Callable vs Bullets: Performance History

Parth Bhatt – Investment Officer, County of San Bernardino

1 2  Callables out yielded bullets from June 2000 to May 2017 by 48 bps, on average.  $10 Million invested in a 1-5 year callable only portfolio in June 2000 turned into $16.084 Million by May 2017.  How much did $10 Million invested in an agency bullets only portfolio turn into? Yield to YieldSpread to Maturity

8 2

7 1.8 1.6 6 1.4 5 1.2 4 1

3 0.8 0.6 2 0.4 1 0.2 0 0 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Oct-00 Feb-01 Oct-01 Feb-02 Oct-02 Feb-03 Oct-03 Feb-04 Oct-04 Feb-05 Oct-05 Feb-06 Oct-06 Feb-07 Oct-07 Feb-08 Oct-08 Feb-09 Oct-09 Feb-10 Oct-10 Feb-11 Oct-11 Feb-12 Oct-12 Feb-13 Oct-13 Feb-14 Oct-14 Feb-15 Oct-15 Feb-16 Oct-16 Feb-17 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Bullets (1 -5 Year) Callables (1-5 Years) Bullet - Callable Spreads Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 3 It’s a Trick Question

 1-5 year treasury and agency bullets only portfolio turns into $19.128 Million.  Bullets out-performed by $3.44 Million.  How much does a 1-5 year treasury only portfolio turn into?

Money Growth $19.12 Million $20,000,000.00

$19,000,000.00

$18,000,000.00

$17,000,000.00

$16,000,000.00

$15,000,000.00 $16.08 Million $14,000,000.00

$13,000,000.00

$12,000,000.00

$11,000,000.00

$10,000,000.00 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Oct-00 Feb-01 Oct-01 Feb-02 Oct-02 Feb-03 Oct-03 Feb-04 Oct-04 Feb-05 Oct-05 Feb-06 Oct-06 Feb-07 Oct-07 Feb-08 Oct-08 Feb-09 Oct-09 Feb-10 Oct-10 Feb-11 Oct-11 Feb-12 Oct-12 Feb-13 Oct-13 Feb-14 Oct-14 Feb-15 Oct-15 Feb-16 Oct-16 Feb-17 Bullets (1 -5 Year) Callables (1-5 Years)

Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 4 Treasuries Only?

 1-5 year treasury only portfolio turns into $17.73 Million.  Treasuries out-perform callable agencies by $1.64 Million.

$19.12 Million

$17.73 Million

$16.08 Million

Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index, BAML 1-5 Year US Bullet Agency Index & BAML 1-5 Year US Treasury Index 5

Why do callables that out yield bullets significantly underperform bullets with respect to total return? 6 Duration – Callables vs Bullets

Duration Instability 3

2.5

2

1.5

1

0.5

0 Jul-02 Jul-07 Jul-12 Jun-05 Jun-10 Jun-00 Jun-15 Apr-01 Apr-06 Apr-11 Apr-16 Jan-05 Jan-10 Jan-15 Feb-02 Oct-03 Feb-07 Oct-13 Feb-17 Oct-08 Feb-12 Sep-01 Sep-06 Sep-11 Sep-16 Mar-04 Mar-09 Mar-14 Nov-00 Nov-05 Nov-10 Nov-15 Dec-02 Dec-07 Dec-12 Aug-04 Aug-09 Aug-14 May-03 May-08 May-13 Bullets (1 -5 Year) Callables (1-5 Years)

Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 7 Bullet – Duration vs Yield

Duration & Conv exity 3 7

2.5 6

5 2 4 1.5 3 1 2

0.5 1

0 0 Jul-04 Jul-11 Jan-01 Jan-08 Jan-15 Jun-00 Jun-07 Jun-14 Oct-02 Oct-09 Oct-16 Apr-06 Apr-13 Feb -0 5 Sep -0 5 Feb -1 2 Sep -1 2 Dec-03 Dec-10 Aug-01 Aug-08 Aug-15 Nov-06 Nov-13 Mar-02 Mar-09 Mar-16 May-03 May-10 May-17 Bullets (1 -5 Year) Duration 5 Year Treasury Yield

 No correlation between yield and duration in the case of bullets.

Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 8 Duration – Negative Convexity

Duration & Negative Conv exity 3 7

6 2.5

5 2

4 1.5 3

1 2

0.5 1

0 0 Jul-02 Jul-07 Jul-12 Jan-05 Jan-10 Jan-15 Jun-00 Jun-05 Jun-10 Jun-15 Oct-08 Oct-03 Oct-13 Apr-01 Apr-06 Apr-11 Apr-16 Sep -0 1 Feb -0 2 Sep -0 6 Feb -0 7 Sep -1 1 Feb -1 2 Sep -1 6 Feb -1 7 Dec-02 Dec-07 Dec-12 Aug-04 Aug-09 Aug-14 Nov-05 Nov-15 Nov-00 Nov-10 Mar-04 Mar-09 Mar-14 May-03 May-08 May-13

Callables (1-5 Years) Duration 5 Year Treasury Yield

 High positive correlation between yields and duration.  Callable bonds share exactly the opposite relationship with duration than do bullets.  As yields rise, bonds become more interest rate sensitive.

Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 9 Price Upside?

Price Upside

109 Average Price $103.20 107

105

103

101

99

97 Average Price $99.88 95 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Oct-00 Feb-01 Oct-01 Feb-02 Oct-02 Feb-03 Oct-03 Feb-04 Oct-04 Feb-05 Oct-05 Feb-06 Oct-06 Feb-07 Oct-07 Feb-08 Oct-08 Feb-09 Oct-09 Feb-10 Oct-10 Feb-11 Oct-11 Feb-12 Oct-12 Feb-13 Oct-13 Feb-14 Oct-14 Feb-15 Oct-15 Feb-16 Oct-16 Feb-17

Bullets (1 -5 Year) Callables (1-5 Years) Par

 On average, callable portfolios were carried at a $0.12 loss vs a $3.20 gain, assuming they were issued at par.

Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 10 Total Return Attribution

 Breaks down an assets return into individual components (i.e. factors)  Done via regression analysis  Currency, country, , spread, etc.  Sum up the component return to create total return number  In this case, we break down the returns of bullets and callables into two different factors  CURVE CARRY – Includes (Accrued Interest + Roll Down)  CURVE CHANGE – Returns attributed to parallel shift in the yield curve (up or down) 11 Total Return Attribution

Curve Carry (Accrued + Roll Down) Curve Change Bullets Callable Delta Bullets Callable Delta Mar-13 0.09% 0.07% 0.02% -0.03% -0.04% 0.01% Jun-13 0.09% 0.08% 0.01% -0.86% -0.75% -0.11% Sep-13 0.15% 0.15% 0.00% 0.06% 0.03% 0.03% Dec-13 0.13% 0.12% 0.01% -0.41% -0.40% -0.01% Mar-14 0.14% 0.13% 0.01% -0.15% -0.12% -0.03% Jun-14 0.16% 0.15% 0.01% 0.04% 0.03% 0.01% Sep-14 0.17% 0.17% 0.00% -0.31% -0.37% 0.06% Dec-14 0.17% 0.16% 0.01% -0.11% -0.34% 0.23% Mar-15 0.17% 0.11% 0.06% 0.43% -0.06% 0.49% Jun-15 0.17% 0.11% 0.06% -0.30% -0.14% -0.16% Sep-15 0.19% 0.13% 0.06% 0.16% 0.16% 0.00% Dec-15 0.21% 0.16% 0.05% -0.84% -0.47% -0.37% Mar-16 0.21% 0.17% 0.04% 0.78% 0.37% 0.41% Jun-16 0.19% 0.14% 0.05% 0.44% 0.07% 0.37% Sep-16 0.18% 0.14% 0.04% -0.41% -0.15% -0.26%

Dec-16 0.26% 0.22% 0.04% -1.26% -0.83% -0.43% Sum 2.68% 2.21% 0.47% -2.77% -3.01% 0.24%

 Callables offer inferior returns to bullets on both factors.

Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 12 Callables – From Issuer’s Perspective

Bullet Yield Curve Hypothetical Callable

Coupon Bullet Price Year Bullet Rate Callable Rate Term Structure Coupon Price Cashflow

5.00% $ 500,000.00 $ 100.00 Year 1 1.00% 1.50% 1.50% $ 550,000.00 $ 100.00 5.00% $ 500,000.00 $ 102.80 Year 2 2.00% 2.50% 2.50% $ 450,000.00 $ 100.00 5.00% $ 500,000.00 $ 103.85 Year 3 3.00% 3.50% 3.50% $ 350,000.00 $ 100.00 5.00% $ 500,000.00 $ 102.96 Year 4 4.00% 4.50% 4.50% $ 250,000.00 $ 100.00 5.00% $ 500,000.00 $ 100.00 Year 5 5.00% 5.50% 5.50% $ 150,000.00 $ 100.00 Total $ 2,500,000.00 Total $ 1,750,000.00

Issuing a callable saves a $750,000 in coupon payments over the life of the 13 Hypothetical Case (Fixed vs Step-up Callable)

Fixed Coupon Callable

Fixed Coupon Callable Price Bullet Equivalent Coupon Price Delta Rate With Cap Price Cashflow

5.50% $ 100.00 $ 101.79 $ 1.79 $ 550,000.00 5.50% $ 100.00 $ 104.20 $ 4.20 $ 550,000.00 5.50% $ 100.00 $ 104.82 $ 4.82 $ 550,000.00 5.50% $ 100.00 $ 103.45 $ 3.45 $ 550,000.00 5.50% $ 100.00 $ 100.00 $ - $ 550,000.00 Total $ 2,750,000.00

Fixed Coupon Callable Step-up cash flow catches up with Fixed Callable in the final provides higher cash year. If called before – Steps-up will always underperform Fixed flow vs Step-Ups Callable

Step-up Coupon Callable

Step-up Cumulative Cumulative Coupon Bullet Equivalent Fixed Coupon Callable Cash Flow IRR Price Delta Coupon (Fixed Coupon (Step- Cashflow Price Outperformance Coupon Callable) Up callable)

4.50% $ 450,000.00 4.50% $ 98.21 $ (1.79) $ 550,000.00 $ 450,000.00 $ 100,000.00 5.00% $ 500,000.00 4.74% $ 102.08 $ 2.08 $ 1,100,000.00 $ 950,000.00 $ 150,000.00 5.50% $ 550,000.00 4.98% $ 103.82 $ 3.82 $ 1,650,000.00 $ 1,500,000.00 $ 150,000.00 6.00% $ 600,000.00 5.22% $ 103.17 $ 3.17 $ 2,200,000.00 $ 2,100,000.00 $ 100,000.00 6.50% $ 650,000.00 5.45% $ 100.00 $ - $ 2,750,000.00 $ 2,750,000.00 $ - Total $ 2,750,000.00 14 When do callables outperform bullets?  Callables outperform bullets when the buyer gets to earn the coupon spread (48 bps – from the first slide) all the way to maturity.  When does this happen?  When the yield curve is flat -> no roll-down return -> no price appreciation for bullets or callables-> callables unlikely to get called.  When yields rise significantly -> prices of both callables and bullets fall below par -> no point calling a bond for par if price is below par -> no point calling a bond to reissue it at higher interest rates -> bonds unlikely to get called. 15 Yield Curve – Flat and Rising

Yield Curve

6

5

4 Flat Yield Curve – December 2006 3

2 Yields are up 100 bps from December 2015

1

0 1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 30Y

Sep-17 Dec-15 Dec-06

Source: Bloomberg 16 Yes: They Do Outperform Occasionally

They outperform when yield curve is flat to Monthly Performance negative for a long period of time. 1.5 3.5

1 3 2.5 0.5 2 0 1.5 -0.5 1

-1 0.5 0 -1.5 -0.5 -2 -1 -2.5 -1.5 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 Sep-15 Sep-16 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Net Performance 3 Month T-Bill - 5 Year Treasury (Spread)

Year 2004 2005 2006 2014 2015

Callable 1.74% 1.86% 4.68% 1.37% 1.27%

Bullets 1.71% 1.46% 4.48% 1.28% 0.89%

Delta 0.03% 0.40% 0.18% 0.09% 0.39%

Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 17 Issues with Callables

 Duration & cashflow targeting becomes hard  Duration volatility gets more extreme as optionality increases (onetime calls -> anytime calls).  Cash flow targeting becomes inherently difficult due to extension/contraction risk.  As Interest rates rise, duration of the callable increases. . It increases at an increasing rate (i.e. higher interest rates go faster, the duration will rise)  Pricing callables is difficult (this deserves its own presentation)  Rely on model pricing because YTM and YTC don’t capture important factors. . Input assumptions dictate everything (model selection, input curve, VOL assumption)  Relative value comparisons can’t be done – each callable bond is different from another (bullet-to-bullet is easily comparable)  Callable bonds are not usually issued in index size, limiting their liquidity.  Bid/ask spreads on callables are much wider than bullets, making the bid side liquidity worse. 18 How can these issues be mitigated?

 Lower optionality in the bond (onetime calls are better than anytime calls)  Lower coupon volatility in the bond (fixed coupon better than step-up coupon) 19

Questions ?