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There has been considerable attention paid to "derivatives" recently in the national press and within municipal and corporate treasury offices across the United States. Media and congressional attention has been focused on some large losses taken by hedge funds, corporations and governmental entities due largely to recent movements in the derivatives' underlying indices. This attention is not simply because of the losses however, but also because of the tremendous growth in the derivatives market itself. Although no one has complete data, it is estimated that the underlying contracts total $14 trillion: three times the total volume of all stocks traded on the NYSE in a month and twice our national GDP. With such a large market, and its inevitable impact on all our financial markets, all investors should be familiar with derivative types, their advantages and their dangers.
There are all makes and models of derivatives. Their value can only be judged on their relative value to your portfolio. The types range from simple callable agencies to MBS structured notes to complex hedge strategies. Before we judge, or react to, the overall derivative market it is wise to more thoroughly understand what a derivative is and why they were developed. Derivatives are not inherently bad but chosen unwisely or without an understanding of their structure and assumptions, they can indeed be ugly!
The derivative market is not a "casino" as some would characterize it, but there is a buyer for each seller in options. A hedge, or opposite position by another market participant, is being made against you to make the trade work. The ability to create a equal and opposite hedge against rates or prices is an important tool to reduce risk in volatile markets. However, if that risk does not exist in the portfolio initially, the derivative changes from a hedge to a speculative position.
The name derivatives has been given to any number of structured securities. Basically derivatives are securities created with embedded options. Most of them have their underpinning in the swap market. They can be as straightforward as options to buy or sell securities or as complex as commodity swaps based on multiple currencies. They can be used to tailor the risk characteristics of a portfolio and give us the ability to eliminate risks. In addition, derivatives allow investors to access markets that otherwise would be unauthorized or unavailable. For example, buying a US agency callable note is actually allowing the investor to access the futures market because by buying that note the investor is actually making an interest rate call. He is either betting that interest rates drop and he will receive additional yield for a shorter than stated maturity note or betting that the rates will rise and he will receive a better spread than normal on a longer security. Without access to the callable market such an interest rate call could not be made. The example however illustrates that derivatives always have two sides. Interest rates will usually go only one way. The investor must be prepared to ready to absorb the impact of either direction or he has only added risk to his portfolio. All sides of a derivatives security must be understood before the investment decision can be made.
This example illustrates some of the key points about derivatives. (1) All derivatives involve tradeoffs between payoff and risk. The options embedded in the structure of a derivative represent opposite positions taken in the futures market or on a potential move in a specific index. In order to evaluate the note for purchase, the investor has to analyze the risk of multiple interest movements. (2) Derivatives often give the investor access to a different market. In this case the security is using the futures market which may or may not be accessible to the investor. To evaluate the note, the underlying basis (contract) must be understood. This may present no problem when it involves US interest rates, but, complex issues involving multiple commodities or indices can make analysis difficult. (3) With the explosion of new derivative types, the investor can be lulled into complacency and not realize the derivative nature of the security. Three years ago we saw primarily bullet (straight) securities from the US agencies. Now a significant number are derivative in nature (floaters, indexed or callable). Because of this growth, some investors buying derivatives may have unrealistic expectations of safety and/or not realize the potential impact on the portfolio as a whole in volatile rate environments. In the worst of cases, potential losses could result. (4) If derivative products are not used to hedge an existing position, the derivative becomes its own risk. Without something to hedge the derivative is simply a speculatve position. Many investors allow themselves to be forced into using the products for "higher" (speculative) yield only. Then, if expected conditions change, the derivative can become more volatile and their negative effect becomes magnified because there is no counter-hedge.
The key with derivatives, as with any investment, is to fully understand the product you are buying and its potential impact under all possible market scenarios. These are sophisticated, computer modeled securities which will react to all the various factors of our interacting global markets. Although there are an unlimited variety of individual derivatives, most fall into a few groups.
The most common of these is the collateralized mortgage obligation (CMO). A CMO is created from mortgages pooled together (the CMO) then split into various individual layers (tranches) with differing payment patterns. In order to analyze a CMO then we should first know how payments from the mortgages will flow to the tranche as it is affected by interest rates and then how the CMO itself will increase in volatility or risk as compounded by the payment flows. The investor must evaluate all the information on all the tranche's cash flow requirements and structure within the CMO itself to determine potential risks.
Other synthetic securities are packaged as "strategies" to fill a market need or opportunity. The market even creates synthetic securities from other synthetic securities. "Custodial receipts" are collections of existing securities structured to emulate the cash flows of a third. In the simplest form, the market might create a trust made up of treasury strips the payments from which replicate a treasury note which is either not available or in limited supply. Although the investor receives equal cash flows, he must be aware that ownership is not in the underlying security but in the trust - a very different type of guarantee!
Swaps substitute different types of risks. A swap can exchange fixed and variable rates for an issuer. Or swaps can be constructed to hedge two similar but opposite movements such as currency movements or international rates. Swaps must be designed by the investor to hedge an existing exposure. For example, if you have high expenses for oil on the spot market, a swap can reduce the risk and replace it with a guaranteed price. However, if you have no oil price exposure, a swap simply creates risk through speculation.
Strips used in the MBS market present ever further risks. The principal portion of a stripped MBS reacts to the same volatility in rates and that volatility is compounded by the effect of rates on the underlying mortgage. Losses in the MBS derivatives, especially stripped IOs and POs, have been especially large because of the extreme volatility. Even the most sophisticated investors were not prepared for the volatility experienced by these bonds in a fast rate change.
It is not unusual to see securities with extremely complex formulas guiding their coupon payments. The issuer of such products is making assumptions on the underlying index and creating a hedge in the indexed market which will protect his issue. Although floors on the coupon levels can protect coupon losses, many formulas can result in zero interest for the life of the bond. In addition, computations on the indexes are often delayed causing the coupon payments to be paid on delayed schedules. The investor must investigate the security thoroughly and understand exactly how all the markets move to make the correct investment decision.
In summary, derivative products offer the investor the opportunity to minimize exposure to interest rates changes and other risks. They also allow us to enter new markets. However, they can represent significant risks to investors who do not do a thorough analysis of the underlying securities and conditions for payment.
New law changes in Texas, and around the country, focus on new reporting requirements to governing boards and commissions. That is because the legislators recognized that in many trouble-ridden portfolios today those governing bodies had been neglecting their oversight responsibilities. The long bull market, which promised continuing profits and opportunities, and the low interest rates, which reduced earnings substantially, forced many investors into high risk situations.
Problem portfolios typically are loaded with high-yield - or promised high-yield - securities. Typically, these problems are the result of two actions by the investor. (1) The investor was invariably stretching for yield for additional earnings or because the market made it look so easy to get yield without risk. However, the market requires risk before reward. The stretch for yield placed more risk than was acceptable in the portfolio and when the market changed the risk remained and the reward had vanished. (2) Secondly, the investor lost track of the level of risk in the portfolio and created excessive exposure to one type of security or sector. Portfolios were barbelled (long and short securities without a ladder to mirror liabilities) or relied solely on one type of security (usually mortgage-backed securities). Normal diversification strategy was traded for risk. The governing bodies had the ability to see these problems develop but had ignored a simple technique that would have identified the developing problem before the portfolios turned in losses.
Benchmarking portfolios and straightforward regular reporting, including those benchmarks, can be your reality check against the tendency to reach excessively for yield. It can also alert you to excessive exposure by security type or market sector. A benchmark must be set with care and thought and then used regularly in reporting.
In a public funds portfolio, the first responsibility of the investor is to know and understand the goals and objectives of the portfolio. Our primary objectives are liquidity and safety. Therefore, portfolios should be short to prepare for liquidity needs and of the highest quality to fulfill our public fiduciary responsibility for safety. Most public entities' portfolios represent operations during a single fiscal year. Therefore, the average weighted maturity (WAM) of the portfolio should be approximately six months or less.
A review of the cash flows during those twelve months will allow you to reasonably set your optimal weighted average maturity. For example, if you have a higher percentage of capital funds which will not be spent for two years, then, the WAM may be longer (180 days). But, if you have less or no longer funds and all the funds will be spent in one year, then, the WAM may be shortened to 90 or 120 days. This establishment of a realistic WAM for your portfolio is paramount. It is this WAM that will help you choose your benchmark.
Since safety is our primary focus, the benchmark for almost every public funds portfolio should be the US Treasury yield curve. As a busy public finance professional, with many hats to wear, you are not paid to significantly outperform the Treasury market. (That is the job of professional money managers who can concentrate on the market and have the technology to follow that market. A public manager is only paid to match or "beat" the Treasury curve by 20-40 bp.)
Once you have set your WAM, you have your benchmark. If your WAM is 180 days, your benchmark is the six month Treasury Bill. By using this benchmark in your regular reporting it can alert you to any dangerous trend towards stretching for yield. For example, when we were in a three percent interest rate environment for a three month WAM portfolio (the benchmark) a portfolio yielding six percent would automatically be suspect. Such a gap over your benchmark screams "risk"! Conversely, if you are significantly below your benchmark, you know the portfolio has market value losses that might need to be addressed, or you might need a change in strategy. The WAM of the portfolio, the yield on the portfolio and the benchmark for that same period should be included on each monthly report you produce. This will give you a realistic picture of how you should be performing versus your specific performance.
The comparable maturity Treasury Bills are the most natural benchmark for public portfolios. You need to compare the average yield on the Bills against your portfolio for the same period.
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