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Home My WebLink AboutPFM Memo-IOC 5-31-2017PfM May 31, 2017 Memorandum To: Xenia Bradford, Director/Treasurer Rico Pardo, Controller City of San Luis Obispo From: Monique Spyke, Managing Director Izac Chyou, Senior Managing Consultant Vincent Xiao, Analyst PFM Asset Management LLC Re: Investment Management Plan and Investment Policy Review MAY 81 2017 We have completed our annual review of the City's Investment Policy (the Policy). We recommend the City make a few changes to incorporate a recent update to the California Government Code (the Code), loosen the credit quality requirement of negotiable certificates of deposit ("negotiable CDs"), allow purchases of corporate notes rated "A" or better by only one national recognized rating agency (NRSRO), and add asset-backed securities to the City's list of Authorized Investments. This memorandum explains our recommended revisions to the Policy. We have also attached a marked -up version of the Policy illustrating these recommendations. Recommendations V. Investment Vehicles We recommend the City update the credit rating language used in the Policy to reflect a recent revision to the Code. Senate Bill 974, which took effect on January 1, 2017, modified Code Sections 53601 et seq. to clarify that the Code's rating requirements specify the minimum credit rating category required at purchase, without regard to "+", "-", or 1, 2, 3 modifiers. This Code change simply codified the credit rating interpretation already used by most public agencies, including the City. This revision did not change the minimum ratings required by the Code for the different investment types. This revision applies to all of the Policy's sections that specify a credit rating requirement for purchase. V. Investment Vehicles. (9) Medium Term Notes and (14) Negotiable Certificates of Deposit The Policy currently requires medium term notes to be rated in a rating category of "A" or its equivalent or better by two or more NRSROs. We recommend the City change this requirement such that medium term notes are rated in a rating cateaory of "A" or its equivalent or better by only one NRSRO. In doing so, we will increase the investable opportunity set to allow for investments in split -rated issues from corporations such as Goldman Sachs, Morgan Stanley, Coca-Cola, and AT&T which are rated in a rating category of "A" or its equivalent or better by one NRSRO while another NRSRO rates the issues in the `BBB" category or is not rated (see Exhibit A). As of December 31, 2016, split -rated corporate notes rated "A" or better by only one NRSRO represents 13% of the 1-5 U.S. Corporate Index. From 1970-2015, on average, 86.6% of "A" rated corporate issuers remained "A" rated, 2.6% were upgraded to "Aa", 5.4% were downgraded to "Baa", and 0.1 % defaulted within a year (see Exhibit B). Exhibit A A -Rated Representative Issuer List Top 10 Issuers J.P. Morgan Chase # of Issues 19 Amount _Emm Outstanding $44,850 Index_W of Corp 1.93% F11111 -- Moody's sap Fi�lch A+ A3 A- Morgan Stanley 19 $42,485 1.86% A3 BBB+ A Goldman Sachs 17 $38,750 1-69% A3 BBB+ A Bank of America 14 $33,964 1.48% Baal BBB+ A Citigroup Wells Fargo 16 $27,350 1.15% Baal BBB+ A 11 $24,950 1-05% A2 A AA - Cisco Systems 11 $18,100 077% Al AA - 2.8% 39.6% Toyota 16 $16,850 071% Aa3 AA- A Daimler Finance 16 $15,950 0.66% A2 A A A - Sumitomo Mitsui 14 $14,500 0.60% Al A Soutce BofA Merrill Lyncn 7-Z) rear U.S. c:arporere Inaex, as or izli ew im Exhibit B Average One -Year Letter Rating Migration Rates, 1970-2015 Fromk7b: Aaa Aa A Baa Ba B Caa Ca -C Default WR Aaa 87.5% 8.1% 06% 01% 3.7% Aa 0 8% 85.2% 84% 0.4% 0.11/0 0.2% + 5.0% 4.7% 5.3% 8.2% 10.6% A 010,❑ 771W'86.6% 5.4% 0.5°!0 01 Baa 4 31-11c. 85.4% 3.71/16 07% Ba C ry°n 2?5 76.2% 72% 0 "'° 011%. 4 80h 73.5% fi i% 0.1% 6.5% 0.6% B Caa t3 mo 0 4°i6 7 0% 66.8% 9 2.8% 39.6% 14.3% 23.7% Ca -C 0 1% 0 6% 2 5% Legend: Upgrades Downgrades to Investment Grade Downgrades to Non -Investment Grade Defaults Source: Moody's Annual Default Study: Corporate Default and Recovery Rates, 1970-2015. 2 rol The Policy currently requires negotiable CDs to be rated in a rating category of "AA" or its equivalent or better by one or more NRSROs. We recommend the City channe this credit rating requirement from "AA" to "A". Major rating agencies have reduced the credit ratings of major financial institutions (see exhibit A), which are the primary issuers of negotiable CDs. This change was due to modifications in the ratings criteria used by rating agencies rather than the financial health of negotiable CD issuers, which has actually improved over the past few years. Therefore, there are almost no AAA -rated corporate issuers remaining and there are very few AA -rated issuers. A -rated issuers make up around 43% of the 1-5 year Corporate Index (see exhibit C). This rating requirement change in the Policy would allow the portfolio manager to access a larger opportunity set, further diversify the City's portfolio, add incremental yield (40-50 basis points over 2 -year U.S. Treasuries), and potentially increase risk adjusted returns. Furthermore, "A" rated negotiable CDs are considered safer than "A" rated corporate notes since negotiable CDs are higher on the capital spectrum. We believe that PFM's credit process allows the City to safely utilize "A" rated negotiable CDs. Exhibit C 01 .. 0.2% 87% 0.9% 65% ,.. 00% 04% 1 1% 15.5% 23.2% 18.4% 20% 436% 39 5% 7.6% 29.3% 27% 396% 55.1% 5 1% 100% Source: BofA Merrill Lynch 1-5 Year U.S. Corporate Index by face value, as of 12/31/2016. It is important to note that our ratings criteria recommendation does not represent a change in our stringent credit quality philosophy, rather it is a recognition of the realities of the marketplace and will provide enhanced flexibility for the City, allowing the portfolio to be optimally diversified and to capitalize on market opportunities without adding undue risk. Additionally, the issuer limits of 5% help mitigate credit risk even further. 3 PFM's credit process ensures that all issuers are reviewed and evaluated before purchase. Portfolio managers and traders are only permitted to purchase securities from companies that are on PFM's Approved List. For a company to be added to our approved issuer list, the company must be reviewed and approved by PFM's internal Credit Committee. PFM's Credit Committee is made up of our Chief Credit Officer, Chief Investment Officer, and senior portfolio managers and traders. All corporate research is completed by investment personnel with direct involvement in PFM's investment process. Furthermore, since business and economic conditions can change dramatically, corporate exposure must be constantly monitored. An active approach to investing in corporate securities _� negotiable nn_ ..a:..l I1...... .... al... Approved 'List, DC11A .. e.rfe. .merlin -A- f, and negotiable C'Us is essential. Once VII the App oved r i IVI P 1101111.ci. per I-- I vwrw ensure each issuer continues to meet our credit standards. In addition, we follow news about economic, industry and issuer conditions. PFM has developed a process to detect changes in the financial condition or business outlook of a company. PFM monitors the trading of securities related to a company, including stock prices, credit spreads, and credit default swap levels. We have also developed the means to monitor any changes in the credit rating of an issuer as they are announced. Company quarterly and annual reports are reviewed and analyzed, as are industry trends. In addition, PFM reviews credit agency reports and research reports from major Wall Street firms to gain other perspectives. If the outlook for a company deteriorates, PFM may remove that issuer from our Approved List. If the deterioration is significant enough, PFM may recommend that the holdings of the company are sold. V. Investment Vehicles. (12) Asset -Backed Securities An asset-backed security (ABS) is a security in which its income payments and value is derived from and collateralized or "backed" by a specified pool of underlying assets such as receivables. Investors of these securities receive the principal and interest payments of the underlying loans allowing diversification of their portfolios away from traditional government and corporate debt. PFM currently finds value in AAA -rated ABS backed by high-quality auto loans and credit card receivables. These ABS maintain credit ratings that are higher than those of bonds issued by the U.S. Treasury and federal agencies while providing higher yields. Utilizing high-quality asset-backed securities in a fixed-income portfolio can improve diversification and offer potential return enhancement. Accordingly, we recommend that the Cit consider authorizing a 15% allocation to ABS. This allocation to ABS is more conservative than the Code's maximum allocation limit of 20%. Furthermore, we recommend a maximum allocation per issuer of 2.5% as an additional required level of diversification, which is consistent with the 4 1*3 City's requirements for other non-government sectors. The minimum credit requirements and maturity limit consistent with Code. 1-5 Year Index Returns Source: BoM Merrill Lynch 1-5 Year Indices. Returns greater than a year are annualized. We would be happy to discuss any questions regarding our recommended changes to the Policy. 5 As of 12/31/16 Effective Duration Yieldj Pe .. Ending 12/31/16 LlYear 3 Years 5 Years U.S. Treasury 2.65 1.40% 1.08% 1.10% 0.80% Agency 2.21 1.41% 1.12% 1.13% 0.96% Corp AAA 2.85 1.81% 1.32% 1.63% 1.62% Corp AA 2.62 2.03% 1.93% 1.77% 2.06% Corp A 2.65 2.22% 2.29% 2.00% 2.73% ABS (0-5) 1.45 1.72% 1.92% 1.36% 1.41% Source: BoM Merrill Lynch 1-5 Year Indices. Returns greater than a year are annualized. We would be happy to discuss any questions regarding our recommended changes to the Policy. 5