Techniques for Investing in a Low Interest Rate Environment American Public Power Association Business and Financial Conference September 21, 2004 Presented by Ross Byers, JEA with assistance from Tom Davis, JEA APPA CONFERENCE

APPA CONFERENCE, 9/21/04 Investment Objectives ●Safety of Capital ●Liquidity ●Highest Possible Yields in a low interest rate environment consistent with Safety and Liquidity

APPA CONFERENCE, 9/21/04 First, let’s define “low interest rate environment” ● I started in this business in 1979 and low interest rates to me for many years meant under 10% ● For instance, from 1985 through 1999 short/intermediate term rates generally ranged from 4% to 10% ● However, beginning in 2000 we have witnessed an unprecedented decline in short-term rates which bottomed with the Fed funds target at 1% from mid-2003 until the Fed raised rates on June 30, 2004

APPA CONFERENCE, 9/21/04 Fed Funds Target Rate, Jan to August 2004 High: 9.75% (Feb. ’89) Low: 1.0% (June ’03 - June ’04) Avg.: 5.25%

APPA CONFERENCE, 9/21/04 3 Month LIBOR, January 1985 to August 2004 High: 10.3% (Feb. ’89) Low: 1.1% (Mar. ’04) Avg.: 5.51%

APPA CONFERENCE, 9/21/04 Risk/Reward ● In the ’85 to ’99 period, let’s assume your short-term portfolio was yielding 6% at a given point in time ● If rates rose 200 basis points, your MTM value would be below cost and your current yield would be below market ● In the current very low interest rate environment since 2000, if rates were to rise 200 basis points the same points made above would be true ● However, the magnitude of the effect on performance measured from a yield viewpoint is much greater, i.e. 1% to 3% versus 6% to 8% ● The impact is a 200% change versus a 33% change ● From an investment income budget standpoint, the magnitude of this variance could be hard to explain to a non-finance CEO. During the decline in rates, you may have already experienced this.

APPA CONFERENCE, 9/21/04 How Do We Manage Our Short-term Portfolios if rates remain in this 1% - 4% range for an extended period, i.e. the whole decade? ●First, let’s look at some of our available instruments

APPA CONFERENCE, 9/21/04 Risk/Reward Profile Low Risk/Low Yield Money Market funds, High grade CP, T-bills, Agency discount notes, Repurchase Agreements Moderate risk/Higher Yield 2 to 5 year notes, Adjustable rate mortgages, callable agency notes, step-up bonds, Intermediate term MBS and CMOs Higher risk/Higher Yield Lower grade corporate bonds, Notes with derivatives, and other exotic instruments

APPA CONFERENCE, 9/21/04 How Do We Manage Our Short-term Portfolios if rates remain in this 1% - 4% range for an extended period, i.e. the whole decade? ●Second, what are some of the measurement tools that our various organizations use to judge our performance?

APPA CONFERENCE, 9/21/04 Alternatives for Measuring Investment Performance ● Managing for Yield versus Managing for Total Return ● Select Benchmark Index to correspond with measurement criteria ● Examples of Yield Benchmarks: 12 month rolling one month LIBOR, 1 year or 2 year Treasury constant maturity ● Examples of Total Return Benchmarks – Lehman 1-5 yr. Gov’t/Credit Bond Index, Lehman 1-3 yr. Gov’t Bond Index

APPA CONFERENCE, 9/21/04 How Do We Manage Our Short-term Portfolios if rates remain in this 1% - 4% range for an extended period, i.e. the whole decade? ● Lastly, let’s evaluate different strategies in varying interest rate environments, staying in our 1% to 4% range of interest rates. ● Our scope is limited to maturities 5 years and under

APPA CONFERENCE, 9/21/04 Before we discuss specific investment alternatives, let’s quickly review some basic strategies to improve yields. Depending on your investment philosophy, guidelines and/or policy, some or all of these may not be appropriate. ● Reduce Credit Quality – AAA 10-year agency is +50; AAA Corporate is +70; A- rated 10 year is +100 and lowest investment grade is +140 ● Lengthen Maturities – Spread between 2-year and 5-year Treasuries is 90 basis points ● Buy Callables/Step-up bonds – Bullet 2 year is +25; 2 year non-call 3 month Bermuda is +50 ● If the portfolio has maturity constraints (i.e. debt service sinking funds), receive fixed – pay floating interest rate swaps are an example of a way to increase yield

2-Year & 5-Year Treasury Rates, Jan. ’94 to Aug. ’04 Avg. Spread 52 bp Spread since ’01: 1.07% 9/15 Spread: 90 bp Like the early ’90s when spreads for 2s to 10s were very wide, similarly spreads for 2s to 5s have widened in the last 3 years on the fear that we will return to higher rates.

APPA CONFERENCE, 9/21/04 Basic Example ● Buy 2.5 year agency versus 6 month agency discount notes ● Evaluating additional yield for extension risk ● Also, evaluating overall yield if not held to maturity

APPA CONFERENCE, 9/21/04 Invest in a 2.5 yr Fannie Mae NC 6 mo. 1X at a 3.12% yield for 2.5 years? Or invest in 6 month agency discount notes at 1.90%, waiting for higher rates. What’s the breakeven rate that you’d need at the end of 6 months for the last 2 years? 3.426%. Will 2 year agency bullets yield that much 6 months from now? Check the forward curve to get an idea…

APPA CONFERENCE, 9/21/04 Agency forward curve at 3/21/05 indicates a 2 year agency yield of 3.24%. This is below the breakeven rate of 3.426% from last slide. Relying on the forward curve would tell you to go ahead and buy the 2.5 year callable instead of waiting for higher rates.

APPA CONFERENCE, 9/21/04 What if you have to sell the bond after 6 months and rates have risen? You could have earned 1.90% for 6 months in discount notes. At what price can you earn still earn 1.90% if you sell? This equates to a 75 basis point increase in rates at the end of 6 months; i.e. an increase to 3.45% for a 2 year agency bullet.

APPA CONFERENCE, 9/21/04 Another approach could be to use somewhat more sophisticated bond analytic tools. Utilizing analysis tools available from your Investment Advisors and/or Investment Broker/Dealers can help you model various scenarios that provide information on expected returns. The example I’m going to show you is from Citigroup using “Yield Book.”

APPA CONFERENCE, 9/21/04 Assumptions Used for Computer Simulation (Yield Book) ● Maximize Yield subject to a maximum loss constraint of 3% ● A 3% loss on a 2 year is approximately a 160 bp immediate increase in rates and a 325 bp increase in rates after 1 year. Loss constraint does not include coupon interest earned. ● Securities have maximum maturity of 5 years ● Available Securities - Treasuries and Agencies

APPA CONFERENCE, 9/21/04 Four One-Year Scenarios ● 1994 Style Bear Flattener – 2-yr. rises 344 bp and 10-year up 190 bp ● 1999 Style Bear Flattener – Much Tamer than ’94 case. Two-yr. rises to 4.11% and 10-year increases to 5.43% ● Bear Steepener – A prolonged bear steepener is unusual, but is not impossible if the fiscal situation deteriorates while the economy weakens. Two-yr. yield at 2.44% and the 10-year is 5.32% ● 12-month Forwards – 12-month forward curves are realized

APPA CONFERENCE, 9/21/04

Securities Universe ● Treasuries with maturities less than/equal to 5 years ● Bullet/Callable agencies with maturities less than/equal to 5 years ● Step-up agencies – With a 2007 final maturity ● Floating-rate agencies - Five-yr. floating rate at LIBOR – 9 and Four callable cap floaters – 5 NC1 and 5 NC2 with 5% and 5.5% caps

APPA CONFERENCE, 9/21/04 OPTIMAL PORTFOLIO (SELECTED BY COMPUTER MODEL) $100 Million Portfolio: Two bullet agencies (38%) Three callable agencies (42%) August 2009 Libor Floater (20%) Yield to mat. is 3.14%, compared to 2-Yr. Treas. yield of 2.44% Duration is 1.6 years compared to 2 yr. T-note of 1.9 years

APPA CONFERENCE, 9/21/04 One- Year Performance Across Scenarios

APPA CONFERENCE, 9/21/04

This has been a brief look at some strategies we utilize at JEA. I’m sure I’ve only touched on a handful of options that are available. I’d like to open it up to the floor to hear some additional ideas that you may be utilizing.