the merits of diversification in portfolio management · the merits of diversification in portfolio...
TRANSCRIPT
FIXED INCOME RESEARCH
The Merits of Diversification in
Portfolio Management
Intended for Institutional Clients Only
See Page 43 for Important Disclaimers & Disclosures
April 14, 2016
Ellis Phifer, CFA, CMT
Managing Director
(901) 579-4831
2
Objectives
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Broad Understanding of Diversification Theory
Implication for Public Sector Portfolio
Diversification Within the Agency Sector
Broader Asset Class Diversification
3
Diversification
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
4
Stock Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
0
1000
2000
3000
4000
5000
6000
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Stocks
Stocks
Stocks
Return 9.92%
St Dev 15.53%
MaxDD -50.95%
$100 becomes 4,868$
5
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Annual Returns
Stocks
Stock Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
6
0
500
1000
1500
2000
2500
3000
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Bonds
Bonds
Bond Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Bonds
Return 8.04%
St Dev 8.36%
MaxDD -15.79%
$100 becomes 2,394$
7
-20%
-10%
0%
10%
20%
30%
40%
50%
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Annual Returns
Bonds
Bond Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
8
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Annual Returns
Stocks Bonds
Stocks and Bonds
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
9
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Annual Returns
Stocks Bonds Blend
Blended Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
10
0
1000
2000
3000
4000
5000
6000
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Stocks Bonds
Blended Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
11
0
1000
2000
3000
4000
5000
6000
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Stocks Bonds
0
1000
2000
3000
4000
5000
6000
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Stocks Bonds Blend
Blended Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
12
Blended Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Stocks Bonds Blend
Return 9.92% 8.04% 9.37%
St Dev 15.53% 8.36% 9.14%
MaxDD -50.95% -15.79% -23.11%
$100 becomes 4,868$ 2,394$ 3,961$
13
0
1000
2000
3000
4000
5000
6000
7000
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Stocks Bonds Blend Full Diversified
Fully Diversified
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
T-Bills, S&P, Small Caps, Foreign Stocks, Emerging Markets, Treasuries, Corporates, Commodities, REIT,
Long Treasuries, Gold, Foreign Bonds
14
Diversified Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Stocks Bonds Blend Diversified
Return 9.92% 8.04% 9.37% 10.36%
St Dev 15.53% 8.36% 9.14% 7.98%
MaxDD -50.95% -15.79% -23.11% -29.74%
$100 becomes 4,868$ 2,394$ 3,961$ 5,738$
T-Bills, S&P, Small Caps, Foreign Stocks, Emerging Markets, Treasuries,
Corporates, Commodities, REIT, Long Treasuries, Gold, Foreign Bonds
15
Diversification
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Not designed to increase returns, but sometimes that
occurs.
Intended to reduce volatility and drawdowns.
• By adding uncorrelated assets.
• Not by adding less risky assets, though that helps.
Keep in mind, correlations are not constant. In times
of crisis, correlations increase among asset classes,
reducing the benefits of diversification.
16
Objectives
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Broad Understanding of Diversification Theory
Implication for Public Sector Portfolio
Diversification Within the Agency Sector
Broader Asset Class Diversification
17
Simple Portfolio Comparison
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
vs.
A
B
18
Portfolio A
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
19
Portfolio B
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
20
Goal of Public Sector Portfolio Diversification
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Fixed income products are all very correlated.
Most volatility is driven by interest rate sensitivity.
Lack of uncorrelated investments means you have to
diversify by focusing on:
• Liquidity
• Cash Flow
o Maintain enough cash flow so that you are not
forced to sell securities.
o Spread out maturity to reduce reinvestment
risk.
21
Objectives
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Broad Understanding of Diversification Theory
Implication for Public Sector Portfolio
Diversification Within the Agency Sector
Broader Asset Class Diversification
22
Diversification Factors
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Maturity
Call Date
Call Type
Issuer
Dollar Price
Deal Size
Coupon Type (Fixed/Floating/Step)
Coupon Payment Dates
23
Callable Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
24
Call Type
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
One Time (1x) or “European” Call
• Callable once after a specified lockout period. For example, a 5-year bond which is callable one-time after 2 years.
Continuous or “American” Call
• Callable anytime with a specified period of notice (usually 10 or 30 days).
Discrete or “Bermuda” Call
• Callable on interest payment dates only by a predetermined call schedule.
“Canary” Call
• A hybrid between a Bermuda call and a European call.
25
Issuer
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
November 2013
26
Issuer
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
June 2009
27
Federal Home Loan Banks
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
The Federal Home Loan Bank system was organized in 1932 under the Federal Home Loan Bank Act.
Organized Prior to Fannie Mae (1938) or Freddie Mac (1970).
The Act was designed to restore confidence in the U.S. banking system and revive the post-depression housing market.
The Act also created the need for a credit system to ensure the availability of funds to finance home loans.
Thus, the primary purpose of the FHLB is to lend funds in the form of collateralized advances to member institutions for making home loans.
Super Lien Authority.
State Tax advantage keeps demand high.
28
FHLB Debt Highlights
Joint and several obligations of the system banks.
Not guaranteed by the Federal Government.
Typically not subject to State income taxes.
Issued as senior debt.
Senior debt rated AA+/Aaa.
Website: www.fhlb-of.com
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
29
Farm Credit
Federal Farm Credit Bank – FFCB
• Oldest of the GSEs
• Co-operative Structure
• Over $275 Billion in Assets
• Debt Issuance Growing Fast – Becoming Player in Daily AA+/Aaa GSE Debt Issuance
• Net Income of over $3.5 Billion in each year over past 5 years.
• Regulatory Oversight
o Farm Credit Administration – Executive Branch
• Added Protection
o Farm Credit System Insurance Corp
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
30
Other Large U.S. GSEs Tennessee Valley Authority (TVA)
Federal Agriculture Mortgage Corporation (“Farmer Mac”)
Alternative Issuers in Agency Market Private Export Funding Corporation (PEFCO)
Financing Corporation (FICO)
U.S. Agency for International Development (USAID)
Overseas Private Investment Corporation (OPIC)
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
31
TVA Tennessee Valley Authority – TVA
• Nation’s Largest Public Power Producer
• Wholly Owned by Federal Government
o Does Not Issue Stock
• Sole Discretion to Set Power Rates
o Directed by TVA Act to Set Rates to Cover Debt Costs
• Diversified Power Production
o Coal-Fired Units
o Operating Nuclear Units
o Hydro Units
o Combustion-Turbine Units
o “Green Power” Facilities
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
32
TVA Table II
Comparison to Two of the Largest GSEs, Fannie Mae and Freddie Mac
TVA Fannie Mae and Freddie Mac
Federal Charter 1933 1938 (FNMA)
1970 (FHLMC)
Ownership Federal
Government Shareholders
Financial Objective Profit Neutral For Profit
Primary revenue source Electricity Sales Mortgages
Explicit guarantee by the U.S. Gov. No No
Rating of senior unsecured securities AA+/Aaa AA+/Aaa
Business type Public Power
Utility Financial Services
Approximate level of outstanding debt securities
$25 Billion $450 Billion each
State and local income tax exemption Yes No
Source: Tennessee Valley Authority, Bloomberg
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
33
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Farmer Mac provides a secondary market for agricultural and rural utility loans through the mobilization of external capital.
Created by Congress in response to the agricultural credit crisis in the mid-1980s.
Farmer Mac is a Government Sponsored Enterprise (GSE) and an institution of the Farm Credit System (FCS).
Farmer Mac is regulated by the Farm Credit Administration (FCA), an independent agency in the executive branch of the United States government.
Farmer Mac has $1.5 billion U.S. Treasury backstop supporting guarantees.
34
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
35
Other Diversification Factors
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Dollar Price – Discounts and Premiums (Cushion)
Deal Size
Larger deal size are more liquid. Global deals greater than
$1Billion have the most liquidity.
Smaller auction deals are not as liquid but offer higher
yields.
Coupon Type
• Fixed/Floating/Steps.
• Step alternatives to floaters currently attractive.
Coupon Payment Dates
• Structure coupon payments months just like you would
maturity and call dates to reduce reinvestment risk.
36
Objectives
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
• Broad Understanding of Diversification Theory
• Implication for Public Sector Portfolio
• Diversification Within the Agency Sector
• Broader Asset Class Diversification
37
Asset Class Diversification
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Introducing additional asset classes can boost returns
and provide further diversification.
• Mortgages
• Agencies
38
Treasury vs Swaps
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
39
Mortgage Backed Securities
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Compare to 3Year NC 6Month 1X @ 1.15%
3-year Avg Life, 2.48 Effective Duration
40
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
MBS vs Callables
41
Taxable Municipal
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
• New York St Urban Dev 1.38% 3/15/2018 - Rev
• Aa1/AAA
• Yields 1.308%, +40bps to Agency Bullets
• FHLMC 0.875% 3/07/2018 – 0.90%
• California State 6.20% 10/1/2019
• AA3/AA
• Yield 1.88%, +66bps to Agency Bullets
• FHLMC 1.25% 10/02/2019 - 1.22%
42
Question & Answer
43
Disclaimers & Disclosures
The information contained herein is based on sources considered to be reliable but is not represented to be complete
and its accuracy is not guaranteed. The opinions expressed herein reflect the judgment of the author at this date and are
subject to change without notice and are not a complete analysis of every material fact respecting any company, industry
or security Raymond James & Associates, Inc. and affiliates and their officers, directors, shareholders and employees
and members of their families may make investments in a company or securities mentioned herein before, after or
concurrently with the publication of this report. Raymond James & Associates, Inc. may from time to time perform or
seek to perform investment banking or other services for, or solicit investment banking or other services from any
company, person or entities mentioned herein. Neither the information nor any opinion expressed herein constitutes a
solicitation for the purchase or sale of any security. Raymond James & Associates, Inc. makes no representation as to
the legal, tax, credit, or accounting treatment of any transactions mentioned herein, or any other effects such
transactions may have on you and your affiliates or any other parties to such transactions and their respective affiliates.
You should consult with your own advisors as to such matters.