Cash Flow Analysis in Portfolio Management January 13, 2011 Presented by: Carlos Oblites, Senior Managing Consultant PFM Asset Management LLC

PFM Investment Advisors to the Public Sector $0 $5 million $10 million $15 million $20 million $25 million Liquid0-1 Years1-2 Years2-5 Years $20 $10 $0 $5 Current Investments $15 $9 $6 $5 Cash Flow Needs Do Current Investments Meet Cash Flow Needs? 2

PFM Investment Advisors to the Public Sector $0 $5 million $10 million $15 million $20 million $25 million Liquid0-1 Years1-2 Years2-5 Years $20 $10 $0 $5 Current Investments $15 $9 $6 $5 Cash Flow Needs Do Current Investments Optimize Earnings? 3

PFM Investment Advisors to the Public Sector4 How Much Liquidity is Enough? Cost of insufficient liquidity –Delayed payments –Additional interest costs –Transaction costs –Bad press Cost of excess liquidity –Lost investment income –Bad press Understanding cash flow is critical! 4

PFM Investment Advisors to the Public Sector Cash Flows Most Crucial Questions –How much to keep liquid? = “Will I have it available when I need it?” –How much to lock up in longer maturity securities? = “Will I earn a good return it?” 5

PFM Investment Advisors to the Public Sector6 What to Do? “I think we’re all in agreement that it’s time to abandon the “waiting for a miracle strategy.” Earnings 6 Returns

PFM Investment Advisors to the Public Sector Approach Determine Cash Flow Needs –Consider all funds –Determine amount of cash needed for expenditures –Consider the timing of receipts and expenses Categorize your funds –Funds that needs to be kept liquid –Funds available to invest longer = “core balance” 7

PFM Investment Advisors to the Public Sector Cash Flow Information Sources Bank statements General ledger balances Budgets Capital project spending Investments 8 All Accounts--Historical Cash Balance JanuaryFebruaryMarchAprilMayJune ,653 62, , , ,689 91, , , , , , , , , , , , , , , , , , , , , , , , ,193 JulyAugustSeptemberOctoberNovemberDecember , , , ,220 41, , , , , ,516 97, , , , , , , , , , , , , , , , , ,516 97, ,371

PFM Investment Advisors to the Public Sector Sample Cash Flow Report (in $1,000’s) JulyAugustSeptemberOctober Revenues Tax receipts10,0004, Investment income Other income1, Total Revenues11,3504, Expenses Accounts Payable500003,000 Insurance Premiums01, ,000 General Admin Total Expenses5751, ,075 Monthly Net Cash10,7753,385(55)(5,910) Beg Balance2,00012,77516,16016,105 End Bal12,77516,16016,10510,195 9

PFM Investment Advisors to the Public Sector10 Macro Forecasting Process Analysis of Historical Monthly Cash Flows 5,000,000 10,000,000 15,000,000 20,000,000 25,000,000 30,000,000 35,000,000 40,000,000 Jan-99 Apr-99 Jul-99 Oct-99 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02Jan-03 10

PFM Investment Advisors to the Public Sector11 Computation of Growth Fund balances sometimes show growth trends Historic Monthly BalanceAverage Portfolio Growth Analysis of Historical Monthly Cash Flows 5,000,000 10,000,000 15,000,000 20,000,000 25,000,000 30,000,000 35,000,000 40,000,000 Jan-99 Apr-99 Jul-99 Oct-99 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Average Monthly Increase: $205,118 Historic Annual Growth Rate: 9.9% 11

PFM Investment Advisors to the Public Sector12 Balance Projections Historic data can be used to predict future investable balances Actual Monthly Balances Projected Monthly Balances Projected Portfolio Growth 5,000,000 10,000,000 15,000,000 20,000,000 25,000,000 30,000,000 35,000,000 40,000,000 45,000,000 Jan-99 May-99 Sep-99 Jan-00 May-00 Sep-00 Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 12

PFM Investment Advisors to the Public Sector13 Core Portfolio Most governments have a “core” or stable portion of the portfolio Analysis of Portfolio 5,000,000 10,000,000 15,000,000 20,000,000 25,000,000 30,000,000 35,000,000 40,000,000 45,000,000 Jan-99 May-99 Sep-99 Jan-00 May-00 Sep-00 Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 Historical Liquid Funds Historical Core Funds Projected Liquid Funds Projected Core Funds 13

PFM Investment Advisors to the Public Sector How to Invest it? Determined by: 1.Cash flow needs 2.California Government Code 3.Investment policy 4.Investment objectives 5.Current market conditions 14

PFM Investment Advisors to the Public Sector15 Key Investment Objectives Protect principal Provide necessary liquidity to cover both ongoing and unexpected cash needs Maximize earnings recognizing need for safety and liquidity, and subject to restrictions specified by Government Code and the local governing body 15

PFM Investment Advisors to the Public Sector16 And If These Are Bond Proceeds? 1. Determine if issue will meet spend-down exceptions per arbitrage rebate regulations 2. Identify investment options (legal, bond covenants, policy) 3. Formulate investment strategy based on rebate status 16

PFM Investment Advisors to the Public Sector Selecting Maturities for Project Funds Things to consider: –What is the project schedule? –What are future rate expectations? Does it make sense to buy longer investments if interest rates are rising? 17

PFM Investment Advisors to the Public Sector Selecting Maturities for General Funds Things to consider –Are there any investment restrictions? –What is your target average maturity? –What is your benchmark to measure performance? 18

PFM Investment Advisors to the Public Sector Before you buy, you must make sure that the investments comply with your public agency’s preferences. –Social issues –Prior history with particular investment Additional Considerations 19

PFM Investment Advisors to the Public Sector Specific Goals Assure steady income stream = Enhance portfolio yield Grow the portfolio value = Enhance portfolio total return 20

PFM Investment Advisors to the Public Sector Risk and Return of Different Duration Targets © 2011 PFM Asset Management LLC 21 Risk/Return of Various Benchmarks 10 Years Ended 12/31/2010 Merrill Lynch IndexDuration Overall Return Cumulative Value of $50,000,000 Quarters With Negative Returns LAIF0.50 Years2.85%$66,225,4620 out of 40 1 Year Treasury Index0.99 Years3.16%$68,230,6323 out of Year Treasury Index1.85 Years3.92%$73,448,5125 out of Year Treasury Index2.57 Years4.46%$77,394,91111 out of Year Treasury Index5.51 Years5.50%$85,399,05815 out of 40

PFM Investment Advisors to the Public Sector Target: Average Maturity or Duration Time years High Average Maturity Band Low Average Maturity Band Target 22

PFM Investment Advisors to the Public Sector Implementation Based upon expected cash flows and investment policy, four decisions must be made: –Sector selection –Credit quality –Average maturity or duration –Maturity position (yield curve strategy) 23

PFM Investment Advisors to the Public Sector Once you know your target duration, choose a portfolio structure that will capitalize on market conditions. –Match cash flows exactly—great for most liquid portions of portfolio –Laddered –Bullet –Barbell Maturity Positioning 24

PFM Investment Advisors to the Public Sector $0 $5 million $10 million $15 million $20 million Liquid0-1 Years1-2 Years2-5 Years $15 $9 $6 Current Investments Cash Flow Needs $6 $15 $9 Portfolio Structure: “Match Cash Flows Exactly” 25

PFM Investment Advisors to the Public Sector Portfolio Structure: “Laddered” $0 $5 million $10 million $15 million $20 million 0-1 Yr1-2 Yrs2-3 Yrs3-4 Yrs4-5 Yrs $12 mm $0 Laddered 26

PFM Investment Advisors to the Public Sector Portfolio Structure: “Bullet” $0 $5 million $10 million $15 million $20 million $25 million $30 million $35 million $40 million 0-1 Yr1-2 Yrs2-3 Yrs3-4 Yrs4-5 Yrs Bullet $36 mm $0 27

PFM Investment Advisors to the Public Sector Portfolio Structure: “Barbell” $0 $5 million $10 million $15 million $20 million $25 million $30 million $35 million $40 million 0-1 Yr1-2 Years2-3 Years3-4 Years 4-5 Years $18 mm $0 $18 mm $0 Barbell 28

PFM Investment Advisors to the Public Sector U.S. Treasury Yield Curve 3m 2y 5y 10y 30y Time to Maturity Yield Yield Curves: “Positively Sloped” 29

PFM Investment Advisors to the Public Sector Time to Maturity Yield U.S. Treasury Yield Curve 3m 2y 5y 10y 30y Yield Curves: “Inverted” 30

PFM Investment Advisors to the Public Sector U.S. Treasury Yield Curve 3m 2y 5y 10y 30y Time to Maturity Yield Yield Curves: “Flat” 31

PFM Investment Advisors to the Public Sector Actual U.S. Treasury Yield Curves 32 11/3/20101/4/2011Change 3 month0.12%0.13%+ 0.01% 6 month0.15%0.18%+ 0.03% 1 year0.20%0.26%+ 0.06% 2 year0.33%0.62%+ 0.29% 3 year0.47%1.02%+ 0.55% 5 year1.11%2.01%+ 0.90% 10 year2.57%3.33%+ 0.76% 30 year4.04%4.41%+ 0.37% U.S. Treasury Yield Curve November 3, 2010 vs. January 4, 2011 Source: Bloomberg Fed holding short rates near zero What structure does this environment call for?

PFM Investment Advisors to the Public Sector Yield Curve Getting Steep Once More 291 bps 271 bps Source: Bloomberg 33

PFM Investment Advisors to the Public Sector Source: Bloomberg Treasury Yields Rebound From Record Lows 1.17% 0.33% 0.62% 34

PFM Investment Advisors to the Public Sector Determine how much is liquid, how much is core Reduce unnecessary liquidity—but mind the current environment Keep communication lines open with all parties involved: –Project Manager –Investment Manager –Budget Manager After ensuring safety and correct liquidity level, invest it! Optimize! Key Concepts 35

PFM Investment Advisors to the Public Sector Questions? Cash Flow and Investing 36 Insufficient Liquidity Risky Investments Volatile Markets Bad Returns