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FIXED INCOME RESEARCH
The Merits of Diversification in
Portfolio Management
Intended for Institutional Clients Only
See Page 43 for Important Disclaimers & Disclosures
April 14, 2016
Ellis Phifer, CFA, CMT
Managing Director
(901) 579-4831
Ellis.Phifer@raymondjames.com
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Objectives
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Broad Understanding of Diversification Theory
Implication for Public Sector Portfolio
Diversification Within the Agency Sector
Broader Asset Class Diversification
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Diversification
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
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Stock Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
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Stocks
Stocks
Stocks
Return 9.92%
St Dev 15.53%
MaxDD -50.95%
$100 becomes 4,868$
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Annual Returns
Stocks
Stock Portfolio
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Bonds
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Bond Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Bonds
Return 8.04%
St Dev 8.36%
MaxDD -15.79%
$100 becomes 2,394$
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Annual Returns
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Bond Portfolio
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Annual Returns
Stocks Bonds
Stocks and Bonds
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Annual Returns
Stocks Bonds Blend
Blended Portfolio
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Blended Portfolio
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Stocks Bonds Blend
Blended Portfolio
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Blended Portfolio
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Stocks Bonds Blend
Return 9.92% 8.04% 9.37%
St Dev 15.53% 8.36% 9.14%
MaxDD -50.95% -15.79% -23.11%
$100 becomes 4,868$ 2,394$ 3,961$
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Stocks Bonds Blend Full Diversified
Fully Diversified
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T-Bills, S&P, Small Caps, Foreign Stocks, Emerging Markets, Treasuries, Corporates, Commodities, REIT,
Long Treasuries, Gold, Foreign Bonds
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Diversified Portfolio
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Stocks Bonds Blend Diversified
Return 9.92% 8.04% 9.37% 10.36%
St Dev 15.53% 8.36% 9.14% 7.98%
MaxDD -50.95% -15.79% -23.11% -29.74%
$100 becomes 4,868$ 2,394$ 3,961$ 5,738$
T-Bills, S&P, Small Caps, Foreign Stocks, Emerging Markets, Treasuries,
Corporates, Commodities, REIT, Long Treasuries, Gold, Foreign Bonds
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Diversification
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Not designed to increase returns, but sometimes that
occurs.
Intended to reduce volatility and drawdowns.
• By adding uncorrelated assets.
• Not by adding less risky assets, though that helps.
Keep in mind, correlations are not constant. In times
of crisis, correlations increase among asset classes,
reducing the benefits of diversification.
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Objectives
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Broad Understanding of Diversification Theory
Implication for Public Sector Portfolio
Diversification Within the Agency Sector
Broader Asset Class Diversification
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Simple Portfolio Comparison
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
vs.
A
B
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Portfolio A
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
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Portfolio B
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Goal of Public Sector Portfolio Diversification
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Fixed income products are all very correlated.
Most volatility is driven by interest rate sensitivity.
Lack of uncorrelated investments means you have to
diversify by focusing on:
• Liquidity
• Cash Flow
o Maintain enough cash flow so that you are not
forced to sell securities.
o Spread out maturity to reduce reinvestment
risk.
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Objectives
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Broad Understanding of Diversification Theory
Implication for Public Sector Portfolio
Diversification Within the Agency Sector
Broader Asset Class Diversification
22
Diversification Factors
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Maturity
Call Date
Call Type
Issuer
Dollar Price
Deal Size
Coupon Type (Fixed/Floating/Step)
Coupon Payment Dates
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Callable Portfolio
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Call Type
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
One Time (1x) or “European” Call
• Callable once after a specified lockout period. For example, a 5-year bond which is callable one-time after 2 years.
Continuous or “American” Call
• Callable anytime with a specified period of notice (usually 10 or 30 days).
Discrete or “Bermuda” Call
• Callable on interest payment dates only by a predetermined call schedule.
“Canary” Call
• A hybrid between a Bermuda call and a European call.
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Issuer
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
November 2013
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Issuer
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
June 2009
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Federal Home Loan Banks
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
The Federal Home Loan Bank system was organized in 1932 under the Federal Home Loan Bank Act.
Organized Prior to Fannie Mae (1938) or Freddie Mac (1970).
The Act was designed to restore confidence in the U.S. banking system and revive the post-depression housing market.
The Act also created the need for a credit system to ensure the availability of funds to finance home loans.
Thus, the primary purpose of the FHLB is to lend funds in the form of collateralized advances to member institutions for making home loans.
Super Lien Authority.
State Tax advantage keeps demand high.
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FHLB Debt Highlights
Joint and several obligations of the system banks.
Not guaranteed by the Federal Government.
Typically not subject to State income taxes.
Issued as senior debt.
Senior debt rated AA+/Aaa.
Website: www.fhlb-of.com
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
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Farm Credit
Federal Farm Credit Bank – FFCB
• Oldest of the GSEs
• Co-operative Structure
• Over $275 Billion in Assets
• Debt Issuance Growing Fast – Becoming Player in Daily AA+/Aaa GSE Debt Issuance
• Net Income of over $3.5 Billion in each year over past 5 years.
• Regulatory Oversight
o Farm Credit Administration – Executive Branch
• Added Protection
o Farm Credit System Insurance Corp
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
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Other Large U.S. GSEs Tennessee Valley Authority (TVA)
Federal Agriculture Mortgage Corporation (“Farmer Mac”)
Alternative Issuers in Agency Market Private Export Funding Corporation (PEFCO)
Financing Corporation (FICO)
U.S. Agency for International Development (USAID)
Overseas Private Investment Corporation (OPIC)
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
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TVA Tennessee Valley Authority – TVA
• Nation’s Largest Public Power Producer
• Wholly Owned by Federal Government
o Does Not Issue Stock
• Sole Discretion to Set Power Rates
o Directed by TVA Act to Set Rates to Cover Debt Costs
• Diversified Power Production
o Coal-Fired Units
o Operating Nuclear Units
o Hydro Units
o Combustion-Turbine Units
o “Green Power” Facilities
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
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TVA Table II
Comparison to Two of the Largest GSEs, Fannie Mae and Freddie Mac
TVA Fannie Mae and Freddie Mac
Federal Charter 1933 1938 (FNMA)
1970 (FHLMC)
Ownership Federal
Government Shareholders
Financial Objective Profit Neutral For Profit
Primary revenue source Electricity Sales Mortgages
Explicit guarantee by the U.S. Gov. No No
Rating of senior unsecured securities AA+/Aaa AA+/Aaa
Business type Public Power
Utility Financial Services
Approximate level of outstanding debt securities
$25 Billion $450 Billion each
State and local income tax exemption Yes No
Source: Tennessee Valley Authority, Bloomberg
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
33
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Farmer Mac provides a secondary market for agricultural and rural utility loans through the mobilization of external capital.
Created by Congress in response to the agricultural credit crisis in the mid-1980s.
Farmer Mac is a Government Sponsored Enterprise (GSE) and an institution of the Farm Credit System (FCS).
Farmer Mac is regulated by the Farm Credit Administration (FCA), an independent agency in the executive branch of the United States government.
Farmer Mac has $1.5 billion U.S. Treasury backstop supporting guarantees.
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THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
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Other Diversification Factors
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
Dollar Price – Discounts and Premiums (Cushion)
Deal Size
Larger deal size are more liquid. Global deals greater than
$1Billion have the most liquidity.
Smaller auction deals are not as liquid but offer higher
yields.
Coupon Type
• Fixed/Floating/Steps.
• Step alternatives to floaters currently attractive.
Coupon Payment Dates
• Structure coupon payments months just like you would
maturity and call dates to reduce reinvestment risk.
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Objectives
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
• Broad Understanding of Diversification Theory
• Implication for Public Sector Portfolio
• Diversification Within the Agency Sector
• Broader Asset Class Diversification
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Asset Class Diversification
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Introducing additional asset classes can boost returns
and provide further diversification.
• Mortgages
• Agencies
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Treasury vs Swaps
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Mortgage Backed Securities
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Compare to 3Year NC 6Month 1X @ 1.15%
3-year Avg Life, 2.48 Effective Duration
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THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
MBS vs Callables
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Taxable Municipal
THE MERITS OF DIVERSIFICATION IN PORTFOLIO MANAGEMENT
• New York St Urban Dev 1.38% 3/15/2018 - Rev
• Aa1/AAA
• Yields 1.308%, +40bps to Agency Bullets
• FHLMC 0.875% 3/07/2018 – 0.90%
• California State 6.20% 10/1/2019
• AA3/AA
• Yield 1.88%, +66bps to Agency Bullets
• FHLMC 1.25% 10/02/2019 - 1.22%
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Question & Answer
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Disclaimers & Disclosures
The information contained herein is based on sources considered to be reliable but is not represented to be complete
and its accuracy is not guaranteed. The opinions expressed herein reflect the judgment of the author at this date and are
subject to change without notice and are not a complete analysis of every material fact respecting any company, industry
or security Raymond James & Associates, Inc. and affiliates and their officers, directors, shareholders and employees
and members of their families may make investments in a company or securities mentioned herein before, after or
concurrently with the publication of this report. Raymond James & Associates, Inc. may from time to time perform or
seek to perform investment banking or other services for, or solicit investment banking or other services from any
company, person or entities mentioned herein. Neither the information nor any opinion expressed herein constitutes a
solicitation for the purchase or sale of any security. Raymond James & Associates, Inc. makes no representation as to
the legal, tax, credit, or accounting treatment of any transactions mentioned herein, or any other effects such
transactions may have on you and your affiliates or any other parties to such transactions and their respective affiliates.
You should consult with your own advisors as to such matters.
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