Presented By

THE INVESTMENT PORTFOLIO: WHAT MAKES SENSE TODAY?IBA Annual Conference September 21, 2015

Jason HaleyFixed Income Strategist

Agenda

• Overview of fixed income investment process– Development of philosophy and strategy– Walk-through of investment cycle

• Fundamental research of macro factors – Two types of research: macro and micro– Defining macro risk– Multi-dimensional risk analysis (MDRA)

• Assessment of current market themes

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Building A Portfolio

• When planning a meal, you don’t start with the grocery shopping

• You first decide:1. What are you looking to create? (defining portfolio objective)

• What is the duration and cost of my liabilities?• What spread / return do I need to maximize profitability given

specific risk limits?2. What are the best recipes for that meal? (selecting a strategy)3. What ingredients do I already have in the pantry?4. What ingredients do I need? (security selection)

• The ingredients should be thought of more as a collection of individual risks than a collection of individual securities

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Liability Driven Investing (LDI)

• Strategy typically associated with pension plans and life insurance portfolios, but applicable to depositories as well

• Develop a fixed income portfolio whose duration is the same as that of the institution’s liabilities

• Goals:1. Produce added returns to achieve long-term investment goals2. Keep portfolio’s macro risk profile aligned with liability structure

• Excess portfolio returns are generated via sector allocation / rotation and security selection

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Market Timing

The Investment Process – An Overview

• A well developed investment process has an:– Investment philosophy – Investment strategy

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The Investment Process – The Investment Philosophy

• A portfolio of fixed income securities with wide risk-adjusted spreads properly matched to the duration of the market produces a total return in excess of the market return

• The incremental return available from security selection, based on careful relative-value analysis and market research, is significantly greater and more consistent than the incremental return from predicting the direction of interest rates

• Within the investment grade fixed income market, the spread sectors offer the greatest opportunity for excess return through security selection

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The Investment Process – The Investment Philosophy (continued..)

• A strong commitment to market research and experienced fixed income professionals can provide a better understanding of fixed income security relative value, with the goal being the identification of high credit quality investments that generate risk-adjusted returns in excess of the market return

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The Investment Process – The Investment Strategy

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• The investment strategy is designed to generate a consistent and predictable return over the preferred benchmark

Investment Strategies Emphasize:

Sector Analysis:

Portfolios typically overweight the “spread sectors” (Agency commercial and residential MBS, CMOs, Agency debentures and some asset-backed sectors). Combinations of assets in these sectors offer competitive risk-adjusted returns over alternative “market” portfolios

Security Selection:

Selecting individual bonds that offer attractive risk-adjusted yields to alternative securities

Duration Targeting and Risk Management:

Don’t make significant “bets” on the direction of interest rates. Keep the portfolio’s duration matched closely to the benchmark duration at all times

The Investment Process – Summary

• Developing a well thought-out philosophy and strategy will provide a framework in which the portfolio manager can seek to earn greater returns on a risk-adjusted basis

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Strategy Investment ReturnPhilosophy Strategy Investment ReturnPhilosophy

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Institutional Fixed Income Portfolio Management

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Understanding Two Types of Research

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• Research can be broken down in macro and micro components

Fundamental (Macro)

Market Analysis

Economics

Sector Relative Value

Portfolio Risk

Relative Value

Portfolio Construction

Individual Security Selection

Portfolio Measurement and

Attribution

Quantitative (Micro)

Research

Fundamental (Macro)

Market Analysis

Economics

Sector Relative Value

Portfolio Risk

Relative Value

Portfolio Construction

Individual Security Selection

Portfolio Measurement and

Attribution

Quantitative (Micro)

Research

Defining Risk

• What are macro factor risks?– “Macro factor risks are market variables that contribute to an

assets yield, affect asset pricing and drive return and return variance”

– 5-way macro factor risk analysis typically includes • Level • Slope • Spread

– Swap spreads and asset spreads to swaps • Implied volatility• Prepayments

– 6-way analysis includes credit

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Macro Factor Sensitivity Analysis - MDRA

• Multi-dimensional risk analysis (MDRA) involves creating macro factor sensitivity tables designed to identify portfolio risks

• Duration risk is only one of many market risks that push around market values

• Measuring and understanding a portfolio’s risk positioning is critical in performance measurement

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Macro Factor Sensitivity Analysis - MDRA

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UNBUNDLED MACRO FACTOR RISKSAssets Credit Level Slope Spread Vol Prepay

Cash - - - - - -US Treasury - - - -Agency Bullet - - -Agency Callable - -30-Year MBS -5-Year Corporate/Muni - -

2014-2015 Review

• Investors who stayed the course during / following the 2013 “taper tantrum” were rewarded with solid gross and net returns in late 2013 and 2014

• Agency fixed MBS well outperformed duration-matched rates in 2014

• High-quality MBS have struggled versus rates (agency bullets and Treasuries) in 2015 amid curve flattening and higher volatility

• Down-in-coupon (DIC) MBS and other convexity-protected collateral has produced more stable carry and total return in 2015

• Spreads have widened across sectors throughout 2015– IG credit spreads ~ 20 bps wider YTD– Agency OAS ~ 15 bps wider YTD

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Sector Returns

Bullet Agencies Gross Net * Gross Net * Fixed MBS Gross Net * Gross Net *1yr - 3yr Maturity 0.47% -0.12% 1.13% -0.27% 10yr New 2.71% 0.85% 0.14% -2.14%3yr - 5yr Maturity 2.34% -0.38% 2.15% -0.28% 15yr New 4.98% 1.62% 2.00% -0.96%

15yr Mod. Seas. 2.57% 1.09% 1.40% -1.14%Callable Agencies 15yr Seas. 2.12% 1.59% 0.65% -0.70%

1yr - 3yr Maturity 0.73% -0.12% 1.50% 0.29% 20yr New 7.33% 2.79% 2.04% -1.23%3yr - 5yr Maturity 3.54% 0.09% 3.00% -0.57% 30yr Mod Seas. 2.37% 0.92% 0.56% -1.62%

30yr Seas. 3.85% 2.94% 1.80% 0.17%Fixed CMO's

PAC 2.48% 0.34% 2.69% 0.72% Variable MBSSEQ 3.16% 0.37% 2.93% 1.22% FNMA P/S Resets 1.77% 1.50% 0.95% 0.51%

FNMA 5/1 Hyb. 2.73% 0.29% 1.26% -1.06%Variable CMO's FNMA 7/1 Hyb. 1.51% -0.07% 2.37% -0.25%PAC/SEQ Floaters 0.82% -0.07% 0.53% 0.36% GNMA P/S Resets 1.51% 1.00% 0.08% -1.11%

GNMA 3/1 Hyb. 1.21% -1.54% 1.55% -0.97%GNMA 5/1 Hyb. 1.45% -1.37% 1.58% -0.93%

* Net of duration-matched swaps ladder** 2015 returns annualized as of 8/31

2014 Returns 2015 Returns 2014 Returns 2015 Returns

MBS Coupon Stack (Citigroup BIG Returns)

Fannie Mae 30yr Fannie Mae 15yrCoupon 2014 2015 * Coupon 2014 2015 *2.50% 10.93 1.68 2.00% 5.80 0.773.00% 9.75 1.97 2.50% 5.28 1.493.50% 8.16 1.91 3.00% 4.32 1.714.00% 6.77 1.97 3.50% 3.47 1.584.50% 5.26 2.00 4.00% 2.28 0.185.00% 3.99 2.02 4.50% 1.16 1.015.50% 3.76 1.85 5.00% 1.18 0.026.00% 3.96 1.496.50% 4.72 2.83

Ginnie Mae 30yr Ginnie Mae 15yrCoupon 2014 2015 * Coupon 2014 2015 *3.00% 8.84 1.25 3.00% 5.18 0.413.50% 6.96 0.95 3.50% 3.88 0.754.00% 5.70 0.18 4.00% 2.36 0.324.50% 4.68 (0.18)5.00% 3.51 2.415.50% 2.76 2.886.00% 2.99 2.246.50% 4.18 3.03

* Annualized as of 8/31

Returns

Returns Returns

Returns

Stronger Dollar

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75

80

85

90

95

100

105

U.S. Dollar Index (DXY)

Source: Bloomberg

Inflation Expectations Falling

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1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40

2.60

5yr TIPS Breakeven (%)

Source: Bloomberg

Curve Flatter

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100

120

140

160

180

200

220

240

260

2yr/10yr UST Spread (in bps)

Source: Bloomberg

5yr Swap Spreads

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0

20

40

60

80

100

120

140

Bas

is P

oint

s

Source: Bloomberg

Option Premiums Falling

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50

60

70

80

90

100

110

120

Realized vs. Implied Volatility1yr x 10yr Swaption (in bps)

Implied Vol 90-day Trailing Vol

Source: Credit Suisse

Spreads Widening - Credit

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50

60

70

80

90

100

110

120

5yr Investment Grade CDX Index (in bps)

Source: Bloomberg

Spreads Widening - MBS

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-10

-5

0

5

10

15

20

25

30

Fannie 15yr CC Nominal Spreads to Swaps (in bps)

Source: Bloomberg

Summary of Current Themes

• Expected monetary policy divergence has:– Pushed U.S. dollar higher– Sparked volatility in currency and commodity markets– Pushed inflation expectations lower– Flattened U.S. rate curve– Induced greater rate volatility

• Spread widening has made spread sectors more attractive relative to early 2015, particularly for high-quality front-end assets

• Elevated volatility negative for assets with at-the-money options

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Portfolio Positioning

• Continue to favor up-in-credit duration barbell strategy (prefer to add leverage in more liquid sectors than go down in credit)

• Reduce vol exposure in MBS space via down-in-coupon 15yr and convexity-protected collateral

• Agency CMBS also less sensitive to high vol and spread pickup relative to debentures

• Auto and credit card ABS spreads at the wide end of 3-5yr trading ranges

• Investment-grade corporates trading at widest levels 2-3yrs• Dollar rolls have weakened but still offer attractive financing

alternative for many investors• Enhance cash returns via repo

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Conclusion

• Institutional investors should have well-developed investment framework centered with a clear philosophy and strategy

• Portfolio management is a continuous process that starts with establishing goals and guidelines that govern the overall selection and management of the portfolio

• Macro factor risks are 1) observable, 2) measurable, and 3) affect asset prices and returns

• In the current market, asset spreads are at recent wides, but rate volatility remains elevated

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Balance Sheet Cross Section

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June 2015 Call Report Data

Balance Sheet Cross Section

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