Fresno County Employees’ Retirement Association February 6, 2008 Andrew Phillips, Managing Director, Co-Head of US Fixed Income Dan Mc. Laughlin, CFA, Managing Director 0
Table of Contents I. Black. Rock Update II. Review of Fixed Income Investment Philosophy and Process III. Market Review and Update IV. Portfolio Review Appendices A. 1 FCERA Guidelines Summary
Black. Rock Update Acquired fund of funds business from Quellos Group, LLC on 1 October • Adds attractive absolute return products and enhances ability to deliver innovative solutions to clients • Bryan White, former Quellos CIO, leads combined fund of funds platform with more than $28 billion 1 in assets under management New Developments • Multi‐Asset Portfolio Strategies (MAPS) group • Focuses on portable alpha, target and relative return, global tactical & strategic asset allocation, LDI, and fiduciary services • Multi‐Strategy Fixed Income Alpha (MSFIA) strategy • Alpha engine for portable alpha product; complements Multi‐ Strategy Hedged Equity Alpha (MSHEA) strategy • Prepared Portfolios for DC investors: Target Date and Target Risk funds Total Assets of US$1. 36 Trillion Alternatives / Real Estate $71 Billion Asset Allocation / Balanced $139 Billion Liquidity $313 Billion Equity $322 Billion Fixed Income $511 Billion Risk Management Investment Accounting $5. 75 Trillion $100 Billion Institutional Client Types Corporations 36% Insurers 20% • Global real estate equity and debt businesses total $29 billion Public Funds & Union / Industry 17% • Interest in alpha extension strategies from US, UK, and Australia Sub-Advisory 14% • Growth in equity strategies, particularly US large cap, natural resources, global, European, UK, and quantitative equity Official Institutions 8% Non-profit & Healthcare 3% • Opportunities in global bond and local currency mandates Government Authorities 2% • Enhanced Commodity strategy for US and non‐US investors Existing Products - Investment and Growth As of 31 December 2007 1 BAA 2 assets as of 1 Oct 2007; assets for BAA closed end funds reflect net asset value as of the most recent valuation date plus unfunded capital commitments As of 31 December 2007
Black. Rock, Inc. Corporate Governance Ownership Structure Approximately 49% Merrill Lynch & Co. ; 45% voting interest 34% The PNC Financial Services Group, Inc. 17% Employees and the public Black. Rock Board Members Current Composition Laurence Fink William Albertini* NYSE Listing BLK Mathis Cabiallavetta* Dennis Dammerman* Board Composition 17 Directors: 3 Black. Rock, 2 Merrill, 2 PNC, 10 independents Bill Demchak Robert Doll Chairman & CEO Laurence Fink Kenneth Dunn* Gregory Fleming President Rob Kapito Murry Gerber* James Grosfeld* Robert Kapito Executive Committee (Ex. Co) Laurence Fink, Paul Audet, Robert Connolly, Bob Doll, Rob Fairbairn, Peter Fisher, Ben Golub, Charles Hallac, Robert Kapito, Barbara Novick, Quintin Price, Susan Wagner, and Bryan White David Komansky* Sir Deryck Maughan* Operating Committee (Op. Co) Rob Kapito, Scott Amero, Paul Audet, Bob Doll, Ben Golub, Peter Hayes, Michael Huebsch, Susan Mink, Fred Lieblich, Milan Lint, Barbara Novick, and Bryan White Thomas O’Brien* Linda Gosden Robinson* James Rohr John A. Thain – Strategic & corporate management overseen by Laurence Fink and Sue Wagner Organizational Initiatives – Rob Kapito oversees day‐to‐day operations – Committees work with Ex. Co and Op. Co to streamline governance process 3 *independent
Black. Rock is a Global Organization Over 5, 500 employees in 19 countries, including more than 700 investment professionals • Seventeen investment centers in US, UK, Europe, Asia and Australia • Clients located in over 60 countries North America: • Atlanta • Boston* • Chicago • Durham* • Florham Park* • Newport Beach* • New York* • Los Angeles • Philadelphia* • Pittsburgh • Princeton* • San Francisco* • Seattle* • Wilmington* • Regional Offices South America: • Montevideo Institutional clients *Denotes investment centers As of 31 December 2007 4 Asia: • Hong Kong* • Seoul • Singapore • Taipei • Tokyo* UK, Continental Europe & Middle East: • Amsterdam • Stockholm • Brussels • Vienna • Eindhoven* • Zurich • Frankfurt • United Kingdom • Geneva ‐ Edinburgh* • Luxembourg ‐ London* • Madrid ‐ Peterborough • Milan • Isle of Man • Munich • St. Helier • Paris Australia: • Brisbane • Melbourne* • Perth • Sydney*
Clients Benefit from Pooled Expertise of Black. Rock’s Resources “One Black. Rock” reflects an organizational structure with functional, regional, and product dimensions • Ensures consistency on a global basis • Tailors products and services to clients and to local needs • Promotes teamwork • Facilitates operational integrity and efficiency Black. Rock Total AUM of US$1. 36 Trillion Over 5, 500 Employees Account Management Portfolio Management Black. Rock Solutions® Firmwide Infrastructure Pension Plans Fixed Income Financial Modeling Foundations · Endowments Equity Investment Data & Accounting Portfolio Administration & Operations Financial Institutions Official Institutions Corporations Consultants Multi-Asset Portfolio Strategies Liquidity Regional and Country Offices Worldwide 5 Strategy & Product Development Real Estate Portfolio Analytics Facilities Management Alternatives Trading Systems Legal & Compliance Technology Finance Transition Management Human Resources Risk & Quantitative Analysis Private Clients New York · Boston · Chicago Edinburgh · Florham Park · Hong Kong London · Princeton · San Francisco Seattle Sydney Tokyo · Wilmington Advisory & Hedging New York · Boston · Durham Edinburgh · Eindhoven · Florham Park Hong Kong · London · Melbourne Newport Beach · Philadelphia Princeton · San Francisco Seattle · Sydney · Tokyo · Wilmington New York · Edinburgh · London Melbourne · Philadelphia · Princeton Tokyo · Wilmington
Diverse Products in Multiple Asset Classes and Styles Total AUM of US$1. 36 Trillion Fixed Income: $511 Billion US Core/Core PLUS/Core Enhanced Index Global/Regional/Non‐Dollar US Intermediate US Municipals Equity & Asset Allocation / Balanced: $461 Billion 130, 998 85, 226 65, 697 37, 329 26% 17% 13% 6% US Long 32, 369 6% US Short Mortgages/CMBS CDOs LIBOR Managed Accounts Stable Value Enhanced Cash High Yield Corporates Bank Loan US Inflation‐Linked Emerging Markets Absolute Return Preferred 28, 291 24, 154 22, 377 14, 723 14, 458 12, 650 10, 368 10, 128 6, 443 5, 182 3, 980 2, 613 1, 858 1, 675 5% 5% 4% 3% 2% 2% 1% 1% <1% 193, 622 62% Tax‐Exempt 49, 994 16% International 25, 995 8% Government 24, 461 8% Securities Lending 19, 265 6% As of 31 December 2007 6 13, 820 75, 145 65, 871 55, 155 23, 906 20, 834 15, 318 15, 157 13, 548 10, 647 8, 186 6, 799 6, 349 5, 435 30% 16% 14% 12% 5% 5% 4% 3% 3% 2% 2% 2% 1% 1% Alternatives & Real Estate: $71 Billion Private Equity & Debt: Private Equity Fo. F, Black. Rock Kelso Capital Hedge Fund of Funds: Broadly Diversified Core, Focus, Custom Real Estate Equity: Core, Core/Enhanced Core, Value-Added, UK Property, European Property, Australian Property Real Estate Debt: Anthracite Capital (REIT), Carbon Capital I, II, and III Liquidity: $313 Billion Prime Asset Allocation / Balanced Index/Enh Index US Large/Multi‐Cap Sector‐Specific UK Global Europe Asia Pacific Managed Accounts Emerging Markets Latin America US Mid/SMID Cap US Small Cap EAFE/Non‐US Single-Strategy Hedge Funds: Diversified Fixed Income, Municipal Bond, Credit-Oriented Fixed Income, Sector-Specific Equity, Region-Specific Equity Capital Markets: Opportunistic Credit, Opportunistic Mortgage, CDOs, Business Development Corporation Commodities: Active Long-Only and Hedged, Passive/Futures-Based Multi-Asset Class Strategies: Portable Alpha, Target and Relative Return, Global Tactical and Strategic Asset Allocation, LDI, and Fiduciary Services
Investment Philosophy Emphasizes Relative Value Portfolio duration is controlled within a narrow band Value is added primarily through sector and sub-sector rotation and security selection Representative Core PLUS Portfolio as of 31 December 2007 Narrow Duration Band vs. Benchmark Years Active Sector Rotation Quarters Ended Black. Rock Core PLUS Portfolio 7 Quarters Ended Black. Rock Duration Band Treasury/Agency MBS Corporates ABS CMBS Extended Sectors
Sub-Sector Rotation Adds Value Black. Rock’s relative value approach encompasses a broad range of sub-sectors within the corporate and mortgage sectors All securities are evaluated within our risk management framework Representative Core PLUS Portfolio as of 31 December 2007 Corporates/Asset-Backeds Mortgages/Commercial Mortgage-Backeds Quarters Ended Finance Utility Non‐US Non‐Credit 8 Industrial ABS High Yield Quarters Ended Emerging Markets 15‐Yr Generic 30‐Yr Generic ARMs CMOs 15‐Yr Seasoned 30‐Yr Seasoned CMBS/Multifamily
Investment Strategy Group Sets Macro Investment Themes Top-down determination of investment themes based upon bottom-up inputs Investment themes establish parameters for bottom-up sub-sector and security selection Pre-ISG Meetings Global Governments Team Global Credit Team Global Mortgage Team Global ABS Team Risk & Quantitative Analysis Team 9 ISG Meeting Investment Strategy Group Co-Chairs Scott Amero, CIO Peter Fisher Risk Review Team Presentations Discussion Dissent Special Topics Minutes Investment Themes Interest Rate Risk Country/Currency Risk Yield Curve Risk Cash Flow Risk Credit Risk Liquidity Risk
Bottom-Up Portfolio Construction is a Team Effort Senior portfolio managers oversee groups of portfolios and determine investment needs based upon ISG themes, mandate type, and account guidelines • Scott Amero, CIO, and Peter Fisher are co‐heads of fixed income Core Team Andy Phillips ∙ Stuart Spodek ∙ Matthew Marra ∙ Brian Weinstein Steve Switzky Kelly Campbell Joshua Friedberg Sector specialists source opportunities and work together to address the needs of all portfolios • Lead sector specialists facilitate idea generation US Govt / Agency Derivatives Stuart Spodek 1 Peter Fisher Matthew Marra Jeff Jacobs Tom Musmanno David Sayles Brian Weinstein Josh Friedberg Jack Hattem Scott Wetzel Non-Dollar Global Gordon 1 Andrew Scott Thiel 1 Brita Steffelin Yudhveer Chaudhry Yoni Saposh Amar Bashir Hiroyuki Nozaki Javier Revelo 10 Corporates New York Europe 2 Jeff Cucunato 1 Paul Shuttleworth 1 Scott Amero Adam Cohen Michael Huebsch Daniel Mc. Kernan John Burger Tom Mondelaers Andrew Yorks Owen Murfin Kevin Holt Marc Rovers Brad Perkins Calum Smith Stephan Bassas Daniel Chen Marc Dichek Greg Cavallo Kristina Koutrakos Nathaniel Toothaker EMD Hussain 1 Imran Daniel Ruiz Daniel Shaykevich High Yield Kevin Booth 1 James Keenan 1 Mark Williams Jeff Gary Tom Colwell Mitchell Garfin Adrian Marshall Derek Schoenhofen Residential Mortgages Commercial Mortgages Eric Pellicciaro 1 Dave Chesney Ron D’Vari Michael Lustig Glen Perillo Andy Phillips Laura Powers Kishore Yalamanchili Colm Murtagh Ron Sion Daron Greene Matthew Kraeger Sean Mac. Donald Alexander Reiss Marshall Sebring Matthew Rodriguez Euro Thiel 1 Scott Michael Krautzberger 1 Jason Smith Hans Kamminga Michel Van der Sanden Chris Allen Neil Weller ¹Lead sector specialist; 2 European investment centers include London, Eindhoven, and Edinburgh Steve Switzky 1 Ron D’Vari Reginald Leese Mark Warner Kelly Campbell Jeanie Spano Andrew Kaufman Steve Kleiman Yen Endo 1 Shigeru Shuji Fujita Kunihide Takeuchi ABS / CDO Municipals Todd Kopstein 1 Ron D’Vari 1 Reginald Leese Kishore Yalamanchili David Carney Michael Khankin Steve Ruth Sriram Sumaithangi Xavier Goss AUD Miller 1 Steve Russell Maddox Penny Chin Cameron Garlick Joseph Berbari Peter Hayes 1 Ted Jaeckel James Pruskowski Walter O’Connor Joe Andrews Marie Sheehan Margaret Heymsfeld Sterling Andrew Belshaw 1 Stuart Niman Panos Ferendinos David Curtin
Deep and Experienced Team of Analysts Supports Investment Process Research analysts are embedded within the portfolio management team • Sit with portfolio managers in New York, Edinburgh, London, Princeton, and Tokyo High Yield Corporates Peter Schwartzman 1 Rob Wartell 1 Zach Alpern Philip Brendel Dave Delbos Anthony Heyman Atif Malik Chirag Patel Paul Merwin Ryan Mollett Amit Patel Melvin Rosa 1 Lead Investment Grade Corporates - US Doug Oare 1 Matt Anavy Ned Hole Ann Keane Gary Low Keven Maloney Keith Olsen Karina Saade Sandra Sullivan Ted Stevens Dave Taerstein Investment Grade Corporates – Non-US Bruce Hamilton 1 Kevin Craig Andrew Fraser Shuji Fujita Christian Holder Stephen Hunnisett Tatiana Spineanu Kunihide Takeuchi Non-Corporate ABS, MBS, CMBS David Bai Christian Holder Michael Khankin Steve Kleiman Keith Olsen Alexander Reiss Gabriel Rivera Mark Schnell Ted Stevens Sriram Sumaithangi Municipals Jack Erbeck 1 Jim Schwartz 1 Brian De. Paulo Chris Fornal Susan Heide Karen Hogan Lidia Martinez Tim Milway Joe Pangallozzi Joe Plonski Brian Pyhel Todd Smith analyst Proprietarily-developed tools aid research process • Galileo™, our global research database, allows analysts to share, store and access information and insights across asset classes and locations • The Matrix™, our risk monitor, enables portfolio managers to view issuer exposure across portfolios on a real‐time basis • Mortgage prepayment modeling provides option‐based valuations and scenario analysis across a wide variety of mortgage types Quandamental™ process for structured finance securities • Rigorous collateral analysis and expected loss forecasting • Advanced modeling of complex cash flow structures • Proprietary ongoing deal surveillance using updated econometric models 11
Black. Rock is a Leader in Risk Management Risk events have increased investor awareness and sensitivity Investment success reflects significant commitment to people and systems sinception of firm • Global research team includes approximately 50 analysts • Black. Rock Solutions® has over 1, 000 professionals and $5. 75 trillion under risk management Risk-aware culture focuses on providing consistent, risk-adjusted returns Benefit of risk management tools is highlighted during periods of increased market uncertainty Risk Events Impact Results 1994: Cash Flow Risk Mortgage prepayments slowed dramatically as the Fed tightened n g 12 1994 Return (%) High 0. 44 Median ‐ 1. 72 Low ‐ 8. 38 BLK MBS 0. 17 LB MBS ‐ 1. 61 1998: Liquidity Risk LTCM had broad market impact n g 1998 Return (%) High 11. 22 Median 8. 68 Low 2. 19 BLK Core 9. 06 LB US Agg 8. 67 n 2002: Credit Risk Corporate debacles resulted in numerous downgrades and high profile bankruptcies g n g 2002 Return (%) High 13. 08 Median 9. 78 Low 2. 93 BLK Core 10. 18 LB US Agg 10. 26 Mortgage-Broad Market and Active Sector Rotation Manager Universe. Source: (c) Frank Russell Company © Russell/Mellon Analytical Services LLC, 1999. All rights reserved. n g
U. S. Economy and Markets in Review Fixed Income Market Performance Equity Market Performance Interest rates closed the quarter lower as uncertainties surrounding monetary policy, housing weakness, and credit market turmoil resulted in a massive flight to quality. Capping off a volatile year, U. S. equities experienced severe pressure during the final two months of trading. Uncertainty related to housing weakness and the credit crisis resulted in a significant decline in consensus earnings expectations, pummeling a market which was already disappointed by the extent of Fed easing in December. Economic Data Gross Domestic Product Core CPI and PPI Annual Rates, Reported Quarterly (Year-over-Year) Source: Bloomberg Summary The FOMC lowered the benchmark interest rate by 75 basis points to 3. 50% on January 22 nd, the biggest single cut since 1982. The emergency reduction came a week prior to their regularly scheduled meeting, as the Federal Reserve was confronted with a global stock sell-off fanned by increased fears of a recession. The discount rate was also lowered by the same amount to 4. 00%. Policymakers stated they took the action “in view of a weakening of the economic outlook and increasing downside risks to growth. ” The Fed has now cut its target rate by a sharp 1. 75 percentage points since August 2007. 13
U. S. Economy and Markets in Review Economic Data 2 -Year Treasury Yields vs. Fed Funds Target Rate Home Sales and Prices Source: Bloomberg Growth § The U. S. economy expanded at a 4. 9% annual pace in the third quarter, revised from a previously estimated 3. 9%. The change was caused by an upward revision in private inventory estimates and a better trade balance. This growth compares with gains of 0. 6% and 3. 8% in the first and second quarters, respectively. § U. S. employment posted its smallest increase in over four years while the jobless rate hit a two‐year high, as the housing downturn continued to take its toll in December. Payrolls grew by 18, 000 after a 115, 000 increase in November. The unemployment rate rose to 5. 0% from 4. 7% in November. Average hourly earnings rose 0. 4%, and were 3. 7% higher from a year earlier. § U. S. consumer confidence unexpectedly rose in December due to an increase in consumers’ expectations for the state of economic activity in the near future. The Conference Board’s Index of Consumer Sentiment rose to 88. 6, the first gain in five months, from a revised 87. 8 in November. Orders for U. S. ‐made durable goods increased by 0. 1% in November, following a 0. 4% decline in October. Excluding transportation goods, orders fell 0. 7%. § Housing starts declined 14% in December to an annual rate of 1. 006 million. For all of 2007, starts were down 25%. Building permits slid to the lowest level in 12 years, falling 8. 1% to a 1. 068 million annual pace. New home sales fell 4. 7% in December to a seasonally adjusted annual rate of 604, 000, also a 12‐year low. Year‐over‐year new home sales were down 26%. Existing home sales fell 2. 2% in December to an annual rate of 4. 89 million, declining 13% for all of 2007. Inflation § Headline consumer prices increased 0. 3% in December, bringing the year‐on‐year rate to 4. 1%. Excluding food and energy, CPI climbed 0. 2% and is up 2. 4% year‐on‐year. U. S. producer prices fell 0. 1% in December, following a 3. 2% gain in November. Headline and core PPI rates are up 6. 3% and 2. 0% year‐on‐year, respectively. 14
Treasury and Agency Securities Agencies Treasuries sold off following the Fed’s announcement of their new Term Auction Facility (TAF), designed to help ease liquidity concerns over year end. The curve steepened 4 bps in December, as the 2 -year rose 5 bps while 10 -year yields climbed 9 bps, closing the year at 3. 05% and 4. 02%, respectively. Agency debt posted positive excess returns in December. Though excess returns were still negative for the year, agencies were the best performer among spread sectors. GSE portfolios continue to shrink which has kept long-term debt issuance light. Net Purchases of US Fixed Income Securities by all Foreign Investors – 6 -Month Rolling Sum Yield Curve Shifts 3 m 2 y 3 y 5 y 10 y 30 y Source: US Treasury Source: Bloomberg Portfolio Strategy § Short duration versus the index with a bias to position the portfolio for a yield curve steepener. § Continue to be underweight agencies, but have opportunistically added to gain swap spread exposure. 15
Investment Grade Corporate Bonds Outlook Investment grade credit gained 8 bps over duration-matched Treasuries in December. The 25 bps cut by the Fed in the middle of the month disappointed market participants who were looking for a larger reduction to help stem the slowdown in economic activity. However, subsequent steps by the Fed and other central banks to relieve short-term funding pressures helped to lead a rally in credit. Despite announcements of further write-downs related to subprime mortgage investments, capital was still readily available to most large financial institutions as evidenced by convertible and preferred issuance out of Fannie Mae, Freddie Mac, Citigroup, and Wachovia. Lastly, the announcement that Citigroup would take its seven SIVs back on balance sheet was a net positive for the broader credit market and helped support credit into the quiet holiday period. Investment Grade Corporate Bond Gross Issuance Lehman Credit Index: OAS versus Credit Quality Composition Baa = 32% OAS = 181 $ Billions Baa = 22% OAS = 97 Source: Lehman Brothers Portfolio Strategy § Opportunistically adding exposure through attractively valued new issues. Prefer the shorter end of the curve where swap spreads are wider and breakevens more attractive. § Favor financials over industrials and are biased towards high quality, non-cyclical credits. 16
Mortgage-Backed Securities Outlook Mortgages posted 11 bps of excess return versus Treasuries in December. The basis, along with most other high quality spread sectors, benefited from tighter swap spreads and better than expected financing over year end. The underperformance across spread products in November was primarily due to investors preparing for a wave of delevering trades at distressed levels in December, as financing over year end was expected to be extremely difficult and at highly unattractive rates when available. These concerns were allayed with the announcement of the Fed’s newly created Term Auction Facility program which made $40 billion in financing available over year-end to a wide array of investors, as well as news that many large financial institutions secured new capital, eliminating the need for “fire sales” to delever balance sheets. While mortgages outperformed Treasuries, they underperformed CMBS, investment grade corporates, and swap spreads in December. Housing Starts $ Billions All MBS Holdings by Large Banks: October 1996 - Present Source: Bloomberg Portfolio Strategy § Remain overweight MBS, with a bias toward premium (above par) coupons relative to discounts within pass-throughs. § Continue to look for opportunities in high quality, but less liquid assets in the CMBS, ARM and CMO markets. 17 Source: Federal Reserve
Commercial Mortgage-Backed Securities (CMBS) Outlook Volatility continued in the Commercial Real Estate sector in December, with CMBS posting 107 bps of excess return. CMBS triple-A spreads to benchmark swaps tightened as a number of fast money investors and dealers covered short positions in the synthetic CMBX product by using cash bonds as a substitute as the basis was dislocated. Four deals came to market totaling $6. 6 billion, down from an average monthly issuance in 2007 of $25 billion, as the origination of loans in the commercial real estate space is grinding to a halt. Limited issuance has caused thinly traded subordinate cash spread visibility to remain weak. Underlying commercial real estate fundamentals remain sound and CMBS delinquencies are at historically low levels. Seasoned CMBS Delinquencies Basis Points Investment Grade CMBS Spreads to Swaps AAA Spreads BBB Spreads Source: Lehman Brothers Source: Bear Stearns Portfolio Strategy § Overweight the sector as fundamentals remain strong and short to mid-term supply technicals look positive. § Higher-rated CMBS classes, both new and old, continue to represent attractive relative value, offering stable, high credit quality cash flows and less idiosyncratic risk than other spread sectors. § Favor stable, seasoned deals which have collateral with transparent histories. Overweight the short to intermediate and 10 -year part of the curve. 18
Asset-Backed Securities (ABS) Outlook Volatility and lack of liquidity continued to be the dominant themes within the ABS sector during December. In terms of residential ABS, negative housing data and continued deterioration in the subprime mortgage market caused the ABX indices to sell off early in the month, closing down roughly 5 -10 pts for the month. One positive headline for the sector was the announcement of the Treasury department to enforce a rate reset freeze on select subprime borrowers who currently have adjustable rate mortgages. Following the announcement, various tranches of the ABX indices rallied as much as 15 pts but eventually sold off as investors viewed the changes as a marginal positive for the sector. In addition, the major rating agencies downgraded numerous subordinate home equity bonds and CDOs which caused spreads on subordinate bonds to widen even further. On the contrary, senior AAA rated home equity bonds rallied as buyers returned to the market with the feeling that senior bonds had been oversold. Consumer ABS spreads also began to widen early in the month due to a lack of liquidity and investors’ fear of contagion from the subprime mortgage sector but rallied late in the month. Auto and credit card ABS sectors tightened 10 -20 bps. Spreads to Treasuries of Selected ABS Sub-sectors (AAA-Rated) Annual Issuance of Asset-Backed Securities 886 792 $ billions 629 454 108 3 -Yr Credit Card 3 -Yr Auto Loan 529 368 153 180 190 201 231 287 3 -Yr Home Eq. Source: Lehman Brothers Source: JP Morgan Portfolio Strategy § Remain cautious on credit and valuations. Bearish on the home equity sector but are selectively purchasing bonds from issuers/servicers with strong track records. § Favor short, high quality paper. Adding two-year auto paper from prime issuers with low concentrations of subprime borrowers. Neutral on credit card paper at current levels and are negative on subordinated home equity bonds. 19
High Yield Corporate Bonds Outlook Despite a strong start to the year, subprime-related concerns caused the high yield index to return 1. 87% in 2007, the smallest return since 2002. Relative to duration-neutral Treasuries, high yield lagged 777 bps. The overall flight to quality was reflected in returns by credit quality. However, instead of double-B credits leading the way, single-B paper fared better. The best performing sectors in December were paper, wirelines, healthcare, and utilities. The worst performing sectors were building materials, automotive and retailers. The yield spread on the index at year-end was 569 bps, with a yield to worst of 9. 64% versus 7. 70% at the end of 2006. High Yield Corporate Bonds: Yield Spread to 10 -Year Treasuries Spread Basis Points Spread to Worst of High Yield Index vs. Altman’s Default Rates Source: Spreads from CSFB; Default Rates from Altman/SSB Source: Lehman Brothers Portfolio Strategy § Maintain an allocation of approximately 2% in high-yield. Emphasis on select names at the higher quality end of the credit spectrum. § Biased toward the Wireless and Media Non-Cable sectors, while underweight Gas Pipelines and Food & Beverage sectors. 20
Non-U. S. Dollar Global Economic Summary The market remains focused on global monetary policy prospects. Recent data in Europe confirm the existing softening trend in activity and is presenting clearer evidence about the magnitude of the credit crunch and the extent to which it is spilling over to the European economy. The risk from credit-market fallout has caused the ECB to shelve its tightening plans for now, and in Japan, a lackluster growth picture and uncertainty in the global economy will likely delay the normalization of monetary policy by the BOJ. Dollar Index (DXY) Central Bank Rates Source: Central Bank Websites Central Bank Watch § § § ECB: Rates left unchanged at 4. 00% in January Bank of Japan: Rates left unchanged at 0. 50% in January Bank of Canada: Cut rates by 25 basis points to 4. 00% in January Reserve Bank of New Zealand: Rates left unchanged at 8. 25% in December Bank of England: Rates left unchanged at 5. 50% in January Source: Bloomberg § Performance of the U. S. dollar was broadly stronger during December amid a major credit squeeze and another wave of risk liquidation. Wide scale repatriation and accumulation of dollars for balance sheet needs helped the greenback reach 8‐week highs against the Euro, Swiss Franc and Japanese Yen around mid‐ month. However, most of these gains were ceded towards the end of the month, with the Yen and Swiss franc finishing mostly unchanged, down 0. 4% and 0. 1% respectively against the USD. Portfolio Strategy § Long position in European bonds. 21
Emerging Markets Outlook Emerging Market external debt reversed the negative return in November and gained 0. 62% in December, to close 2007 up 6. 28%. The negative events in Pakistan concerning Benazir Bhutto remained mostly local with no contagion effects into other countries. Emerging market currencies generally had positive returns across the board, but experienced some selling pressure in the middle of the period due to strength in the U. S. dollar against other global currencies. Local rates continued to move higher in many countries albeit at a slower pace than that experienced in November, particularly in Brazil and Turkey. Going into 2008, the main downward risks to the asset class are global episodes of risk aversion similar to those experienced with subprime in 2007, and the materialization of a prolonged slowdown in the global economy triggered by slowing consumption in the United States. The direction of commodity prices will remain important for balance of payments expectations. Policy makers may allow currencies to appreciate further to mitigate the inflation shock experienced through 2007 with commodity prices. Year-to-Date Performance -- External Debt vs. Local Debt Year-to-Date Spread Performance Source: JP Morgan, Bloomberg Portfolio Strategy § Retain strong quality and liquidity biases. § Small positions in Argentina, Peru and Colombia. 22
Fixed Income Market Review: Fourth Quarter 2007 Market Review Data released over the course of the fourth quarter suggest that some of the underlying growth momentum in the real economy has slowed. Headwinds to growth in 2008 include mortgage-related weakness, higher energy prices and tighter lending standards. Yield Curve Shifts Yield Curve The year ended with lower yields, a steeper curve, and higher implied volatility – a risk reduction theme we have witnessed in the U. S. markets since late in the second quarter. • The FOMC cut the fed funds target rate 25 bps at each of its scheduled meetings over the quarter, and it now stands at 4. 25%. • The benchmark 2‐year note rallied 94 basis points over the quarter to close the year at 3. 05%. The yield curve steepened 55 bps as thirty‐year yields fell 38 bps, closing the quarter at 4. 45%. Source: Bloomberg The global fixed income markets were hostage to headlines in the fourth quarter, as news of portfolio write-downs, ratings downgrades and malfunctioning money markets fueled a flight to quality. • Spread sectors of the Lehman Aggregate Index dramatically underperformed Treasuries in November. With the exception of the asset ‐backed sector, spreads bounced back and tightened during December. Nonetheless, spread sector excess returns for the year were significantly negative. • Q 407 credit sub-sector excess returns: Industrials (‐ 205 bps), Utilities (‐ 227 bps), Financials (‐ 333 bps). 23 Duration-Adjusted Excess Returns vs. Treasuries (Basis Points) Spread Sector Performance 4 Q 07 2007 Source: Lehman * Lehman High Yield 2% Issuer Capped Index **Lehman Emerging Markets Index (US Dollar)
Broader Fixed Income Opportunities Appear To Be Ahead In 2008 Market environment changes during 2007 increased the dispersion of investment returns across sectors. Dispersion of Returns Across Sectors - Lehman U. S. Aggregate Index Duration-Adjusted Excess Returns vs. Treasuries by Calendar Year* Factors which had supported low volatility and reduced risk premia were: • Prolonged tightening of global monetary policy • Increased financial innovation and growth of structured products • Complacency among investors • High returns of lower‐quality credit assets • Perilous risk/reward profiles Factors contributing to the reemergence of volatility: • Housing market turmoil • Credit market volatility *As of 31 December 2007 Source: Lehman Brothers We believe active management and a focus on relative value opportunities should benefit from the return of market volatility. 24
Fresno County Employees' Retirement Association Portfolio Review and Outlook: 4 Q 07 Black. Rock Strategy as of December 31, 2007 Deteriorating growth fundamentals likely will prompt additional rate cuts from the Fed. However, weakness in consumption may not bring any lessening of inflationary pressure. Probable implications include a steeper yield curve, a reversal of the monetary easing at the Fed’s earliest opportunity and the persistence of volatility. Modestly short duration relative to the index with a slight yield curve steepening bias. Spread risk: Overweight relative to the index. Limited exposure to “plus” sectors. Sector biases: • Treasuries: Underweight with a bias toward on‐the‐run issues. Allocation to TIPS. • Agencies: Underweight. • Mortgages: Remain overweight MBS, with a bias toward premium (above par) coupons relative to discounts within pass‐ throughs. Continue to look for opportunities • • • to swap out of agency MBS and into other high quality, but less liquid assets in the CMBS, ARM and CMO markets. Corporates: Opportunistically adding exposure through attractively valued new issues. Prefer the shorter end of the curve where swap spreads are wider and breakevens more attractive. Favor financials over industrials and are biased towards high quality, non‐cyclical credits. CMBS: Overweight. Favor seasoned, high quality issues. ABS: Small overweight with an up‐in‐quality, tier‐ 1 security bias. Favor short‐dated fixed rate auto ABS. High Yield: Modest exposure. Continued focus on higher credit quality names. Non-USD: Long position in European bonds. Small allocation to Japanese yen‐denominated debt and Mexican peso securities. Emerging Markets: Small positions in Argentina, Peru and Colombia. Sector Allocation vs. Benchmark Performance Attribution (% Market Value) Positives Credit underweight 25 CMBS overweight Yield curve positioning As of 12/31/07 Non‐dollar allocation ABS security selection As of 9/30/07 Negatives Non‐agency MBS allocation
Portfolio Composition: Fresno County Employees’ Retirement Association September 30, 2007 Characteristics as of September 30, 2007 Portfolio Benchmark Difference Characteristics as of December 31, 2007 Portfolio Benchmark Difference 26 Effective Duration (Yrs. ) 4. 35 4. 48 ‐ 0. 13 Effective Convexity ‐ 0. 45 ‐ 0. 21 ‐ 0. 24 Yield 6. 02 4. 91 1. 11 Average S&P Credit Quality AA+ AAA Effective Duration (Yrs. ) 4. 43 4. 63 ‐ 0. 20 Effective Convexity ‐ 0. 51 ‐ 0. 14 ‐ 0. 37 Yield 6. 01 5. 32 0. 69 December 31, 2007 Average S&P Credit Quality AA+ AAA
Portfolio Characteristics: Fresno County Employees’ Retirement Association Sector Allocation as of January 25, 2008 Credit Quality as of January 25, 2008 Estimated NAV: $231, 551, 450 Sector Allocation vs. Lehman Aggregate Index Characteristics as of January 25, 2008 Portfolio Benchmark Difference 27 Effective Duration (Yrs. ) 4. 01 4. 23 (0. 22) Effective Convexity (0. 38) (0. 26) (0. 12) Yield 5. 30 4. 43 0. 87 Average S&P Credit Quality AA+ AAA
Portfolio Performance: FCERA As of December 31, 2007 Gross-of-Fees Total Return in USD (Ann%) Net-of-Fees Total Return in USD (Ann%) 1 Month Active Return 4 Q 07 1 Yr 3 Yr . 10 ‐ 0. 17 ‐ 0. 42 0. 07 1 Month Since Inception Active Return 4 Q 07 1 Yr 3 Yr Since Inception 0. 08 ‐ 0. 23 ‐ 0. 66 ‐ 0. 21 ‐ 0. 16 FCERA Portfolio Lehman US Aggregate Index *Results do not reflect the deduction of management/advisory fees; management/advisory fees and other expenses will reduce a client's return. For example, assuming an annual gross return of 8% and an annual management/advisory fee of 0. 25%, the net annualized total return of the portfolio would be 7. 74% over a 5‐year period. Fees are described in Part II of Black. Rock's Form ADV. Past results are not necessarily indicative of future results. 28 **Results reflect the deduction of management fees. The fees for the Fresno County Employees' Retirement Association are 25 basis points on the first $100 million, 20 basis points on the next $100 million, 17. 5 basis points on the next $100 million and 15 basis points on assets above $300 million. Past results are not necessarily indicative of future results.
FCERA Guideline Summary 29
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