ANALYSIS OF CREDIT PORTFOLIO FCERA May 2014 SEATTLE | 206.622.3700 - PowerPoint PPT Presentation

ANALYSIS OF CREDIT PORTFOLIO FCERA May 2014 SEATTLE | 206.622.3700 LOS ANGELES | 310.297.1777 www.wurts.com

E X E C U T I V E S U M M A R Y  Since the asset liability study was presented in mid-2013, spreads for High Yield (HY) and Investment Grade (IG) corporate bonds have tightened considerably.  The purpose of this presentation is to dimension the go ‐ forward range of outcomes associated with these planned exposures.  While we still advocate these asset classes as long-term strategic allocations, the entry point for investment is not as favorable as mid 2013 (which is the case for many risk assets).  The analysis herein uses starting yield to maturity (YTM), duration, and historical credit spreads to estimate future returns under different time periods given changes to credit spreads. Assumptions: 10 Year Standard • Median spread based on the last 10 years of spreads (monthly). Return Deviation Forecast Forecast • Assumes no change in Treasury (i.e. risk-free) rates. Investment 4.0% 5.8% • Ignores the impact of active management, and associated fees. Grade • No assumptions are made about corporate default rates. High Yield 4.4% 10.5% 2

H I S T O R I C A L C R E D I T S P R E A D S Investment Grade Spreads: Trailing 20 Years 600 Investment Grade: US IG Credit Spread  Current spread: 101 bps 500 20 Year Avg. (123) 10 Year Avg. (143) 400 61 st percentile relative to 5 Year Avg. (162)  20 year history 300  42 bps tighter than 10 200 year avg. 100 101 77 55 0 1994 1997 2000 2003 2006 2009 2012 High Yield Spreads: Trailing 20 Years 1800 US HY Credit Spread High Yield: 1600  20 Year Avg. (468) Current spread: 344 bps 1400 10 Year Avg. (484) 1200 72 nd percentile relative 5 Year Avg. (573)  1000 to 20 year history 800  140 bps tighter than 10 600 year avg. 400 344 200 238 239 0 1994 1997 2000 2003 2006 2009 2012 3 As of April 30, 2014

D O W N S I D E R I S K  Currently, spreads are narrower (bonds are priced more expensive) relative to historical levels. The following table, illustrates the increase to credit spreads if the market reverts to the median or 25 th percentile of the last 10 years: Changes to Spreads (in basis points) Median 25th Percentile High Yield 140 316 Investment Grade Corporate 42 99  Currently High Yield is priced to yield 5.04% while the YTM on Investment Grade is 3.0%.  The graph to the right illustrates the Downside Risk depreciation in market value of the bond indices Median Spread 25th Percentile if spreads widen instantaneously. 0% ‐ 2%  But with wider spreads the bonds ‐ 4% are subsequently priced to deliver higher ‐ 6% yields. ‐ 8% High Yield ‐ 10%  The next page estimates the total return Investment Grade ‐ 12% over three and five year time frames, assuming ‐ 14% spreads widen at the beginning or end of the period. 4

S C E N A R I O A N A L Y S I S 3 Year Annualized Total Return 3 Year Annualized Total Return 5% 5% High Yield High Yield 4% 4% Investment Grade Investment Grade 3% 3% 2% 2% 1% 1% 0% 0% Median Spread 25th Percentile Median Spread 25th Percentile Scenario 1 : If credit spreads widen to either the median or 25 th Scenario 2 : If credit spreads widen to either the median or 25 th percentile of historical spreads at the end of year 1, what is the percentile of historical spreads at the end of year 3, what is the annualized return for the 3 year period. annualized return for the 3 year period. 5 Year Annualized Total Return 5 Year Annualized Total Return 5% 5% High Yield High Yield 4% 4% Investment Grade Investment Grade 3% 3% 2% 2% 1% 1% 0% 0% Median Spread 25th Percentile Median Spread 25th Percentile Scenario 3 : If credit spreads widen to either the median or 25 th Scenario 4 : If credit spreads widen to either the median or 25 th percentile of historical spreads at the end of year 1, what is the percentile of historical spreads at the end of year 4, what is the annualized return for the 5 year period. annualized return for the 5 year period. 5 Duration of HY index: 4.2 years. Duration of IG index: 7.6 years.

C O N C L U S I O N  While spreads could certainly stay at current levels or tighten further, a more likely outcome appears to be some form of reversion to historical averages.  The timing and magnitude of an increase in spreads will drive the realized returns.  All things equal, an increase earlier in the period is generally more favorable than an increase at the end of the period.  As the time period under consideration is extended, the average returns improve.  While their may be some significant depreciation of market value at some point in the future, the downside risk is still materially less than equities, and the yield component serves an important role within the broader portfolio. 6

A P P E N D I X 7

S U M M A R Y O F A S S U M P T I O N S : R E T U R N S Ten Year Historical Ten Year Return Forecast Standard Deviation Sharpe Ratio Asset Class Index Proxy Sharpe Ratio Forecast Forecast Geometric Arithmetic Equities 5.9 6.9 14.6 0.23 0.47 US Large S&P 500 5.1 6.9 19.7 0.13 0.46 US Small Russell 2000 International Developed MSCI EAFE 8.3 9.8 18.2 0.32 0.43 International Small MSCI EAFE Small Cap 8.5 10.3 20.0 0.30 0.52 Emerging Markets MSCI EM 10.1 12.6 24.0 0.32 0.55 8.1 10.5 23.6 0.24 0.96 Private Equity Cambridge Private Equity Fixed Income 2.5 2.5 0.5 Cash 30 Day T ‐ Bills 3.1 3.3 6.7 0.09 0.56 US TIPS Barclays US TIPS 5 ‐ 10 3.0 3.3 6.9 0.08 0.61 US Treasury Barclays Treasury 7 ‐ 10 year Global Sovereign ex US Barclays Global Treasury ex US 2.2 2.5 8.1 ‐ 0.03 0.42 Core Fixed Income Barclays US Aggregate Bond 4.1 4.2 3.6 0.45 0.92 Investment Grade Corp. Credit Barclays US Credit 4.0 4.2 5.8 0.26 0.68 4.4 4.9 10.5 0.18 0.71 High Yield Corp. Credit Barclays High Yield 3.5 3.9 8.7 0.12 0.46 Bank Loans S&P/LSTA 3.1 3.4 7.6 0.08 0.60 Global Credit Barclays Global Credit Emerging Markets Debt (Hard) JPM EMBI Global Diversified 5.8 6.2 9.0 0.37 0.77 Emerging Markets Debt (Local) JPM GBI EM Global Diversified 6.6 7.3 12.6 0.33 0.61 Private Credit High Yield + 200 bps 6.4 6.9 10.5 0.37 ‐ Other Commodities S&P GSCI 4.9 6.4 18.2 0.14 0.11 1 Hedge Funds HFRI Fund of Funds 6.3 6.7 9.2 0.41 0.35 6.5 7.3 13.4 0.30 0.99 Core Real Estate NCREIF Property 6.5 9.7 26.8 0.15 0.39 REITs Wilshire REIT Inflation 2.4 1 All returns are gross of fee with the exception of hedge funds. This year we have included both geometric and arithmetic return forecasts. It is important that users of this information understand how we derived it. Our forecast process involves the use of a wide range of data inputs (of a variety of different types) to create geometric return forecasts for individual asset classes – this is the process described at length in this document. We use an industry standard formula to convert these to arithmetic return forecasts, and provide both for client use. Investors wishing to produce expected geometric return forecasts for their portfolios should use the arithmetic return forecasts provided here as inputs into that calculation, rather than the single ‐ asset ‐ class geometric return forecasts. This is the industry standard approach, but requires a complex explanation only a heavy quant could love, so we have chosen not to provide further details in this document – we will happily provide those details to any readers of this who are interested. More broadly, it is important that the user of these forecasts remembers that return forecasts (whoever provides them) are there to provide a guide to the likely future, no more. While we believe that the approach described in this document is an appropriate one to use for those purposes, and that the forecasts resulting from that approach are meaningful and fit for the uses to which they will be put, users of any such forecasts should always bear in mind the fact that the single most difficult thing to predict is the future, and approach that exercise with appropriate skepticism. 8

C R E D I T S U M M A R Y EM Debt EM Debt Private IG Core High Yield Bank Loans (USD) (Local) Credit BC US BC US High BC US High Index BC US Credit S&P LSTA JPM EMBI JPM GBI Aggregate Yield Yield + 2% High Yield + 2% OAS + US OAS + US OAS + US OAS + US Method LIBOR + Spread Current Yield illiquidity 10 ‐ year 10 ‐ Year 10 ‐ Year 10 ‐ Year premium US 10 ‐ Year US 10 ‐ Year US 10 ‐ Year US 10 ‐ Year Spread to LIBOR ‐ ‐ Treasury Treasury Treasury Treasury Default ‐ 0.1% ‐ 0.1% ‐ 4.0% ‐ 4.0% ‐ 0.5% ‐ 0.5% ‐ Assumption Recovery 40% 40% 40% 60% 40% 40% ‐ Assumption Spread 1.1% 1.1% 3.8% 4.9% 3.1% ‐ ‐ Yield ‐ ‐ ‐ ‐ ‐ 6.9% ‐ Risk Free Yield 3.0% 3.0% 3.0% 0.2% 3.0% ‐ ‐ Effective ‐ 0.06% ‐ 0.03% ‐ 2.4% ‐ 1.6% ‐ 0.3% ‐ 0.3% Default Nominal 4.0% 4.1% 4.4% 3.5% 5.8% 6.6% 6.4% Return Inflation ‐ 2.4% ‐ 2.4% ‐ 2.4% ‐ 2.4% ‐ 2.4% ‐ 2.4% ‐ 2.4% Forecast Real Return 1.6% 1.7% 2.0% 1.1% 3.4% 4.2% 4.0% 9