CMTA Advanced Treasury Workshop Floating Rate Notes, Fixed to Float Securities, Step Down Bonds and Convexity Presented by: Tony Garcia, CFA Vice President Pomona, CA January 31, 2012

1 If you can’t explain it to a six year old, you don’t understand it yourself. -Albert Einstein

On the Agenda  Floating Rate Securities  A security where the coupon floats relative to an index  Fixed to Float Securities  A security that has a fixed coupon for a period and then converts to a floating rate security  Step Down Bonds  A callable security where the coupon declines  Negative Convexity  The bane of callable buyers 2

Floating Rate Securities

 Coupon Floats Relative to Index (Benchmark or Reference rate) Coupon Rate = reference rate (index) +/- quoted margin  Indexes  Fed Funds – Daily Reset  Libor – O/N, 1 Month, 3 Month, 6 Month, 12 Month  CMT – Spread to Constant Maturity Treasury with regular resets  Commercial Paper  Prime Rate  Treasury Bill – 1 Month, 3 Month, 6 Month  TIPS – Inflation Indexed  Inverse Floaters – Where the coupon moves in the opposite direction to the reference rate *You cannot buy these* 4

Floating Rate Securities  Issuers  Treasury – TIPS  Agencies – Debentures and Asset Backed  Municipalities  Corporations  Discount Margin  Effective spread to index  Caps and Floor  Cap – The limit to which a coupon can float  Floor – Minimum possible coupon  Collar – When security has both a cap and a floor 5

Components Of Pricing  Spread to Index determines coupon  Reset Frequency  Maturity  Change in Basis 6

Discount Margin  Discount margin is the inferred change in spread to Index  Price changes to reflect change in market  Price change = PV of change in DM  As with YTM 7

Basis Risk  Change in DM to reflect adjustments in market  If credit quality improves DM should decline  If credit quality deteriorates DM will widen  If spreads narrow DM will decline  May also change due to change absolute level of interest rates 8

ING BANK Step Up FRN Source: Bloomberg 9

ING BANK Step Up FRN Source: Bloomberg 10

ING BANK Step Up FRN Source: Bloomberg 11

Value To A Portfolio  Lower Duration  Reset frequency lowers effective duration  Lower Price volatility  Yield will move in direction of underlying index 12

Berkshire FRN 2/11/13 Reset 3 MO Libor +43 Source: Bloomberg 13

Berkshire FRN 2/11/13 Reset 3 MO Libor +43 Source: Bloomberg 14

Berkshire FRN and Treasury 2.75% 2/13 BRK FRN 2/13 TSY /13 DATE PRICE YIELD PRICE YIELD 2/11/ DM /11/ DM CHANGE DM Note: Settlement date held static at 2/11/10 to avoid amortization effect 15

Fixed to float securities

Fixed to Floating Rate Securities 17  Securities begin with a Fixed Coupon rate for specified period then will switch to a Floating Rate Coupon  May be bulleted or callable  Issued by Agencies and Corporations  Can provide protection against rising rates  Basis shift out of a low volatility environment can be a concern

Agency Fixed to Float 18 Source: Bloomberg

Agency Fixed to Float – Coupons 19 Source: Bloomberg

Corporate Fixed to Float 20 Source: Bloomberg

Agency Fixed to Float – Coupons 21 Source: Bloomberg

Step down bonds

Step Down Callable  Security structure where coupon steps down if bond not called  Likelihood of call is very small  Short term cash flow is the focus 23

Source: Bloomberg Step Down Callable 24

Step Down Callable – YTC Schedule Source: Bloomberg 25

5 Year Treasury Yield Source: Bloomberg 26

One Time Callable Source: Bloomberg 27

Agency Bullet Yield Curve Source: Bloomberg 28

Step Down Callable OAS Analysis Source: Bloomberg 29

Callable Agency OAS Analysis Source: Bloomberg 30

Step Down Callable – Comparison YTMOption value Step Down Callable Treasury 2.07 Agency Bullet

Step Down Callable – Cash Flows 32

Convexity

Convexity/Negative Convexity  Convexity  A Measure of how curved the price-yield curve is  The second derivative of the price-yield function  Low coupon and long maturity bonds tend to have high convexities  High coupon and short maturity bonds tend to have low convexities  Negative Convexity  Where the rate of change of the price of a bond slows as rates fall  Generally due to embedded option(s) 34

Price / Yield Function 35 PRICE YIELD

Duration 36 PRICE YIELD

Convexity 37 PRICE YIELD { }

Convexity Changes 38 PRICE YIELD

Negative Convexity 39 PRICE YIELD

Negative Convexity 40 PRICE YIELD

12 Month Horizon Return 41 Pricing Date: 01/16/2013 Type: Spot Curve Currency: USD Horizon Months: 12 Reinvestment Rate:.104 IssuerCouponMaturityYTWEff DurConvFieldName BULLET /12/ Total Return Ending Price Ending Avg Life4.000 Ending Eff Dur Ending Conv STEP UP /30/ Total Return Ending Price Ending Avg Life Ending Eff Dur Ending Conv CALLABLE /11/ Total Return Ending Price Ending Avg Life Ending Eff Dur Ending Conv FNMA 0.70% 1/30/18 QUARERLY CALLS 7/30/13 Coupons: 0.70 to 1/ to 7/ to 1/ to 7/ to 1/18 FHLB 1.0% 1/11/18 QUARTERLY CALLS 7/11/13 FHLMC 0.75% 1/12/18 Source: Bloomberg and Bond Edge

12 Month Horizon Return 42 Pricing Date: 01/16/2013 Type: Spot Curve Currency: USD Horizon Months: 12 Reinvestment Rate:.104 IssuerCouponMaturityYTWEff DurConvFieldName BULLET /12/ Total Return Ending Price Ending Avg Life4.000 Ending Eff Dur Ending Conv STEP UP /30/ Total Return Ending Price Ending Avg Life Ending Eff Dur Ending Conv CALLABLE /11/ Total Return Ending Price Ending Avg Life Ending Eff Dur Ending Conv FNMA 0.70% 1/30/18 QUARERLY CALLS 7/30/13 Coupons: 0.70 to 1/ to 7/ to 1/ to 7/ to 1/18 FHLB 1.0% 1/11/18 QUARTERLY CALLS 7/11/13 FHLMC 0.75% 1/12/18 Source: Bloomberg and Bond Edge

12 Month Horizon Return 43 Pricing Date: 01/16/2013 Type: Spot Curve Currency: USD Horizon Months: 12 Reinvestment Rate:.104 IssuerCouponMaturityYTWEff DurConvFieldName BULLET /12/ Total Return Ending Price Ending Avg Life4.000 Ending Eff Dur Ending Conv STEP UP /30/ Total Return Ending Price Ending Avg Life Ending Eff Dur Ending Conv CALLABLE /11/ Total Return Ending Price Ending Avg Life Ending Eff Dur Ending Conv FNMA 0.70% 1/30/18 QUARERLY CALLS 7/30/13 Coupons: 0.70 to 1/ to 7/ to 1/ to 7/ to 1/18 FHLB 1.0% 1/11/18 QUARTERLY CALLS 7/11/13 FHLMC 0.75% 1/12/18 Source: Bloomberg and Bond Edge

Portfolio Comparison – Bullets vs Callables 44 Security detail Portfolio BulletsPortfolio Callables Par$70,000,000Par $70,000,000 Market Value$71,085,000Market Value$70,225,000 Average Life1.328Average Life1.246 YTM0.517YTM0.918 Modified Duration1.31Modified Duration3.32 Effective Duration1.16Effective Duration1.30 Convexity 0.10 Convexity Porfolio distribution Source: Bloomberg and Bond Edge

Security Shock Testing 45 Source: Bloomberg and Bond Edge

Security Shock Testing 46 Source: Bloomberg and Bond Edge

Security Shock Testing 47 Source: Bloomberg and Bond Edge

Dynamic Cash Flow Shock Testing 48 Source: Bloomberg and Bond Edge

- - Douglas Adams I love deadlines. I love the whooshing noise they make as they go by. 49

Contact Information 50 Tony Garcia, CFA Vice President MAC A T 400 Capitol Mall, 7 th Floor Sacramento, CA Phone: (888) FAX: (916)

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