Asset Liability Matching Variable Rate Debt in the Portfolio by liuqingyan

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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

								
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