments as of May 1, 2014

Scenario (i):100%

Fixed-Rate Bonds

Scenario (ii):Include $3.6B

of Variable-Rate Debt

Benefit of Increased Variable-Rate

ExposureNear-Term Debt Service (FY2014-18) $8,612,695,139 $8,323,669,307 $289,025,832Total Debt Service (FY2014-48) $40,499,926,850 $37,763,635,510 $2,736,291,340Average Annual Debt Service $1,157,140,767 $1,078,961,015 $78,179,752

Reduce Interest Costs

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Debt Service Analysis (Current Rates)

Reduce Interest Costs• Even when assuming rates revert back to their 20-year averages, the cost savings to

taxpayers could potentially exceed $1.2 bn through final maturity of the bonds expected to be issued through FY2018, all while reducing cash flow/budget volatility

• Analysis below assumes short-term rates revert to their 5-, 10- or 20-year averages at the beginning of FY2019, with an additional scenario based on forward rates

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SIFMA 1M LIBOR 3M LIBORSIFMA/

1M LIBORSIFMA/

3M LIBORCurrent 0.100% 0.150% 0.220% 66.7% 45.5%5-Year Average 0.187% 0.232% 0.348% 80.4% 53.8%10-Year Average 1.377% 1.885% 2.036% 73.1% 67.7%20-Year Average 2.149% 3.182% 3.291% 67.5% 65.3%

RateEnvironment

Scenario (i):100%

Fixed-Rate Bonds

Scenario (ii):Include $3.6B

of Variable-Rate DebtBenefit of Increased

Variable-Rate ExposureCurrent $40,499,926,850 $37,763,635,510 $2,736,291,3405-Year Average $40,503,983,571 $37,830,395,939 $2,673,587,63210-Year Average $40,560,522,658 $38,742,792,878 $1,817,729,78020-Year Average $40,594,526,522 $39,336,643,619 $1,257,882,903Forward Rates $40,696,872,748 $40,546,285,920 $150,586,828

Interest Rate Summary

Debt Service Savings Analysis (Total Debt Service, FY2014-48)

Note: Analysis includes debt service on existing and new fixed-rate and variable-rate bonds, as well as the net cash flow of existing interest rate swaps

Note: Current rates as of May 7, 2014

Return Control of the Balance Sheet

• Without hedging through ALM, control of the state’s balance sheet is effectively removed from the hands of the state’s managers

• The day-to-day decisions become irrelevant since significant swings (positive and negative) caused by changes in interest rates are outside of the state’s control and can impact investment income and debt service costs that both feed into the operating budget

• ALM returns control of the balance sheet to the Commonwealth’s managers• The debt financing team will follow ALM as its roadmap in terms of the structure of

its new bonds, knowing that such a strategy improves the state’s balance sheet• Rather than speculate, or try to time the market, or utilize variable-rate to reduce

interest costs in a one-off decision, the Commonwealth is following best practices of corporate finance to insulate its balance sheet from market risk

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Enhanced Level of Risk Management

• As noted previously, creating a natural interest rate hedge does not happen organically

• In following ALM, the state must continually be measuring, monitoring, and reporting on its interest rate risk from a global balance sheet perspective

• As part of its ALM program, a new ALM Committee (or “ALCO”) has been formed• ALCO members include members of the Treasurer’s Debt Management

Department, Cash Management Department, and Executive Office for Administration & Finance

• The ALCO will meet quarterly beginning on 6/30/2014 to measure and report on the net interest rate exposure facing the state’s balance sheet

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The Pro Forma Massachusetts Five-Year ALM Program

Pro Forma Five-Year ALM Plan

• Based on the ALM calculation, Massachusetts will need to target a level of $4.7 bn in variable-rate exposure by the end of FY2018 in order to reduce interest rate risk

• There are two ways for the Commonwealth to add variable-rate exposure: Issue variable-rate bonds – instead of issuing 100% fixed-rate bonds – to fund the

state’s capital plan over the next five years, or Reduce the amount of interest rate swaps that are currently hedging the interest

rates on $3 bn of outstanding variable-rate bonds • A combined approach could also efficiently achieve ALM balance• For example, the interest rate swap on the Commonwealth’s Series 2007 A LIBOR Index

Bonds provides the Commonwealth with a par call in 2017

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Targeted Variable-Rate Exposure at the End of FY2018

Expected Existing Unhedged Exposure at the End of FY2018 $651,095,000Optional Redemption of 2007A LIBOR-Based Swap in FY2017 400,000,000Variable-Rate New Money Borrowings 3,648,905,000Total Unhedged Variable-Rate Exposure at the End of FY2018 $4,700,000,000

Note: For illustrative purposes only, and subject to change

0

100

200

300

400

500

600

2015 2016 2017 2018

Par A

mou

nt ($

's in

Milli

ons)

Fiscal Year

MassDirect NotesFixed-Rate BondsVariable-Rate Bonds

Pro Forma Five-Year ALM Plan• It is important to note that the five-year plan is a flexible one that allows the Commonwealth

to incrementally modify its balance sheet over time rather than make a large and risky adjustment

• Based on the plan (and following the upcoming transaction), the Commonwealth will issue some form of variable-rate bonds for two of its expected four annual borrowings each year through FY2018

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Anticipated Remaining Borrowing Schedule for the FY2014-18 CIP

Q1-Q42016-2025

Q12016-2032

Q22036-2039, 2045

Q32016-2032

Q42036-2039, 2045

Q1-Q42017-2026

Q12017-2032

Q22035-2036, 2046

Q32017-2032

Q42035-2036, 2046

Q1-Q42018-2027

Q12018-2032

Q22034-2035, 2047

Q32018-2032

Q42034-2035, 2047

Q1-Q42019-2028

Q12019-2032

Q22032-2034, 2048

Q32019-2032

Q42032-2034, 2048

Pro Forma Targeted

Amortization



• The plan can be modified, delayed or extended based on the market and the movement in interest rates

• Adjustments to the ALM plan will account for various potential market movements• To a large extent, the state has bought itself some insurance against rates going

higher on the long-end because it has already issued a significant amount of long, fixed-rate bonds while rates have been historically low

• The average life of the portfolio has intentionally been lengthened over the last few years, which has allowed low long-term rates to be locked in and it has preserved variable-rate capacity going forward for when/if rates go higher

• Also, a change in asset balances – either an increase due to higher reserves or a draw-down – will alter the targeted amount of variable-rate exposure to achieve a hedged balance sheet

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0

100

200

300

400

500

600

700

800

2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048

Par A

mou

nt ($

's in

Milli

ons)

Fiscal Year

Projected Issuance - Variable-Rate Bonds

Already Issued Principal Amounts (FY2014)

Principal Amounts to be Issued (FY2014-18)


• While the Commonwealth retains complete structuring flexibility, in the current market there is a strategic preference to replace long fixed-rate bond issuance with variable-rate issuance Reduces overall weighted average cost of capital Comports nicely with the Commonwealth’s rolling retail offering and policy guidelines

39

STEP 1: Structure Variable-Rate Bonds in the Longest Maturities


0

100

200

300

400

500

600

700

800

2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048

Par A

mou

nt ($

's in

Milli

ons)

Fiscal Year

Projected Issuance - Variable-Rate Bonds

Projected Issuance - MassDirect Notes

Already Issued Principal Amounts (FY2014)

Principal Amounts to be Issued (FY2014-18)


• On the short end of the yield curve, the Commonwealth expects to structure bonds offered pursuant to the rolling retail program (“MassDirect Notes” or “MDNs”) for individual investors and governments

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STEP 2: Structure MassDirect Notes in the Shortest Maturities


0

100

200

300

400

500

600

700

800

2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048

Par A

mou

nt ($

's in

Milli

ons)

Fiscal Year

Projected Issuance - Variable-Rate BondsProjected Issuance - Other Fixed-Rate BondsProjected Issuance - MassDirect NotesAlready Issued Principal Amounts (FY2014)Principal Amounts to be Issued (FY2014-18)


• The final piece of the five-year bond structuring plan is to sell fixed-rate bonds in the short-to-intermediate part of the curve

• Based on this pro forma, the longest fixed-rate new money G.O. bond to be issued over the next five years will have a final maturity of 2032

41

STEP 3: Fill In Remaining Maturities with Other Fixed-Rate Bonds


0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

ARS CPI Bonds Direct PayLetter of Credit

DirectPurchases

LIBOR IndexBonds

Step-UpBonds/Put

Bonds

SIFMA IndexBonds (Step-

Up)

VRDBs

($'s

in M

illion

s)

Projected New MoneyExisting Portfolio

Pro Forma Five-Year ALM Plan• As part of its five-year plan, and as part of its variable-rate debt management policy, the

Commonwealth will add variable-rate exposure by utilizing prudent bond structures so that its debt portfolio remains diversified

• For example, based on the current portfolio of variable-rate products, to add $3.6 bn over the next five years the Commonwealth could use the following structures:

42

24.9%

Potential Pro Forma Product Mix (At the End of FY2018)1) Additional Step-Up Bonds

2) Put Bonds

3) Direct Pay Letter of Credit

4) Direct Purchase

5) VRDBs

• The five-year plan, and the variable-rate debt policy, also takes into account the outstanding hard maturity SIFMA Index Bonds and their incorporation into new variable-rate structures over the next three years

6.4% 2.8% 8.0%

20.9%

16.0%

8.0%

24.6%

13.3%

Note: Existing Portfolio accounts for bonds maturing through FY2018


0100200300400500600700800900

1,0001,1001,2001,3001,4001,5001,6001,7001,8001,9002,000

2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043 2045 2047

($'s

in M

illion

s)

Fiscal Year

New Variable-Rate Bonds - Unhedged

Existing Variable-Rate Bonds - Unhedged

Existing Variable-Rate Bonds - Hedged

• The Commonwealth’s existing variable-rate debt is relatively short• Further, accounting for the expected optional redemption of the Series 2007 A

swap in FY2017, the Commonwealth’s existing swaps have a final maturity FY2033


43

Amortization of Variable-Rate Debt by Hedge Exposure Summary

Endof FY

Hedged Variable-Rate Debt

Unhedged Variable-Rate Debt

$% of Total

Debt $% of Total

Debt2014 $2,593.8 13.2% $1,342.7 6.9%2015 2,434.1 11.8% 2,059.5 10.0%2016 2,216.5 10.3% 2,823.0 13.2%2017 1,540.2 6.9% 3,990.9 17.8%2018 1,474.2 6.4% 4,635.7 20.2%


Program Risks

Risks Associated with the ALM Program

• The introduction of additional variable-rate debt is not a riskless proposition• Market risk, the performance of variable-rate structures, investor demand for

variable-rate products, and execution risks are factors that the Commonwealth will have to consider regularly as it implements its ALM program

• It is important to keep in mind that the ALM program is solely intended to reduce risk

• If it becomes clear that the Commonwealth is exposed to more risk due to the ALM program and additional variable-rate debt, the program can be paused, delayed or stopped

• Risks will be considered on a regular basis by the ALCO

45


• When evaluating the program from a risk perspective, there are four gating questions that should be continually asked by the Commonwealth:1) Can management handle additional variable-rate debt?2) Can the portfolio handle additional variable-rate debt?3) Can the budget handle additional variable-rate debt?4) Can the credit handle additional variable-rate debt?

• These questions should be asked by the ALCO every quarter• If the answer to any one of these is “no,” the program and the ALM target will be

revisited

46


• Three management keys to mitigating risk associated with the implementation of an ALM program:

1) Flexibility: Keep the program flexible. Creating a natural hedge can occur in six or ten years, and does not have to occur by FY2019.

2) Proactive Management: Management should regularly be measuring and reporting on interest rate risk, as well as risks within the variable-rate debt portfolio, specifically. Long-term planning is really important.

3) Debt Management Policies: Management’s strategy, goals and limits should be captured in a debt management policy.

47

• The Commonwealth is a sophisticated borrower and will continue to track and respond to various market conditions over time

• The ALM strategy is fluid and management is prepared to adjust the balance sheet when prudent


48

Market Impact Strategy During Implementation Maintenance StrategyRates Increase (Parallel Shift) No impact Could decrease magnitude of programRates Decrease (Parallel Shift) No impact No impactYield Curve Steepens Accelerate No impactYield Curve Flattens Decelerate Could decrease magnitude of programTax-Exempt/Taxable Ratios Increase Reduce magnitude of program Could reduce magnitude of programTax-Exempt/Taxable Ratios Decrease Increase magnitude of program Could increase magnitude of program Invested Cash Balance Increases Increase magnitude of program Could increase magnitude of programInvested Cash Balance Decreases Decrease magnitude of program Decrease magnitude of programVariable-Rate Market Seizes Up Like it Did in 2008 Decelerate Could decrease magnitude of programBasel III Leads to Reduced Availability of Liquidity Product diversification

Potentially decelerate Product diversification Could decrease magnitude of program

Short-Term Rates Rise Precipitously Potentially decelerate (partially depends on long-term rate performance)

Potentially decrease magnitude (depends on absolute level of variable versus fixed-rates)

Commonwealth G.O. Rating is Downgraded Potentially no impact (partially depends on availability and cost of liquidity and alternative products)

Could decrease magnitude of program

Potential Debt Management Strategies in Different Market Environments

Series 2014 C Financing

Series 2014 C Financing• The Commonwealth plans to issue $500.0 mm of new money SIFMA Index Bonds in June using a Step-

Up structure, a first for the Commonwealth Although these represent the first Step-Up Bonds, the structure is only incrementally different to the

structures the Commonwealth has used in the past• Currently, the Commonwealth plans to structure the initial Step-Up Dates in 2 and 3 years• The 6-month call option prior to each Step-Up Date provides a significant window to successfully

remarket bonds

50

Summary of the Series 2014 C Financing**Subseries 2014C-1 Subseries 2014C-2

Par Amount $250,000,000 $250,000,000Amortization 2039-2044 2039-2044Step-Up Date June 1, 2016 June 1, 2017Optional Redemption Date December 1, 2015 December 1, 2016Step-Up Structure Bonds are subject to mandatory tender for purchase on the applicable Step-Up Date

If the Bonds are not remarketed/refunded on or prior to the applicable Step-Up Date, the Bonds shall pay interest at the Step-Up RateStep-Up Rate 8%Interest Payments Payable on the first Business Day of each month, beginning August 1, 2014

Interest rate resets weekly, effective Thursday Actual/actual basis

Tax Status Tax-exemptDenominations $5,000Pricing Tuesday, June 24, 2014

** Preliminary, and subject to change


• The Commonwealth intends to amortize its upcoming financing from FY2039 to 2044• This is consistent with its five-year plan to use variable-rate structures to fund the

state’s longest borrowing needs (with targeted principal amortization in years 20 through 30)

• Based on the below schedule, the state’s borrowing needs for FY2040 to 2044 for the next five years are exhausted with this financing, using the Executive Office for Administration & Finance’s so-called “2/3rd, 1/3rd” preferred amortization schedule

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Preliminary Amortization

Maturity Structure

Subseries2014C-1

(2-Year Step-Up Date)

Subseries2014C-2

(3-Year Step-Up Date) Total2039 Sinking Fund $29,900,000 $29,900,000 $59,800,0002040 Sinking Fund 35,450,000 35,450,000 70,900,0002041 Sinking Fund 39,525,000 39,525,000 79,050,0002042 Sinking Fund 43,805,000 43,805,000 87,610,0002043 Sinking Fund 65,800,000 65,800,000 131,600,0002044 Stated Maturity 35,520,000 35,520,000 71,040,000Total $250,000,000 $250,000,000 $500,000,000

June 2014S M T W T F S

1 2 3 4 5 6 7

8 9 10 11 12 13 14

15 16 17 18 19 20 21

22 23 24 25 26 27 28

29 30 Denotes pricing and closing


• The Commonwealth has flexibility to move bonds between the 2-year and 3-year Step-Up Dates

• The Commonwealth has the flexibility to up-size or down-size the transaction

52

Transaction Schedule: Mail POS: Friday, June 13 Receive Ratings: By Thursday, June 19 Pricing: Tuesday, June 24 Closing: Monday, June 30

Conclusion

Conclusion

• With the Series 2014 C variable-rate financing, the Commonwealth will be one of the first states to adopt the principles of asset/liability management as its long-term financing strategy

• Over the next five years, the Commonwealth will incrementally reduce its exposure to interest rate risk and position the state’s balance sheet for long-term stability

• As it moves toward ALM balance, the state can achieve both potentially significant budget savings and a meaningful reduction in cash flow volatility by matching assets and liabilities

• The five-year plan builds in flexibility so the state can prudently achieve a natural balance between assets and liabilities

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the massachusetts alm program

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