Ryan McCarroll, CFA Analyzing the Investment Portfolio in Changing Markets The information contained herein is prepared for general circulation and is distributed for general information only. This information does not consider the specific investment objectives, financial situations or particular needs of any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are subject to change without notice. Investors should understand that statements regarding future prospects might not be realized. Please contact Balance Sheet Solutions to discuss your specific situation and objectives. Balance Sheet Solutions, LLC only transacts business in states where it is properly registered or notice filed, or excluded or exempted from registration requirements. Follow-up and individualized responses that involve either the affecting or attempting to affect transactions in securities, or the rendering of personalized investment advice for compensation, as the case may be, will not be made absent compliance with state investment adviser and investment adviser representative registration requirements, or an applicable exemption or exclusion BSS is a SEC Registered Investment Advisor SEC# CRD# All information contained in this document is the confidential property of Balance Sheet Solutions, LLC. Distribution outside of the credit union is strictly prohibited. 1

Current state of fixed income markets Return as a function of risks – Relationship between yield and various risk factors Strategies to asses and optimize risk exposures Agenda

Since the Great Recession

Yield is hard to come by

Interest rates are on the rise!

Post FOMC hike

Expected rate hikes dropped from 4 to 2 – Persistently low inflation – Global growth worries – Strong dollar Will a strong labor market result in wage inflation? Rates moving forward?

Return is a function of Risk Investors are compensated for assuming additional risk above risk free rate IRR Premium – Term, option risk, prepay/extension Liquidity Premium Credit Risk Premium What is a credit union to do?

Interest Rate Risk Liquidity Risk Credit Risk Operational risks – Transaction – Reputation – Compliance – Strategic Assessing Risk…and return

Minimize Risk Manage Risk or Manage Risk Are you adequately compensated for the risk? Are there significant risk concentrations? 10www.balancesheetsolutions.org

Price Risk Option Risk Prepayment Extension risk Re-investment risk Portfolio Interest Rate Risk 5/20/2015www.balancesheetsolutions.org11

A function of: – Maturity – Coupon Does the coupon re-set? How high is the coupon (higher coupon has less price risk-all else equal) Price Risk

FFCB – 2 years to maturity – 3/28/2018 – 0.79% yield FNMA – 4 year maturity – 4/17/2020 – 1.16% yield Which is a better bond? Both bonds are highly liquid Federal agency issues with bullet maturities

Extension – Does your 3 year average life MBS become a 5 year average life instrument if rates rise? Prepayment – If rates fall and prepayments rise what does that mean for actual vs. expected return? Call risk – Are you making directional calls on interest rates? Other IRR risks

Two useful tools: – Total rate of return – Benchmarking Managing Interest Rate Risk

Yield alone is an insufficient measure of return All return components should be considered Measured across various rate scenarios Total Return

Over a given time horizon: Beginning price Interest income Reinvestment income Ending price Actual Income Earned + Change in Market Value = Total Return Total Return Defined

Even if you don’t plan to sell: – Changes in Market value are captured in ALM model – Mark to Market on the balance sheet – Total Return measures actual change in wealth Does Market value really matter?

Use your portfolio to manage and fine tune the IRR risk Investment decisions should not be made in a vacuum Benchmarking is a useful tool Portfolio = Risk Management tool 5/20/2015www.balancesheetsolutions.org19

Multi-purpose tool that lets us: – Define desired risk tolerance for entire balance sheet – Align return objectives within established risk tolerance levels – Provide a decision making framework Ex ante & ex post What is a benchmark?

Benchmarking: The Mechanics 1.Evaluate your current Interest Rate Risk (IRR) 2.Create a few benchmarks – Constructed of laddered portfolios of bullets 3.Run a series of what-ifs – Replace the current, actual investment portfolio with each of the various “benchmark” portfolios 4.Examine scenario output to determine appropriate risk/return trade-off of each benchmark portfolio

CU Interest Rate Risk *Source: Callahan

CU Interest Rate Risk *Source: Callahan

Moving out the curve

Portfolio Liquidity Risk/Return Premium for holding less liquid instruments – Treasury, Agency, MBS, Bank Notes, CD’s – Incremental yield is at least partially compensation for liquidity risk Investing excess cash – Investing excess cash from the balance sheet improves yield-increases liquidity risk.

Treasuries Agency Debt Bank Notes Agency MBS Taxable Municipal CDs Liquidity Spectrum High Low Marketability Yield Premium

Inadequate Policies/poor planning No Contingency Funding Plan No Emergency backstop (Discount Window, CLF) Not Testing Liquidity sources You are not compensated for these risks- don’t take them! Not compensated for these Risks:

Increase return by eliminating “excess cash” – $10mm portfolio of agencies securities 0.97% yield with 2mm in cash 1.16% yield with $0mm excess cash Approximately $19k annually Strategy increases liquidity risk vs. holding excess cash Cash Drag

Reduce cash drag Ensure your portfolio contains some liquid investments Portfolio structure for liquidity (i.e. ladder) Don’t assume risk you are not compensated for! Liquidity Strategy

Most credit risk within loan portfolio Most investments insured/guaranteed Bank notes exception Credit Risk

What is a Bank Note? Debt issued from an MTN program at the bank level Issuer must be a “bank” as defined in Section 3(a)(2) oft the Securities Act of 1933 Exempt from registration under the 1933 Act

Opportunity in Bank Notes Permissible investment authorized by Reg.703 Very under-utilized CU investment option bps spread pick up over agency bullets Analytic support available to aid due diligence

Bank Notes: Credit Risk Credit Unions must assess credit risk at time of purchase/ongoing Key credit metrics same as for a credit union Capital, asset quality, earnings, liquidity Credit risk: Tangible common equity ratio (capital) Tier 1 common equity ratio (risk-wtd capital) Non-performing assets ratio (asset quality) Return on assets (earnings) Loans / deposits (liquidity)

Summary Return is a function of risk IRR, Liquidity, Credit, Operational Don’t be over exposed in any one risk Are there opportunities for you to earn more?

Questions?

Ryan McCarroll, CFA Senior Portfolio Manager (877) x4687 (720) (303) (cell) Thank You!