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Asset/Liability Management
Presented to,
The Florida Government Finance Officers Association
George Majors
Thomas Huestis
Kelly McGary
Presentation Outline
Section 1 Asset / Liability Management Basics
Section 2 Managing To Net Interest Expense
Section 3 Practical Aspects of Implementing an Integrated Asset/liability
Management Approach
Section 4 Credit Perspective
2
Asset / Liability Management Basics
Asset/Liability Mismatches
– Exposure to interest rate risk caused by the structure of assets and liabilities
can have significant budget impacts
– Most tax-exempt entity asset/liability profiles are characterized by long-term
fixed rate liabilities and short-term assets
– In general, debt for capital projects is amortized over the projects useful life
(20 years or longer)
• Public policy objectives
• Budgetary certainty
– Investment assets are generally short-term
• Safety, Liquidity, Return
• State Statutes
• Investment policy - WAM/duration limits
• Interest earnings fluctuate with short-term rates
– Correcting Asset/liability imbalances
• Extend asset duration w/in liquidity needs (GIC, longer maturity bonds)
• Shorten debt duration w/in credit standards (FRN’s, VRDB’s, swaps)
• Match variable rate debt exposure to “core” asset balances
• Consider how assets and liabilities function together (“Net Interest Expense”)
3
Asset / Liability Management Basics
“Net Interest Expense”
• Status Quo characterized by
long-term, fixed-rate debt and – Net Interest Expense (“NIE”) is the difference between the interest expense
relatively short-term assets. incurred on debt-type obligations and interest income earned on investments
• Status Quo can lead to – It is Net Interest Expense, rather than either (a) debt expense or (b) interest
volatile cash flows from income alone that impacts the budgetary bottom line
financial activities:
• Risk of poor interest rate
margins impacting – The objective is to integrate debt and investment strategies toward
budget
minimizing both the absolute level of NIE and volatility in NIE
• Unnecessarily high
interest expense, low
investment income All Fixed Rate Debt Hedged Position
• Difficulty in budgeting
and meeting goals
Stable net cash flow
• By focusing on “Net Stable net cash flow
Investment Income” the
Issuer can expect to increase
net economics while
Volatile net cash flow
simultaneously reducing
existing exposure to interest
rate risk.
• Utilizing variable rate debt
can reduce balance sheet
risk.
4
Asset / Liability Management Basics
Capital Funding Alternatives
• Quadrants I and II call for Borrowing Mode
Pay-As-
long-term, fixed rate
investments which, You-Go Fixed Variable
generally, are not practical
alternatives I II
• Quadrant III depicts the
most common capital
structure among State and
Local Governments Fixed
• Quadrant IV, has provided
the most consistent NIE
Investment Mode
results.
• Assumptions:
– Fixed Borrowing 5.23%
= 12 year average of A+
Generic G.O. Curve
(20Y) III IV
– Fixed Investment 5.72%
= 12 year average of
10Y Treasury and
Variable
Agency rate
– Variable Borrowing =
BMA
– Variable Invest 18-
month Agency less 20
bps.
5
Asset / Liability Management Basics
Historical Net Interest Expense Comparison
• Recent years have been
among the worst for tax-
exempt borrowers seeking
to maximize predictable
Net Interest Expense
(“NIE”)
• Issuers with little or no
variable rate debt have
seen investment income
reduced drastically without
offsetting reductions in
interest expense
• Variable rate issuers were
much better positioned,
but still saw declines in NIE
as investment income
declined more than debt
costs
• Net effect of long liabilities
and shorter assets is
significant (a) adverse
economic exposure to low
interest rates and (b)
volatility in Net Interest
Expense
Assumptions
1. $100 Million Principal
6 2. 5.23% fixed borrowing rate is average of A+ Generic General Obligation
3. 3-month Agency rates less 20 bps is proxy for short-term taxable asset return
4. 18-month Agency rates less 20 bps is proxy for short-term taxable asset return
5. BMA is proxy for short-term tax exempt borrowing costs
Asset / Liability Management Basics
Shortening Liabilities vs. Extending Assets
• Due to liquidity needs and Average duration of Merrill Lynch
other management objectives, 1- 3 year Index (proxy for typical
7.0% investment Portfolio - 1.67 years
individual asset durations are
generally limited to less than
6.415%
5 years 6.5%
6.391%
5.957%
• Accordingly, there is a 6.0%
significantly greater benefit to 5.740%
addressing the asset/liability 5.454%
5.5% 5.311%
mismatch by reducing the
liability duration 5.074% 5.363%
5.23%
5.0% 4.821%
Rate
• The tax-exempt curve is 4.467%
steeper due primarily to the 4.616%
4.5% 4.269%
tax risks associated with 4.151%
owning long-term municipal 4.276%
bonds 4.0%
3.983%
3.808%
• Increased income by 3.5% 3.612%
extending from 6 to 18 3.392%
months = 0.430% 3.120%
3.0%
2.935%
2.750%
• Decreased interest expense
2.5%
by shortening from 10 Years
to 1 week = 1.86% 3 Month 6 Month 1 Year 2 Year 3 Year 4 Year 5 Year 7 Year 10 Year 20 Year 30 Year
Time
Historical A+ Generic G.O. Historical Federal Agency
7
Asset / Liability Management Basics
Historical Costs and Cyclical Lows
– While reducing NIE volatility Historical Cost Comparison
is the primary objective, Long-Term vs. Short-Term Debt Issuance
historically, variable rate
debt costs have been lower
than even the lowest fixed
rates
10/2/1998
4.86%
6/13/03 6/3/05
4.40% 4.32%
8 Notes
1. Assumes Spread to historical BMA of 40 bps to cover associated costs such as remarketing, auction agent, and insurance
Asset / Liability Management Basics
Increasing Floating Rate Exposure
– Issue additional floating rate debt
– Swap existing fixed rate debt to floating
– Refinance existing fixed rate debt with floating rate debt when
existing debt becomes subject to optional redemption
9
Managing To Net Interest Expense
Establishing A Duration Strategy
Historical Yield Spreads Among Candidate Investments
Management Considerations
• Short-term investment yields
have averaged approximately
1.40% over the BMA Index.
• Active management of
portfolio duration and asset
allocation can add significant
value when applied in a
disciplined manner within pre-
established guidelines.
• Short-term asset duration
reduces exposure to repricing
risk
• Shortening of debt duration
hedges short-term interest
rate exposure of asset
portfolio
10
Managing To Net Interest Expense
Short Duration Strategy
Common Terminology • Duration of asset portfolio is shortened to hedge against
• Repricing Risk: The risk that floating rate debt exposure (i.e. BMA Index)
arises when assets and
liabilities are repricing at – Matching of asset and liability duration reduces exposure to repricing risk
different time intervals
• Asset Sensitive: Portfolio with – Establish target duration and acceptable degree of duration mismatch
assets repricing earlier than
liabilities (Reinvestment rate – As interest rates decline, reduced interest income is off-set by reduced
risk)
borrowing costs
• Liability Sensitive: Liabilities
repricing earlier than assets
(market price and interest rate – As interest rates rise, higher borrowing costs are off-set by greater
risk)
investment income
• Basis Risk: Risk that arises
from changes in the relationship – Provides high degree of near-term budgetary predictability (i.e. Net Interest
between interest rates for
different market sectors (i.e. Expense)
taxable & tax-exempt)
11
Managing To Net Interest Expense
Sample Short Duration Portfolio
Average Maturity Less Than 180 Days
Management Considerations
• By establishing management
constraints and operating
parameters, an optimal portfolio
can be established which
maximizes the expected spread
between the asset portfolio and
variable rate tax-exempt interest
costs (BMA).
• For example, subject to the
following portfolio constraints;
1) Average maturity <=180 days
2) Portfolio/BMA Correlation =.90
3) Treasuries >= 35%
4) Agencies <= 65%
5) Corporate = 0%,
The following portfolio results in
the greatest expected spread to
BMA
12
Managing To Net Interest Expense - Short Duration Portfolio Cashflow & NIE Analysis
Short Duration Strategy
Portfolio Cashflow & NIE Analysis
13
Managing To Net Interest Expense
Intermediate Duration Strategy
Common Terminology • Duration of asset portfolio may be extended in effort to
• Scenario Analysis: Simulation maximize expected spread to variable rate debt costs
of several different interest rate
scenarios (flattening, inverted, – Longer duration portfolio may generate greater expected spread over time
steepening, parallel shift, etc)
and the effect on assets and
liabilities – Less near-term budgetary predictability due to repricing risk that results from
• Book Value Perspective:
duration mismatch
Perceives risk in terms of it’s
effect on accounting and – Establish acceptable degree of duration mismatch
earnings.
• Market Value Perspective: – Manage portfolio duration and structure to capitalize on relative value
Perceives risk in terms of it’s
effect on the market value of a
opportunities and manage risks
portfolio
– Must consider tolerance for unrealized losses (market price risk)
– Scenario analysis and stress testing can help quantify exposure
14
Managing To Net Interest Expense
Summary/Q&A
– Interest rate risk is best addressed by focusing on net interest expense,
rather than gross interest expense
• Must consider interest earned on asset portfolio as well as interest payable
• Using all variable rate debt represents risk that rates will rise in future
• Using all fixed rate debt represents risk that rates will decline in future
• Both scenarios expose issuer to interest rate risk and will impact budget
– An Integrated asset/liability management approach reduces balance sheet
risk and speculation regarding future interest rates
• Coordinated investment and borrowing strategy hedges rate movements
• Analyzes how both asset and debt portfolios will perform in future interest
rate environments and what impact on budget will be over time
• Net interest expense may be forecast with relatively high degree of
accuracy
• End result is better net economics and less volatility of NIE
– Questions or Comments?
15
Presentation Outline
Section 1 Asset / Liability Management Basics
Section 2 Managing To Net Interest Expense
Section 3 Practical Aspects of Implementing an Integrated Asset/liability
Management Approach
Section 4 Credit Perspective
16
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Key Implementation Issues
• Premise: Interest rate risk
is best addressed by
•Portfolio management and implementation
focusing on net interest – Variable rate debt
expense, rather than
gross interest expense. – Investment management
• Premise: An Integrated
asset/liability
management approach •Implementation of an integrated approach
reduces cash flow risk
and speculation regarding
– Analyses are consistent with an integrated approach
future interest rates. – Policies and procedures are consistent with an integrated approach
– Education and communication are consistent with an integrated
approach
•Education and communication
17
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Variable Rate Debt – Is it Good Idea?
•Variable rate debt is a powerful debt management tool
for the right issuer for the right purposes
– Reduction in overall cost of capital
– Historically lower average cost compared to fixed rate debt
– Maintenance of future flexibility for change in outstanding debt
– Provides cost effective flexibility to restructure or pay down debt in
future
– May allow for flexibility in timing of fixed rate issues
•Risks and costs need to be considered
18
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Overview of Variable Rate Financing Vehicles
•Funding types:
– Interim (Construction) funding
– Permanent (Long-term) funding
•Multitude of products and programs available:
– Variable Rate Bonds – tax-exempt and taxable
– Commercial Paper – tax-exempt and taxable
– Auction Rate – tax-exempt and taxable
– Variable Rate Loan Programs – tax-exempt and taxable
– Bank Loans – tax-exempt and taxable
•For some issuers, derivatives can be used to create
synthetic variable rate exposure
– Not covered in this presentation
19
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Overview of Variable Rate Financing Vehicles
Program
Liquidity Advantages Disadvantages
Type
Simplest to administer. Must have discrete issues.
Variable Rate Can be converted to Requires liquidity.
Demand Required different modes. Well
Bonds known product trades well
in market.
Most flexible, because it Requires liquidity. Cannot be
can be issued as needed changed to a different mode.
Commercial
Required and ease of changing
Paper
maturity structure to meet
market demand
Eliminates liquidity so Without put feature, not
may have lower overall eligible for money market
costs. Addresses funds. Documentation more
Auction Rate
None different investors. Can complicated than other
Securities
be converted to different programs; higher set up and
modes. marketing costs. Must have
discrete issues.
Does not require issuance Must negotiate master swap
Synthetic
of additional debt to agreements. Exposure to
Floating Rate None
obtain variable rate swap risks.
Debt
exposure.
20
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Issuer options
•For larger issuers, direct issuance of variable rate debt
can be the most cost effective
•Florida variable rate debt pools and programs:
– Florida Municipal Loan Council (League of Cities)
– Sunshine State
– Florida Association of Counties
– Others
21
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Challenges to Utilizing Variable Debt
• Even when completely •Identifying and evaluating new risks
hedged with off-setting
assets, variable rate debt can – Tax reform risk
create new risks. – Credit enhancement and liquidity facility renewal risk
• Variable rate debt imposes – Refinancing risk if using for interim financing
new administrative – Budgetary Risk –appropriately budget for annual debt service
requirements.
payments
– Arbitrage rebate requirements
•Higher administrative costs
– More time consuming to manage
– Must be active in daily management
– Monitoring and reporting
– Requires skilled staff
•Communication and education
– Convincing yourself
– Convincing others
22
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Overview of Variable Rate Financing Vehicles
Product
VRDBs as
Permanent
Financing
Vehicle
Auction Rate
Notes (ARNs)
Commercial
Paper as an
Interim
Financing
Vehicle
23
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Variable Rate Challenge – How to Budget?
•Objective: minimize programmatic impact by making a
reasonable interest rate assumption
•Annual debt service = principal x interest rate
– Future interest rates are unknown for variable rate debt
•Assume average rate in effect through next budget
period
•Assume too high: decrease budgetary resources
available for other purposes
•Assume too low: diverts resources from other purposes
late in the fiscal year
24
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Variable Rate Challenge – How to Budget?
• Make sure that variable rate debt and investment earnings
budget estimates are not inconsistent
• Historical and Current Interest Rates are useful for “Rule of
Thumb” estimation
• Understanding the Fed’s objectives and policy drivers helps
refine estimate. Funds Rate is a driver
• Read what are the various economists saying and predicting
regarding short-term rates
• Keep database of rates
– Fed Funds
– LIBOR
– Investment benchmarks
– BMA
– Your variable rate debt performance
25
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Variable Rate Challenge – Arbitrage Rebate
Considerations
•Exceptions to rebate requirement for new money
transactions
– Six month spending exception
– Eighteen month spending exception
– Two-year spending exception
•Debt service reserve funds
•Computation periods
•Administrative considerations
26
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Communication and Education
• Need to convince yourself first that adding variable rate debt
makes sense
• Projections:
– Project monthly cash flows for the major funds considered
– Look at minimum and maximum investment balances
– Look at your investment practices
– Determine a target variable rate debt component for major fund(s)
• Historical analysis:
– Review historical interest earnings and average rates
– Map an investment proxy against variable debt index
• Opportunity cost analysis
• Policies and procedures consistent with an integrated
approach
27
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Opportunity Cost Analysis
• Concerns that need to be addressed regarding “Why Now?”
– Short-term rates have risen
– Long-term rates are low
– Lose up-side in a rising rate environment
– Financing community pressures
– Political pressures
• Additional Analyses
– Review of historical rate trends
– Calculate break-even rates for variable rate debt to fixed rate alternative
(recognizing this looks at only one-side of the balance sheet)
• Considerations
– Issue additional variable rate bonds
– Phase in new variable rate exposure
– Issue variable rate bonds as fixed rate bonds become currently refundable
28
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Opportunity Cost
29
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Policies and Procedures
•Debt Policy
– Provides for variable rate debt
– Parameters for the amount of variable rate debt
– Government Finance Officers Association Recommended
Practices “Using Variable Rate Debt Instruments”
•Investment Policy
– Maintain investment portfolio consistent with variable rate debt
exposure
•Reserve Policy
– Protection that investment balances will remain stable to continue
to act as a hedge for variable rate debt
30
Practical Aspects of Implementing an Integrated Asset/liability Management Approach
Summary – Variable Rate and an Integrated
Asset/liability Management Approach?
•Variable rate debt is powerful debt management tool for
the right issuer for the right purposes
•Even with integrated Asset/liability management
programs, variable rate debt creates new risks and
additional costs
•An issuer should use a comprehensive approach,
considering the asset side of its balance sheet, when
deciding on variable rate debt exposure
•Communication and education is key for successful
implementation
31
Presentation Outline
Section 1 Asset / Liability Management Basics
Section 2 Managing To Net Interest Expense
Section 3 Practical Aspects of Implementing an Integrated Asset/liability
Management Approach
Section 4 Credit Perspective
32
Credit Perspective
Appropriate Use of Variable-Rate Debt
•Operating Flexibility
•Capital Access
•Asset/Liability Balance
•Financial Management Capabilities
33
Credit Perspective
Credit Considerations
•Operating Flexibility
– Stable reserves, operating margins
– Revenue-raising/rate-setting flexibility
•Capital Access
– Debt levels, access to additional capital
34
Credit Perspective
Credit Considerations (continued)
•Asset/Liability Balance
– Appropriate match of short term assets with short term debt
•Financial Management Capabilities
– Asset and Liability Management Policy
– Ability to respond to unexpected changes in the asset
balance
– Financial management and systems able to monitor
variable rate exposure and regularly assess risk
35
Credit Perspective
Potential Risk Factors That May Warrant
Further Review
•Limited management capabilities
•Lack of financial flexibility
•Volatile cash and short term investment
balances, historically
36
