Understanding Callable Securities PFM Asset Management Nancy Jones and Nsesa Kazadi 50 California Street, Suite 2300 San Francisco, CA

PFM Asset ManagementPresenters: Nancy Jones and Nsesa Kazadi Callable Federal Agencies Federal Agency security with a call optionFederal Agency security with a call option Call option allows the issuer to redeem the security prior to maturity, at the call dateCall option allows the issuer to redeem the security prior to maturity, at the call date –One time –Continuously –Periodically Issuers pay a premium in the form of a higher yield for this featureIssuers pay a premium in the form of a higher yield for this feature The option premium is based on:The option premium is based on: –Current interest rates –Expected future rates –Call structure Yield on Bullet Security + Call Option Premium Yield on Callable Security

PFM Asset ManagementPresenters: Nancy Jones and Nsesa Kazadi Callable or Non-Callable 2 year, non-call one, 5.25% Coupon $1,000,000 par -$1 million $26,250 Year 1 Year 2 Principal Interest $1,026,250 Principal is returned early if security is called $26,250 $1,026,250

PFM Asset ManagementPresenters: Nancy Jones and Nsesa Kazadi Callable Federal Agency Securities Pros High credit quality Additional yield advantage Cons Date principal is returned is uncertain More challenging to analyze competitive offers

PFM Asset ManagementPresenters: Nancy Jones and Nsesa Kazadi Maturity Distribution: Call vs. Maturity Date $0 $20 $40 $60 $80 $100 $120 $ Year1-2 Years2-3 Years3-4 Years4-5 Years To Maturity To Next Call millions

PFM Asset ManagementPresenters: Nancy Jones and Nsesa Kazadi Risk of Callable Securities 3-Year U.S. Treasury Note January 1, 2000 – February 17, 2006 Source: Bloomberg Purchase of 3-year callable, 1-year non-call protection 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% Jan- 00 Jul- 00 Jan- 01 Jul- 01 Jan- 02 Jul- 02 Jan- 03 Jul- 03 Jan- 04 Jul- 04 Jan- 05 Jul- 05 Jan- 06

PFM Asset ManagementPresenters: Nancy Jones and Nsesa Kazadi Current Rates 3-Year Federal AgencyYield Bullet (Non-Callable)4.88% Non-Call 1-Year; 1-Time Call5.075% Non-Call 3-Months; Quarterly Call5.375% Rates as of February 9, 2006

PFM Asset ManagementPresenters: Nancy Jones and Nsesa Kazadi Select the Best Offer Option 1Option 2 Type of IssueNew IssueSecondary Market DescriptionFHLMC 5.125%FNMA 5.10% Maturity DateFebruary 27, 2008February 22, 2008 Call Date2/27/07 (1-time)2/22/07 (1-time) SettlesFebruary 27, 2006February 22, 2006 Price Yield to Call5.125%5.162% Yield to Maturity5.125%5.132% Which security would you buy?

PFM Asset ManagementPresenters: Nancy Jones and Nsesa Kazadi Advantages Option 1Option 2 Type of Issue New IssueSecondary Market DescriptionFHLMC 5.125%FNMA 5.10% AdvantagesLonger time to call date Higher yield-to-call Higher yield-to-maturity Shorter settlement date (earn yield sooner)

PFM Asset ManagementPresenters: Nancy Jones and Nsesa Kazadi Still Undecided? “OAS” it! Option Adjusted Spread Analysis (OAS) can help you select the cheapest callable security. OAS models calculate the value of the call option to arrive at an “option-free” yield spread. The OAS provides an apples-to-apples comparison of callable securities with similar structures. You can also compare the OAS to yield spreads of similar non-callable securities.

PFM Asset ManagementPresenters: Nancy Jones and Nsesa Kazadi Option Adjusted Analysis FHLMC 5.125% February 27, 2008 O.A.S. Effective Duration

PFM Asset ManagementPresenters: Nancy Jones and Nsesa Kazadi Option Adjusted Analysis FNMA 5.10% February 22, 2008 O.A.S. Effective Duration

PFM Asset ManagementPresenters: Nancy Jones and Nsesa Kazadi More Yield = Better Returns? Not Always When buying callable securities, more yield does not always equal more income or better returns! Reinvestment risk: securities get called when rates fall, thus reducing income Negative convexity: price appreciation is limited while potential price decline is unlimited