History of the bond market LAPERS September 18, 2017 Jeff Detwiler, CFA, AAMS Partner/Portfolio Manager 1401 McKinney, Suite 1600, Houston, TX, 77010 Office: 713-853-2322 | Fax: 713-853-2300 www.GarciaHamiltonAssociates.com

Table of Contents Market Quiz Basics and Key Features Evolution of the Bond Market Current and Historical Valuation Market Developments

Question: Which asset class provided the highest return over the past ten years? REITs Large Caps Bonds International Small Caps Ten Year Annualized Returns 7.18% 6.92% 6.21% 4.48% 1.50% Source: eVestment Last Update: 6/30/2017 Asset classes represented by the following indices: Bloomberg Barclays U.S. Aggregate, S&P 500, Russell 2000, FTSE/NAREIT All Equity REITs, MSCI EAFE-GD

Answer: Large Cap Stocks provided the highest return over the past ten years Annualized Returns Asset Class Large Caps REITs International Small Caps Bonds 7.18% 6.21% 1.50% 6.92% 4.48% Source: eVestment Last Update: 6/30/2017 Asset classes represented by the following indices: Bloomberg Barclays U.S. Aggregate, S&P 500, Russell 2000, FTSE/NAREIT All Equity REITs, MSCI EAFE-GD

Why is Return not enough?? Return alone doesn’t account for the risk required to achieve that return Investors must be compensated for risk Therefore, we should measure returns on a risk adjusted basis

Sharpe Ratio The return earned in excess of the risk-free rate per unit of total risk Sharpe Ratio = R - Rƒ σ A higher sharpe ratio equates to better risk-adjusted total returns

Question: Which asset class provided the highest return per unit of risk taken? REITs Large Caps Bonds International Small Caps Ten Year Sharpe Ratios 1.21% 0.44% 0.32% 0.23% 0.05% Source: eVestment Last Update: 6/30/2017 Asset classes represented by the following indices: Bloomberg Barclays U.S. Aggregate, S&P 500, Russell 2000, FTSE/NAREIT All Equity REITs, MSCI EAFE-GD

Answer: Investment Grade Fixed Income produced the highest return per unit of risk taken Ten Year Sharpe Ratios Ten Year Annualized Returns Asset Class REITs Small Caps Bonds Large Caps International 1.21 0.23 0.32 0.44 0.05 6.21% 6.92% 4.48% 7.18% 1.50% Source: eVestment Last Update: 6/30/2017 Asset classes represented by the following indices: Bloomberg Barclays U.S. Aggregate, S&P 500, Russell 2000, FTSE/NAREIT All Equity REITs, MSCI EAFE-GD

What are Bonds? Bonds 101: What are bonds, and why do they exist? A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to an issuer. In return for that money, the issuer provides you with a promise to pay a specified rate of interest during the life of the bond and to repay the principal when it comes due. It takes a lot of money to keep the U.S. Government running and a good deal of it is borrowed money. That’s where we come in. Our job is to borrow the money needed to operate the federal government and account for that debt. Source: US Bond Market Outstanding: www.sifma.org/research/statistics.aspx, www.investinginbonds.com, www.treasurydirect.gov

Types of Bonds Treasury Agency Corporate Securitized Source: www.theinvestorsnews.com, www.dailykos.com, istockphoto/RichardCano, www.forbes.com.

Features: Coupon Coupon: A feature of a bond that denotes the amount of interest due and the date payment will be made. A bond is normally an interest-only loan, meaning the borrower pays the interest every period, but none of the principal is repaid until the end of the loan. Examples: Suppose I want to borrow $1,000 for 30 years and that the interest rate on similar debt issued by similar corporations is 12 percent. I will pay .12 × $1,000 = $120 in interest every year for 30 years. At the end of 30 years, I will repay the $1,000. The $120 regular interest payments that I promise to make are called the bond’s coupons. Source: www.investinginbonds.com

Features: Maturity Maturity: The date when the principal amount of a security is due to be repaid. Generally, bond terms range from one year to 30 years Short-term bonds generally offer lower yields Long-term bonds generally offer higher yields Examples: Suppose I want to borrow $1,000 for 30 years and that the interest rate on similar debt issued by similar corporations is 12 percent. I will pay .12 × $1,000 = $120 in interest every year for 30 years. At the end of 30 years, I will repay the $1,000. The $120 regular interest payments that I promise to make are called the bond’s coupons. Source: www.investinginbonds.com

Features: Rating Rating: Designations used by credit rating agencies to give relative indications as to opinions of credit quality. Generally speaking, a higher rating means less risk but a lower potential return and vise-versa. Examples: Suppose I want to borrow $1,000 for 30 years and that the interest rate on similar debt issued by similar corporations is 12 percent. I will pay .12 × $1,000 = $120 in interest every year for 30 years. At the end of 30 years, I will repay the $1,000. The $120 regular interest payments that I promise to make are called the bond’s coupons. Source: www.investinginbonds.com

Bloomberg Barclays Aggregate Index 1976 $456 Billion Source: Barclays Live

Bloomberg Barclays Aggregate Index 1976 1986 $456 Billion $2.1 Trillion Source: Barclays Live

Bloomberg Barclays Aggregate Index 15 1986 Tax cuts without spending cuts Collateralized Mortgage Obligations (CMO) invented in 1983 15-year Mortgage-Backed Securities (MBS) added to the index in 1985 $2.1 Trillion Source: Barclays Live

Bloomberg Barclays Aggregate Index 1986 2001 $2.1 Trillion $6.9 Trillion Source: Barclays Live

Bloomberg Barclays Aggregate Index 17 2001 Tax increases and “Dot Com” bubble Asset-Backed Securities (ABS) added in 1991 Mortgage Balloons added in 1992 20-year MBS added in 2000 $6.9 Trillion Source: Barclays Live

Bloomberg Barclays Aggregate Index 2017 $19.6 Trillion Source: Barclays Live Last Update: 6/30/2017

Bloomberg Barclays Aggregate Index 1976 2017 $456 Billion $19.6 Trillion Source: Barclays Live Last Update: 6/30/2017

Corporate Credit Quality Distribution $178 Billion Source: Bloomberg

Corporate Credit Quality Distribution 1980 2017 $178 Billion $19.6 Trillion Source: Barclays Live Last Update: 6/30/2017

Valuation by Quality AAA AA A BBB Ratings Examples % of Index* Microsoft, Johnson & Johnson 2.1% AA Berkshire Hathaway, Apple, Wal-Mart 9.8% A JP Morgan, Wells Fargo, Pepsi, Home Depot 39.3% BBB AT&T, Xerox, Waste Management, McDonalds 48.8% Source: Bloomberg, Barclays live Last Update: 6/30/2017 *Percentage of Bloomberg Barclays Investment Grade Corporate Index **Option Adjusted Spread

Historical Corporate Bond Market Valuation Average Option Adjusted Spreads (OAS) Lehman Brothers — Investment Grade Corporate Index Bear Stearns U.S. Credit Downgrade Accounting Scandals Asian/Russian Financial Crisis Greece Gulf War Current 109 Source: Barclays Live Last Update: 6/30/2017

Market Developments Electronic Trading TRACE Data

Electronic Trading Price transparency and operational efficiency Diminished relationships and less proactive sales force Dark pool liquidity

Voice vs. Electronic Communication Source: Bank for International Settlements (2016). Electronic trading in fixed income markets submitted by a study group established by the Markets Committee

Percentage of Trades Executed Electronically Source: Bank for International Settlements (2016). Electronic trading in fixed income markets submitted by a study group established by the Markets Committee

TRACE Example - Corporates Source: Bloomberg Last Update: 6/30/2017

TRACE Example - Mortgages Source: Bloomberg

Conclusion Historically, investment-grade fixed income has provided a high risk-adjusted return relative to other asset classes The composition of the market has changed over time, which has created both risks and opportunities Recent market developments have increased transparency in the bond market