Investing Through the Interest Rate Cycle

&Custodians

Doug MillikenArapahoe County Treasurer

March 25, 2010

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Interest rate cycle

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Different strategies for interest rates

• Four scenarios: – Increasing rates– Near the top– Decreasing rates– Near the bottom

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Increasing interest rates

• Prices will decrease with rate increase• Keep investments short• If increases come quickly, you are better off in

money market fund• Don’t be fully invested: you’ll want to buy the

higher yielding bonds once rates rise

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Rates near the top

• You won’t know for sure when you are at the top • Use strategies with a portion of portfolio• Lock in long term rates • Consider allowable investments, terms• Non-callable bullets• Prices increase as rates fall

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Compare MM to long term yields

• When rates near the top of cycle, long term rates will be lower than money market

• Strategy is to buy lower yielding long term bonds than money market, expecting that MM will decline soon, while long term rates stay high

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Example of scenarioLong term rates lower than MM

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Decreasing interest rates

• Portfolio value remains at or above purchase price, useful in case of emergencies requiring early sale

• Value of portfolio rises• Under concept of total return, increased value is

equal to interest earnings• Usually, you won’t know when rates hit bottom

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Rates near the bottom

• Maximum increase to market value• Bonds at increased value earning very low

yield• Consider selling to take capital gains if allowed

and putting proceeds in money market

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Yield curves

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Usual shape of yield curve

• Shown on lower portion of previous chart• Yield increases with term• No significant changes expected to interest

rates

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Inverted yield curve

• Shown on upper portion of previous graph• Yield declines with term• Market in flux• Market has sold off short and medium term

bonds, and yield has risen• Often predictive of recession

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Concept of total return

• Realized and unrealized capital gains equal to interest earnings

• Compare market value at beginning and end of period

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How are you reviewing your performance?

• Just interest earned, or also market gain?• How does your government view performance?• How do various components of return show up on

CAFR?• What do state statutes and investment policy allow?

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Call-ability

• Issuers gain what you lose• Mathematically, callable issues are worth less than

non-callable• Callable issues create asset to issuer• Sometimes, you want bonds called• Mostly, you want the choice of selling or keeping

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Current opportunity in agencies• Callable step-up• Issue date 11/18/09• First coupon 5/18/10• Final maturity 11/18/14• Beginning coupon 2%• Steps up to 4% on 11/18/11 if not called• Callable at 11/18/11 at par• Selling at premium to yield 1.5%

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Reason I bought it

• FNMA thinks rates will jump up in next year and 7 months. I consider this unlikely, based on current state of economy

• FNMA has right to call at par if rates don’t rise• I get 1.5% for 1 year 7 months, higher than bullet• I’m happy if it’s called• Success of strategy depends on correct prediction of

interest rate movements

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Another example – FHLMC

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Current investment idea

• I purchase CDs in banks based in my county slightly below market interest rate

• I request that the banks makes loans <$500,000 to small and medium sized businesses in county.

• Banks make all credit decisions• In Colorado, banks must collateralize with US

government securities valued at 102% of deposit, so no risk

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Banks report quarterly on each loan: - loan terms

- type of business - location

Public good in keeping businesses alive, allowing expansion and job creation

Yield is higher thanagency or money market

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Benefit to issues with larger issue size

• Trade with lower spread• Readily salable• Analogous to Global Corporate Issues

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Custodians

• Insist on Delivery versus Payment• Money leaves your account only when security put in

your ownership• Security leaves ownership only when money enters

your account• Securities lending can be profitable, but some

investors have lost when agents fail• Sample Banking/Custodian RFP on GIOA website

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Feel free to contact me…

Doug MillikenArapahoe County Treasurer5334 S. Prince St.Littleton, CO 80166dmilliken@co.arapahoe.co.us303-681-5505