2016 fixed income asset class review | september 22-23, 2016 · september 22-23, 2016 . jason...

September 22-23, 2016 Jason Weiner, Director of Fixed Income Germán Gaymer, Fixed Income Investment Analyst

2016 Fixed Income Asset Class Review

Agenda

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I. Fixed Income Market Environment & Performance II. Fixed Income Asset Class Overview III. Fixed Income Manager Review IV. Conclusion

I. Fixed Income Market Environment & Performance

Fixed Income Environment & Performance

4 As of 8/29/2016 Source: Bloomberg

Treasury yields are near record lows as a result of global central bank policies.

Maturity Yield Record Lows 10yr 1.56 1.36 30yr 2.22 2.10

0

1

2

3

4

5

6

%

U.S. Treasury Yields

10yr 30yr


5 As of 8/29/2016 Source: Bianco Research

• Japanese and European Central Banks continue to expand their balance sheets causing interest rates to reach unprecedented levels.


6 Source: Bloomberg & Bianco Research As of 08/31/2016

• Approximately 1/3 of total developed market sovereign debt trades with negative interest rates.


7 As of 8/29/2016 Source: Bloomberg

0100200300400500600700

bps

IG Spreads

IG Average

0

500

1000

1500

2000

2500

bps

HY Spreads

HY Average

Last Avg.* IG 135 181 HY 524 617

Record low interest rates have caused a contraction in risk premiums as investors reach for yield.

Barclays Agg BofA ML IG BofA ML HY

CS Leveraged Loan Index

JP Morgan EMBI GD

JP Morgan GBI-EM GD

JP Morgan CEMBI GD

Last 12 mo. 5.56% 9.37% 9.28% 3.72% 14.45% 11.55% 10.02% YTD 5.52% 9.52% 14.54% 6.44% 14.46% 15.49% 10.94%

*Average as of 01/01/2006


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Source: Bloomberg & Bianco Research As of 08/29/2016

• The bond markets are currently pricing in only a modest probability of a rate hike in 2016.


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Summary • Interest rates may remain lower for longer given central bank policies. • Investors continue to search for attractive yields in other asset classes because

of this persistently low interest rate environment. • Market reactions are making it difficult for the Federal Reserve to increase

rates given tepid economic growth and very low inflation expectations. • Current monetary policy combined with effective fiscal policy could have a

significant impact on the future level of interest rates.

As of 6/30/2015, Net Performance

Market Value YTD 1 YR 3 YR 5 YR

Total Core $6,114,420,362.65 5.26% 5.77% 4.03% 3.87%

Total Non-Core $1,644,318,632.97 1.73% 0.04% n/a n/a

II. Fixed Income Asset Class Overview

Core Fixed Income Pacing Plan Information

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Year Pacing Plan Update

2010 • February – Board education piece on Derivatives presented • Core Fixed Income continues to fund Equities

2011 • Core Fixed Income continues to fund diversification of total plan including Equities, Real Return and Real Estate

2012 • August – Board approved changing the target allocation from 35% to 30% in conjunction with the Asset Allocation Study

• Core Fixed Income continues to fund diversification of the total plan

2013 • September – Board approved Non-Core Fixed Income managers (Loan/CLO) $750M to be funded from Core Fixed Income

• Core Fixed Income continues to fund diversification of the total plan

2014 • June – Board approved Non-Core Fixed Income managers (RMBS/CMBS) $750M to be funded from Core Fixed Income

• September – December- ongoing funding of Loan/CLO portfolios • December – $500M RMBS/CMBS portfolios fully funded • Core Fixed Income continues to fund diversification of the total plan

2015 • February - $500M CLO/Loan portfolios fully funded • March – Board approved reallocating previously approved allocation of $250M each for Bank Loan/CLO and

RMBS/CMBS strategies to existing managers to be funded from Core Fixed Income • April – May – reallocation of RMBS/CMBS fully funded • August Bank Loan/CLO portfolios fully funded • Core Fixed Income continues to fund diversification of the total plan

2016 • February – New Fixed Income Director joined TMRS • February – The Board decided to discontinue securities lending program due to a credit rating agency

downgrade of the lending agent. • April – Securities Lending Legacy Assets were sold and the program was completely terminated • Core Fixed Income continues to fund diversification of the total plan

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Core Fixed Income Allocation

As of June 30, 2016

NOTE: Percentages may not be exact due to rounding; State Street Analytics as of 6/30/16. 12

Core Weighting vs. Target

Mandate Market Value % of Total Fund

CORE FIXED INCOME

BlackRock $4,090,752,009 16.85%

PIMCO $2,023,668,354 8.34%

TOTAL $6,114,420,363 25.18%

25.2%

10.0% 15.2%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Actual Target Difference

Non-Core Fixed Income Pacing Plan Information

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Year Pacing Plan Update

2012 • August – Board approved segregating Non-Core Fixed Income from Core Fixed Income and making it a separate asset classes for better transparency and control. Board also approved 10% target allocation to Non-Core in conjunction with the Asset Allocation study.

2013 • March – Educational session presented to Board (Intro to Non Core) • June – Board approved Non-Core Fixed Income allocation and authorized manager search for the Bank

Loan/CLO strategy • September – Board approved Manager selections for Bank Loan/CLO strategy • December – Board approved 2014 Pacing Plan, including a manager search for the RMBS/CMBS

strategy

2014 • May – Board approved increasing the sector allocation limit from 25% to 40% of the Non-Core Fixed Income asset class. Board also approved manager selections for RMBS/CMBS strategy.

• December – Board approved Pacing Plan, including a manager search for Emerging Market Debt (EMD) Managers

2015 • February – Emerging Market Debt Manager search completed • March – Board approved reallocating previously approved allocation of $250M each for Bank

Loan/CLO and RMBS/CMBS strategies to existing managers • May – Board approved Emerging Market Debt Manager recommendations • December – Board approved 4 Direct Lending Manager recommendation for a total of $950 M

2016 • June – 1st recommendation: Opportunistic Credit Managers for $700 million • September – Expected to make 2nd search process recommendation • December – Expected to make 3rd search process recommendation

Non-Core Fixed Income Allocation

As of June 30, 2016

NOTE: Percentages may not be exact due to rounding; State Street Analytics as of 6/30/16. 14

Non-Core Weighting vs. Target

Mandate Market Value % of Total Fund

NON-CORE FIXED INCOME

Guggenheim $386,830,086 1.59%

Highland $369,715,302 1.52%

Voya $385,517,956 1.59%

Ellington $384,751,724 1.58%

Golub $38,045,454 0.16%

White Oak $79,458,112 0.33%

TOTAL $1,644,318,633 6.77%

6.8%

20.0%

-13.2% -15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Actual Target Difference

PORTFOLIO MANAGEMENT STRUCTURE Fixed Income

15 15

MANAGER STRATEGY PORTFOLIO BENCHMARK

BlackRock Core US Core (enhanced index) Barclays US Aggregate Bond Index

PIMCO Active Core Plus Barclays US Aggregate Bond Index

Highland Capital Non-Core Bank Loan/CLO Debt Credit Suisse Leveraged Loan Index

Guggenheim Bank Loan/CLO Debt Credit Suisse Leveraged Loan Index

Voya Investment Management (formerly ING Investment Mgmt) RMBS/CMBS

33% Barclays US Agg Corp Index and 67% Barclays US Corp High Yield Index

Ellington Management Group RMBS/CMBS

33% Barclays US Agg Corp Index and 67% Barclays US Corp High Yield Index

Golub Direct Lending N/A

White Oak Direct Lending N/A

Deutsche Bank Securities Lending* N/A * Program terminated.

III. Fixed Income Manager Review

Core Fixed Income Asset Class Overview

US Core Fixed Income Objective

Purpose is to diversify the risk of the overall investment portfolio with a secondary goal of capital preservation.

Performance objective is to exceed the Barclay’s US Aggregate Bond Index net of fees over rolling five-year periods and within tracking errors as specified in the Manager contracts, determined according to the specific strategies employed.

Investment Philosophy- BlackRock Top down determination of investment themes are based on bottom-up inputs. Investment

themes establish parameters for sector, sub-sector and security selection. Macro overlays for duration and volatility are viewed as a separate sector and used opportunistically.

Investment Philosophy- PIMCO PIMCO’s investment philosophy is driven by diversifying strategies and focuses on longer

term secular (3-5 year) trends. Seek to add value through top down strategies including interest rate exposures, duration,

volatility, yield curve positioning and sector rotation. Employ “bottom-up” strategies through in depth credit analysis and specific security

selection.

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Annual Manager Report Card for: BlackRock Strategy: Core Bond

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Excellent In Good Standing Fair (working with manager)

Unsatisfactory (remedial action being taken)

Comprehensive Review

Assessment Area Grade Update & Comments

Organization No recent material organizational or structural changes. No additional disclosures made since last review.

People No changes

Philosophy/Strategy/Process No changes

Portfolio(s) No changes

Performance YTD 5.31%. Performance in line with benchmark. ITD 4.27% (8 bps over benchmark).

Compliance No issues

Guideline Changes No changes

Risk Management No issues

Operations No issues

Client Service Client service and portfolio management teams are very accessible and responsive

Other N/A

Annual Manager Report Card for: PIMCO Strategy: Core Bond

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Organization PIMCO has transitioned effectively after the CEO departure. PIMCO has maintained a strong and experienced management team and performance has been in line with expectations. TMRS staff is removing PIMCO from its watchlist.

People No personnel changes regarding TMRS portfolio.

Philosophy/Strategy/Process PIMCO has continued to add key advisors to its Board of Experts.


Performance YTD: 5.17% slight underperformance. ITD 4.31% (18 bps overperformance)





Client Service Client service is extremely responsive and proactive.

Other N/A

Non Core Fixed Income Asset Class Overview

Objective The purpose is to enhance total return through income and capital appreciation and

provide diversification to the total investment portfolio. This allocation may be managed actively and/or passively through multiple managers in consideration of manager concentration risk.

The Performance Objectives is to exceed the returns of a blended benchmark comprised of the Barclays US Corporate High Yield Index 50%, the JPM GBI-EM Global Diversified Index (USD Unhedged) 25%, and JPM CEMBI Broad Diversified Index 25%, net of fees over rolling five-year periods and within tracking errors as specified in the manager contracts or otherwise agreed to in writing, determined according to the specific strategies employed.

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Annual Manager Report Card for: Ellington Management Group Strategy: RMBS/CMBS

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Organization No material changes since last review.

People No departures related to TMRS. Strong portfolio management team.

Philosophy/Strategy/Process Strategy focuses on security selection and scenario analysis. Firm utilizes proprietary models to uncover value in the securitized credit market.


Performance YTD: 1.44% underperformance versus benchmark, mainly due to benchmark mismatch. ITD: 2.01%


Guideline Changes In discussions to expand mandate and benchmark.



Client Service No issues

Other N/A

Annual Manager Report Card for: Voya Investment Management Strategy: RMBS/CMBS

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Organization

On August 31, 2016 Voya announced that its CEO was stepping down. The CEO will be replaced by current CIO, who at the same time will be replaced by current Head of Public Fixed Income. The transition shows staff that Voya was prepared for this kind of event. Staff believes there is no immediate impact to TMRS portfolio. Staff will continue to monitor the situation.

People No changes

Philosophy/Strategy/Process Micro-level collateral analysis. Macro themes expressed through asset allocation.


Performance YTD: 0.68% underperformance versus benchmark, mainly due to benchmark mismatch. ITD: 2.12%

Compliance No changes

Guideline Changes No issues



Client Service Client service and portfolio management teams are very accessible and responsive.

Other N/A

Annual Manager Report Card for: Highland Capital Strategy: Bank Loans/CLO

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Organization Independent. 100% employee-owned. In 2015, formed “Highland Alternative Investors” a liquid alternatives platform.

People CLO Portfolio Manager was terminated and replaced.

Philosophy/Strategy/Process Strategy includes fundamental analysis, proactive due diligence and exploiting price inefficiencies.


Performance YTD:1.82% underperformance due to higher CLO exposure and industry selection. ITD: -0.05%




Operations No changes

Client Service No issues

Other N/A

Annual Manager Report Card for: Guggenheim Partners Strategy: Bank Loans/CLO

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Organization No additional disclosures made since last review. Guggenheim has undertaken some organizational restructuring. Staff believes there are no material changes regarding TMRS portfolio.

People No material changes regarding TMRS portfolio.

Philosophy/Strategy/Process Strategy relies on fundamental analysis and proactive relative value security selection.


Performance YTD: 2.79% underperformance due to CLO exposure. ITD: 2.39%

Compliance Restriction on non-rated securities miscoded on compliance program. Error corrected.



Operations No changes

Client Service New team in place. Global restructuring of client service area.

Other N/A

Securities Lending At the February 2016 Board Meeting, the TMRS Board of Trustees decided to terminate the Securities Lending

Program due to a credit downgrade of Deutsche Bank and consequent breach of TMRS’ IPS. Deutsche Bank was notified immediately and the Securities Lending program was significantly downsized. The

remaining portfolio was kept in place to fund the legacy assets portfolio until they could be sold. The chart below depicts the unrealized losses for the legacy portfolio from 2007 until the program was terminated.

The largest unrealized loss occurred on January 2009 when TMRS legacy portfolio has a total unrealized loss of $185,848,083.

All legacy assets were sold by April 21st 2016 and the final loss for TMRS was approximately $3,810,879. Staff will re-evaluate the securities lending program during the custodial search in 2017.

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$(200,000,000)

$(150,000,000)

$(100,000,000)

$(50,000,000)

$-

$50,000,000

TMRS Legacy Portfolio Loss

IV. Conclusion

Conclusion and Recommendations

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• TMRS Investment Staff and RVK concur that no structural changes are needed/recommended at this time

• PIMCO Recommendation • Staff is removing PIMCO from the watch list after continued monitoring

and extensive review. Staff is comfortable with the current organization.

• Continue to monitor managers and address any highlighted issues

• Continue expansion of the non-core fixed income allocation

• Reduce core fixed income according to recent asset allocation study

DISCLOSURE

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TMRS periodically discloses public information that is not excepted from disclosure under Section 552.0225(b) of the Texas Public Information Act. Information provided by a manager, a general partner or other data

provider to TMRS or a TMRS service provider, and contained in these materials, may have been independently produced or modified by TMRS or the TMRS service provider.

2016 fixed income asset class review | september 22-23, 2016 · september 22-23, 2016 . jason...

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