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If rates rise, fixed-income investment portfolios can experience: –Extension of duration and average maturity if issue is callable –Earnings at a lower yield than yields available in the market until you reinvest –Decrease in market value Risks Associated with Rising Interest Rates 1 © PFM Asset Management LLC
Relationship Between Rates and Market Value Investment Choices Amount you Receive at Maturity Investment ChoicesAmount Received at Maturity Security Type Spend Coupon Rate Annual Interest Earnings Return of Face Amount Interest Earnings Return of Principal + Interest Yield Today$1,000,0005%$50,000$1 mm$50,000$1,050,0005% Tomorrow$1,000,0006%$60,000$1 mm$60,000$1,060,0006% Tomorrow?5%$50,000$1 mm$50,000?? How much would you pay for this security? 2 © PFM Asset Management LLC
Relationship Between Rates and Market Value Investment Choices Amount you Receive at Maturity Investment ChoicesAmount Received at Maturity Security Type Spend Coupon Rate Annual Interest Earnings Return of Face Amount Interest Earnings Return of Principal + Interest Yield Today$1,000,0005%$50,000$1 mm$50,000$1,050,0005% Tomorrow$1,000,0006%$60,000$1 mm$60,000$1,060,0006% Tomorrow$990,0005%$50,000$1 mm$50,000$1,060,0006% You would require a discount of $10,000 to make up for the $10,000 difference in interest. 3 © PFM Asset Management LLC
Total Return = Yield + Change in Market Value Total Return Merrill Lynch Treasury Index Annual Returns 20042005200620072008 1-5 Year Treasury1.31%1.39%3.81%8.16%8.73% 2-Year U.S. Treasury Note Yield History 2004 – 2008 Total Return Yield:4.41% ∆MV:-3.02% = 1.39% Total Return Yield:3.07% ∆MV:+5.09% = 8.16% 1.39%8.16% Source: Bloomberg, B of A Merrill Lynch 4 © PFM Asset Management LLC
Duration is a risk measure that measures the sensitivity of a bond’s value to changes in interest rates. A portfolio’s duration is an approximation of the percentage change in the portfolio for a 1% change in yield. Evaluating Bond Price Sensitivity 5 © PFM Asset Management LLC
Horizon Analysis: Diversified Portfolio with Duration of 2.6 Years Basis Point Shift on 12/31/12 Total Return Through 3/31/20136/30/20139/30/201312/31/2013 No Change 0.49%0.95%1.43%1.88% +25 basis points 0.01%0.49%0.98%1.45% +50 basis points -0.48%0.01%0.52%1.00% +100 basis points -1.45%-0.93%-0.39%0.13% 6 © PFM Asset Management LLC
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