Rising Interest Rates and the Impact on PFIA Securities
Barry Baughier, Senior Managing Consultant
750 North St. Paul Street, Suite 540  Dallas, Texas 75201  214.247.7079  baughierb@pfm.com
Ken Couch, Senior Managing Consultant 221 West 6th Street, Suite 1900  Austin, Texas 78701  512.472.7194  couchk@pfm.com
Dual Mandate . . . Dueling Mandates
2
Fed’s Key Mandates: Mixed Progress
•
•
Monthly Change in Non-Farm Payrolls
Job growth slowed from
231,000 per month in Q2 to
167,000 in Q3
The unemployment rate
reached a recovery cycle
low of 5.1%
Wage growth remained
tepid
500
230,000 1-year avg.
400
Thousands
•
300
200
100
0
-100
Sep-15
Sep-14
Sep-13
Sep-12
2.5%
2.0%
1.5%
1.0%
0.5%
Aug-15
Aug-14
Fed's Long Term Inflation Target
Aug-13
Core PCE
Aug-12
Core CPI
0.0%
Aug-11
Falling energy prices and
lack of wage pressure are
helping keep broad
inflationary measures low.
Inflation Indicators
3.0%
Aug-10
•
The personal consumption
expenditures (PCE) price
index, the Fed’s preferred
gauge of core inflation,
continues to undershoot the
2% target.
YoY % Change
•
Sep-11
Sep-10
-200
Source: Bureau of Labor Statistics; Bloomberg
3
FOMC Key Policy Tool
•
Benchmark for short term interest rates.
Fed Funds Target Rate (Upper Bound)
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
Current Range: 0-25bps
0.0%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Bloomberg; Federal Reserve
4
FOMC Statement Highlights
•
Economic activity is expanding at a moderate pace.
Household spending and business fixed investment have been
increasing moderately, and the housing sector has improved
further… The labor market continued to improve, with
solid job gains and declining unemployment.
•
Recent global economic and financial developments may
restrain economic activity somewhat and are likely to put
further downward pressure on inflation in the near term…
The Committee continues to see the risks to the outlook for
economic activity and the labor marks as nearly balanced but September
17
is monitoring developments abroad.
•
The current 0 – 0.25% target range for the federal funds rate remains appropriate …the
Committee will assess progress - both realized and expected - toward its objective of
maximum employment at 2% inflation
•
Committee anticipates that it will be appropriate to raise the target range for the federal
funds rate when it has seen further improvements in the labor market and is reasonably
confident that inflation will move back to its 2% objective over the medium term.
Source: Federal Reserve
5
Rate Volatility on Economic Data
•
Treasury yields moved up and down in response to evolving economic conditions, tracking in part (i) the
strength of global economy, (ii) the persistent low inflation environment, and (iii) the expectations for a Fed
rate hike.
Daily bps Yield Change: 3yr Treasury
Tsipras surrendered to
10
European demands
Yields rise before
September Fed meeting
Fed Governor Lockhart
said FOMC was “close” to
being ready to raise rates
5
0
-5
-10
China devalues currency
Greece worries mount
as voters reject austerity
-15
No hike
9/29
9/25
9/23
9/21
9/17
9/15
9/11
9/9
9/7
9/3
9/1
8/28
8/26
8/24
8/20
8/18
8/14
8/12
8/10
8/6
8/4
7/31
7/29
7/27
7/23
7/21
7/17
7/15
7/13
7/9
7/7
7/3
7/1
-20
Source: Bloomberg
6
Drivers of Yield Changes in the 3rd Quarter
U.S. 6 Month Treasury Yield
0.30%
•
The three major headlines throughout the quarter
– Greece debt woes, China growth scare, and
FOMC’s “no hike” decision – impacted the yield
curve differently.
•
Short and intermediate maturities were most
impacted by changing FOMC expectations while
longer maturities were driven by slowing global
growth and inflation expectations.
FOMC Decision
0.25%
0.20%
0.15%
China Slump
Fed Doesn’t Hike
0.10%
0.05%
Greece Concerns
0.00%
6/30/15
7/31/15
8/31/15
9/30/15
U.S. 2 Year Treasury Yield
U.S. 10 Year Treasury Yield
0.85%
FOMC Decision
China 0.80%
0.75%
2.50%
Devalues Currency
Greece worries
2.40%
FOMC Decision
2.30%
0.70%
2.20%
0.65%
2.10%
0.60%
Greece Concerns
2.00%
China Devalues Currency
0.55%
0.50%
6/30/15
Greece
Greece Concerns
7/31/15
China Slump
8/31/15
9/30/15
1.90%
6/30/15
China Slump
7/31/15
8/31/15
9/30/15
Source: Bloomberg
7
Trend Towards Lower Rates
•
Low inflation and tepid economic data, both in the U.S. and abroad, pushed longer-term yields
lower. Yields on securities with maturities of two years or less, the part of the curve that is most dependent
on Federal Reserve policy, moved up in advance of the September FOMC meeting, but quickly reversed
after the “no hike” decision. The end result was that the quarter ended with generally lower yields and
a flatter yield curve than at the beginning of the quarter.
Change in Yield: QTD (9/30/15 vs. 6/30/15)
0.10%
0.05%
0.05%
0.05%
0.00%
-0.05%
-0.03%
-0.01%
-0.03%
-0.05%
-0.10%
-0.09%
-0.10%
-0.15%
-0.20%
-0.19%
-0.25%
-0.30%
-0.27%
-0.29%
-0.28%
-0.30%
-0.32%
-0.35%
-0.34%
10-yr/30-yr
5-yr/10-yr
2-yr/10-yr
3-yr/5-yr
2-yr/5-yr
2-yr/3-yr
30-Year
10-Year
7-Year
5-Year
3-Year
2-Year
1-Year
6-Month
3-Month
-0.40%
Source: Bloomberg
8
Outlook for the Fed Funds Target Rate
Probability of September Rate Hike
•
Market expectations for a September hike
fluctuated as participants digested the impact
that deteriorating economic data would have on
the FOMC’s view of progress towards its goals.
•
While investors are torn on the timing of an
initial rate hike, the expectations for
subsequent hikes remains tempered.
60%
50%
40%
30%
20%
10%
9/30/15
Current Outlook for Fed Funds Target Range
100%
80%
80%
1.00-1.25
0%
1.25-1.50
7/31/15
8/31/15
9/30/15
Dec-16
30%
6/30/15
20%
Oct-15
40%
0.75-1.00
Nov-16
50%
0.50-0.75
40%
Sep-16
60%
0.25-0.50
60%
Jul-16
70%
Jun-16
Probability
90%
Apr-16
Probability of December Rate Hike
Mar-16
8/31/15
Jan-16
7/31/15
Dec-15
0%
6/30/15
1.50-1.75
FOMC Meeting Dates
Source: Bloomberg, “Current Outlook” as of 10/7/15.
9
FOMC “Dot Plot” from September Meeting
FOMC Survey: Appropriate Pace of Policy Firming
5
Minutes Sep-15
Mar-15 Median
4
Jun-15 Median
Sep-15 Median
Fed Funds Futures
3
2
1
0
-1
2015
2016
2017
2018
Longer Term
Source: Bloomberg; Fed Funds Futures as of 9/30/2015
10
FOMC Statement Highlights
•
Kept interest rates unchanged, but kept a December rate hike
firmly in play. “…the Committee will assess progress - both
realized and expected - toward its objective of maximum
employment at 2% inflation”
•
Information received since the Federal Open Market
Committee met in September suggests that economic activity
has been expanding at a moderate pace.
•
Household spending and business fixed investment have been
increasing at solid rates in recent months, and the housing
sector has improved further; however, net exports have been
soft.
•
The Committee expects that, with appropriate policy
accommodation, economic activity will expand at a moderate
pace, with labor market indicators continuing to move toward
levels the Committee judges consistent with its dual mandate.
October
28
•
Fed played down international turbulence and global developments.
•
Markets shifted their expectations of a December hike, with rates futures contracts upping
the chance of a move this year to 43 percent from 34 percent prior to the statement.
Source: Federal Reserve
11
FOMC: Stop or Go?
•
Market Volatility: Stop
Huge plunge in the Chinese stock market
triggered a global sell-off in equity markets, as
well as heighted volatility in global bond and
currency markets. Fed is concerned about
financial stability and market liquidity.
•
Inflation: Caution
Core PCE running well below Fed’s 2% target.
Some Fed officials expect inflation to move back
to the target over the medium term. Falling
commodity prices are keeping broad inflation
metrics low.
•
Full Employment: Go
Unemployment rate of 5.1%, average job gains
of 228K per month over the past year.
12
What Does This Mean For
Public Funds Investors?
13
Portfolio Structures For Different Rate
Environments
Amounts Invested
Ladder
Portfolio Structure
Description
Bonds are purchased across the
maturity spectrum in roughly equal
amounts.
Yield Curve Change
A laddered portfolio will perform well in
most interest rate scenarios.
Amounts Invested
Barbell
Maturity Horizon
Greater weightings are given to
shorter and longer maturity bonds.
A portfolio with a barbell structure will
likely perform better than a bulleted or
laddered portfolio when the yield
curve flattens.
Investments are over weighted in the
intermediate maturity relative to longer
and shorter bonds.
Generally a portfolio with a bulleted
structure will perform well when the
yield curve steepens.
Amounts Invested
Bullet
Maturity Horizon
Maturity Horizon
14
Texas Pubic Funds Investment Act
Permitted Investments
Obligations of, or Guaranteed by Governmental Entities – 2256.009
Certificates of Deposit – 2256.010
Repurchase Agreements – 2256.011
Banker’s Acceptances – 2256.012
Commercial Paper – 2256.013
Money Market Mutual Funds – 2256.014
Guaranteed Investment Contracts – 2256.015
Local Government Investment Pools – 2256.016
Source: Texas Revised Statutes, Section 2256.009-016
15
Risk / Return Relationship
Risk and return are directly correlated
Higher Yield
•
Long Term
Treasury
Lower Yield
MMF / LGIP
T‐Bill
1
Agency Disc. Note
Gov’t Repo
BA.
2
3
4
Long Term
Agency
MBS
8
9
ABS
Commercial CD
Paper
5
Less Risk 6
7
10
More Risk
Risk Factor
For Illustrative Purposes Only
16
Short Maturity Yield Environment
•
Yields on commercial paper and negotiable CDs remain attractive alternatives to Treasury bills and shortterm agencies where yields are constrained by Fed policy.
•
CP/CD rates vary significantly by issuer, credit quality and structure
Money Market Yield Curves
September 30, 2015
0.70%
Average CD/CP
6/30/2015
0.60%
Average CD/CP
9/30/2015
0.50%
Average CD/CP
3/31/2015
Yield
0.40%
Federal
Agencies
0.30%
U.S.
Treasuries
0.20%
0.10%
0.00%
1
2
3
4
5
6
7
8
9
10
11
12
-0.10%
Maturity in Months
Source: Bloomberg; PFMAM. Information on CD/CP ranges are estimates based on independently compiled data, are for general information purposes only.
17
2256.009 Treasuries/Agencies/Muni’s –
U.S. Treasury Yield Curve
•
The yield curve flattened over the past three months as short-term yields rose in anticipation of a Fed rate
hike this year while low inflation kept long-term yields subdued.
Yield Curve History
U.S. Treasury Yield Curve
4.00%
09/30/14
06/30/15
09/30/15
1-Mo.
0.01
-0.01
-0.02
3-Mo.
0.02
0.01
-0.01
6-Mo.
0.03
0.11
0.07
1-Yr.
0.10
0.27
0.32
2-Yr.
0.57
0.65
0.63
0.50%
3-Yr.
1.04
1.01
0.90
0.00%
5-Yr.
1.76
1.65
1.36
7-Yr.
2.20
2.08
1.74
10-Yr.
2.49
2.35
2.04
30-Yr.
3.20
3.12
2.86
3.50%
3.00%
Yield
2.50%
2.00%
1.50%
1.00%
-0.50%
361 2 3
mmy y y
5
y
7
y
September 30, 2015
10
y
30
y
June 30, 2015
September 30, 2014
Source: Bloomberg
18
2256.009 Treasuries/Agencies/Muni’s –
Market Still Expects Higher Yields in the Future
U.S. Treasury Yield Curve
2.5%
+23 basis points
Consensus outlook for Q3 2016
2.0%
1.5%
+57 basis points
1.0%
Yield curve as of 9/30/2015
0.5%
0.0%
Fed Funds
2
y
5
y
Maturity
10
y
Source: Bloomberg; Forecasts provided by Bloomberg contributor composite as of 9/30/2015.
19
2256.009 Treasuries/Agencies/Muni’s • Rates of Treasury notes with a shorter maturity of two to three years are expected to rise faster with the Federal Reserve's actions. • Treasuries with longer maturities will experience only modest losses. • For better protection, consider bonds with a shorter duration, which measures the sensitivity of the price of a bond to interest rate changes. 20
2256.009 Treasuries/Agencies/Muni’s -
21
2256.009 Treasuries/Agencies/Muni’s •
MUNICIPAL BONDS
– As the economy improves, state and local government revenues tend to
improve, and this benefits municipal bond investors.
– Look closely into the issuer's credit standing and the terms of the bond.
22
2256.009 Treasuries/Agencies/Muni’s –
Callables, No Free Lunch
•
The bonds may be called prior to maturity and, thus, the term of the investment
may be shorter than expected.
•
The option to call the bonds belongs to the issuer and not the investor.
•
Rising interest rates create a potential challenge for holders of callable bonds.
This is called interest rate risk.
•
What happens when rates start to rise? Initially, the callable bond behaves very
much like a non-callable bullet bond.
– With market rates still below the callable bond’s coupon, the likelihood of the
bond being called is high, and interest rate sensitivity (duration) is low.
23
Impact of Interest Rate Movements on Callables
24
Interest Rate Environment Determines Callable
Performance
2-Year Federal Agency
January 1, 2011 – October 31, 2015
2.0%
1.5%
1.0%
0.5%
0.0%
2011
Sector Returns
2012
2013
2014
2015
2011
2012
2013
2014
2015 YTD
Past 5 Years
1-5 Yr. Bullet
Agency
2.62%
1.52%
0.03%
1.29%
1.62%
1.40%
1-5 Yr. Callable
Agency
1.67%
0.85%
-0.01%
1.38%
1.75%
1.10%
Source: Bloomberg
25
Impact of Rate Movements on Callables
3‐Year Federal Agency
April 2001 – April 2011
6%
5%
4%
3%
MATURES
2%
1%
0%
Apr-01
Purchase of 3‐year callable, 6‐month call protection
Apr-02
Apr-03
Apr-04
Apr-05
Apr-06
Apr-07
Apr-08
Apr-09
Apr-10
Apr-11
Source: Bloomberg
26
Managing Callable Risk
•
Limit percentage of callable securities held in portfolio
•
Utilize different call structures
•
Diversify callable issuers
Good
Better
Best
Callable holdings diversified by
maturity and structure
Callable holdings diversified by
maturity and structure
Callable holdings diversified by
maturity and structure
Be aware of market trends that
will affect the callability of the
callable securities in your
portfolio
Evaluate performance
characteristics historically;
Model security returns
prospectively
Buy callables only when
imbedded option is properly
valued
27
2256.010 Certificates of Deposit
•
If and when the Fed acts, it can take a while for deposit rates to catch up
•
Typically a lag between the federal funds rate movement and the actual deposit
rate movement
•
The lag can range from a month to as long as two months for larger banking
institutions
28
2256.010 Certificates of Deposit
•
The best way to use CDs is a Laddered Strategy
– Laddering in longer terms when rates are set to decrease, capture
longer term rates
– Short ladder when rates are expected to increase
Short-Term Strategy
Long-Term Strategy
30 Months
5 Year
24 Months
4 Year
18 Months
3 Year
12 Months
2 Year
6 Months
1 Year
29
2256.013 Commercial Paper (“CP”)
•
Short-term, promissory note for short-term financing
•
Always good for short-term strategies
•
As CP is a short-term instrument, the benefit will be seen immediately from any Fed hike
•
CP maturities range from 1 day to 270 days
Commercial Paper Yield Curve
September 30, 2015
0.60%
0.50%
Yield
0.40%
0.30%
0.20%
0.10%
0.00%
1
2
3
4
5
6
Maturity in Months
7
8
9
Source: Bloomberg; PFMAM. Information on CD/CP ranges are estimates based on independently compiled data, are for general information purposes only.
30
2256.016 Local Government Investment Pools
•
Most regularly utilized short-term investment for Texas public funds
•
How much the Fed raises rates will effect how much pool rates will raise
•
Yields on the pools reflect short-term interest rates
– Maturities of 60 days or less
– Should or could see the effect within 30 days of any raise
Even if pools rates rise, longer term investments will also be higher
31
Strategies & Summary
•
While staying short to wait for Fed rate increase seems to be the “word on the
street”, this can cost you
•
Avoid trying to predict rates and trying to time a portfolio
•
Employ a strategy based on yield curve and market conditions, as well as cash
flow analysis.
•
Control risk without giving up yield
32
“Q & A”
33
Disclaimer
This material is based on information obtained from sources generally believed to be reliable and available to
the public, however PFM Asset Management LLC cannot guarantee its accuracy, completeness or suitability.
This material is for general information purposes only and is not intended to provide specific advice or a
specific recommendation. All statements as to what will or may happen under certain circumstances are
based on assumptions, some but not all of which are noted in the presentation. Assumptions may or may not
be proven correct as actual events occur, and results may depend on events outside of your or our
control. Changes in assumptions may have a material effect on results. Past performance does not
necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not
an offer to purchase or sell any securities.
34