Feature Articles and Resources

• Investment Strategies for the Current Economy
  
• Investment Alternatives for Smaller Governments
  
• Tips for Reducing Costs and Maximizing Revenues
  
• What Are Other Governments Doing?
• 2006 Public Investor Index of Articles

• Panel of Economists: Economic and Interest Rate Outlook
  
• Interest Rate Outlook
  
• Snapshot of Economy and Interest Rates

• Performance Benchmarks
  • 10-Bill Index
  • Money Market Fund Index
  • LGIP Index
  • Key Rates: Cash Markets
  • Relative Value Yield Chart

Investment Strategies for the Current Economy

Current Environment. Economic data make interpreting the health of the national economy more challenging with each passing month. The housing market has continued its resilience as new and existing home sales showed gains in November (3.4 percent and 0.6 percent respectively), indicating that buyers remain active. Conversely, sellers are not as enthusiastic as new home prices have fallen 15.3 percent on a year-over-year basis.

Manufacturing turned around in December as the ISM index registered an expansionary reading versus what had been a contracting reading in November. This sentiment could lead to more economic activity which could help the economy’s expansion in 2007 and fend off any recessionary pressures economists fear. The balance of growth and inflation will be major themes throughout 2007 that warrant following.

• The most recent (December) Core CPI reading registered a 2.6 percent increase year-over-year. This continued elevated reading does concern the Fed and most of this increase has been spread across all components of the inflation index.
  
  
• Growth for the third quarter settled in at 2.0 percent. While this generally disappointed the market and signaled some concern about growth, many economic fourth quarter economic releases yielded optimism about fourth quarter exceeding third quarter growth by as much as 1.0 percent. This could keep the Federal Reserve on the sidelines for longer than forecasted in 2007 by economists.

Prudent Investment Strategies. The Federal Reserve has held the federal funds rate at 5.25 percent. The last move was during the June 29, 2006, meeting when the rate was increased 25 basis points. The Fed‘s policy statement has not clearly removed the option of hiking rates nor has it signaled any cause for concern that would lead to an ease in rates. Given this scenario, how can a public investor best allocate assets?

• Remaining defensive is still an appropriate stance. A mix of callable paper, some minor extension trades in the three- to six-month area of the curve, and some prime-based or fed funds floaters are a potential way to safely maximize portfolio returns at this time. LIBOR floaters will probably not perform as well in the near-term.
  
  
• Continue rolling cash inside of a month as the curve will most likely be range-bound in the near-term as all of the policy tightening filters though the economy. The portfolio should be positioned to have the flexibility to ‘buy the dips’ in an environment without a clearly directional interest rate path.

Byron Gehlhardt is a portfolio manager for MBIA Asset Management Group. The opinions expressed in this article are solely those of the author, are based on sources of information believed to be reliable, and are subject to change without notice.

Investment Alternatives for Smaller Governments

As a smaller entity you may think that you do not have many investment alternatives. On the contrary, even with strict state laws and local policies, you have many options that offer value. Here we have chosen those investment alternatives that are most representative of what is available to small entities within strict safety and liquidity guidelines. (The specific investment alternatives available to your government will depend upon your state statues and local policies.) The public investor has to look at each of these alternatives first to determine the advantages and disadvantages of each. Only by looking at all characteristics of an investment type can you be sure you are making valid comparisons on yield and feel comfortable with your decisions.

Treasury Bills. There is a general fallacy that a U.S. government guarantee is a synonym for totally risk-free investing. Market prices change with everything from market conditions and currency swings to wars and weather. In the fixed income market, rates and prices change inversely. (Prices up mean rates down.) Since Treasury Bills (T-bills) by definition are no longer than one year, fluctuating rates have only a limited effect. But a 50-basis-point swing on a $1 million, one-year T-bill results in a change in market value of approximately $4,500 and may affect your ability to sell it at breakeven or better. The government guarantee holds only if the T-bill is held to maturity. Despite this reality in market changes, the T-bill remains the staple of short-term investing for small investors. They are guaranteed, they may rise in value to allow profit taking, and they are the most liquid market in the world.

Many larger investors actually use T-bills as a cash equivalent because of this liquidity. This type of trading causes what we call an active "secondary market" for the T-bills where you can always find a buyer. (Just remember it may not be at your price.)

The short end of a normally shaped treasury yield curve is usually steeply upward sloping. Since T-bills constitute the short end of the treasury yield curve they have the natural effect of "rolling down the curve" which is very beneficial to the small investor.

The ability to buy directly from the Treasury is often touted as a benefit of T-bills. The Treasury has created TreasuryDirect, which allows you to invest online and safe-keep at the Fed. This has made the auction process less cumbersome and less expensive. Because of the size and efficiency of this market, it is also just as effective to buy from a broker competitively.

GSE Discount Notes. Discount notes ('discos") of many Government Sponsored Enterprises (GSEs) are nearly as liquid as Treasury Bills. In addition, discount notes can be bought with differing maturity dates. While T-bills are “posted” for specific dates, GSE discount notes are posted for a range of dates. (GSEs are also known as “instrumentalities.”)

The yield advantage of GSE securities is based primarily on credit quality. Unlike T-bills, GSE securities are not backed by the full faith and credit of the U.S. government. Theoretically, the credit quality of a GSE security does not equal that of a T-bill or Treasury Note, which creates credit risk. Since risk is reflected in increased yield, the GSE should pay the investor for increased risk. The difference between the T-bill yield and the GSE is called "spread" and a good spread will be 20-30 basis points. Since the credit risk is minimal, the increased yield makes these an excellent choice.

Spreads will vary considerably given market conditions, but a general rule of thumb is that there should be a spread over the comparable T-bill. Watch for legitimate spread claims and check all the sectors you might buy. In an inverted curve, a salesperson will often say, "these offer a great spread of 22+ to the T-bill." What he doesn't say is that the shorter bills or cash are even a better buy. So you have to check where all the relative value is.

Although GSE and U.S. Government Agency securities are both loosely referred to as “agencies,” technically, only U.S. Government Agency securities have the formal backing of the U.S. government. For more information on GSEs, see the article, “Understanding GSEs.”

Default/Credit Risk Scale

Source: A Public Investor’s Guide to Money Market Instruments, GFOA.

Short Treasury and Agency Notes. Notes, by definition, vary from one year to 10 years in maturity and carry a semi-annual fixed coupon. Depending on a government's cash flow requirements, Notes may be an appropriate investment. (For more guidance, see the GFOA recommended practice, "Maturities of Investments in a Portfolio.") However, in evaluating notes remember that – unlike T-bills and 'discos' – the coupon notes can be priced at either a discount or premium. The premium/discount will have to be amortized/accredited to reflect its true book value. Also, remember to check for "embedded options" that might make the agency notes callable or have more esoteric structures. A "bullet" has no surprises and will coupon and mature on schedule.

Certificates of Deposit. CDs have been a staple of small investors for many years. In most states these are required to be collateralized. The primary advantage of CDs is their flexibility on maturity dates and size. However, the primary disadvantage is their illiquidity. If you need the funds before maturity there is no secondary market. You will have to pay a normal 25 percent penalty rate to get your money. A service called CDARS enables investors to receive FDIC coverage on CD investments up to $30 million. For more information on CDARS, see the September 2004 issue.

Liquidity Scale

Source: A Public Investor’s Guide to Money Market Instruments, GFOA.

Repurchase Agreements. The 'repo' is the mainstay of the large investor's short-term investing. Small investors use it indirectly through pools and funds. It is a multi-billion dollar daily market that provides liquidity and funding to "the street." A repo is a very safe, collateralized alternative that allows investment of odd amounts of money overnight. If your funds are "swept" overnight, your bank may use a repo as the investment. A specialized form for bond funds is called a "flex repo." It can be done easily with a primary dealer but requires size. It is recommended that repos be done with primary dealers only. When doing repos, always make sure that The Bond Market Association Master Repurchase Agreement is in place, which defines the agreement and transaction completely. (For more information, see Considerations for Governments in Developing a Master Repurchase Agreement.)

An independent custodian is critical and makes the repo cost efficient. The smaller investor can access the repo market and avoid collateral handling costs through a tri-party repo. The collateral is held by a separate bank in a large money center (e.g., New York City). This has the same guarantees and controls, but avoids the collateral transfer costs. In addition, some firms have a small-user repo program using a modified tri-party agreement.

There are no real disadvantages to repos in supplementing your marketable securities, but you must be careful to have a Master Agreement in place and have your collateral priced. And it is very important to use delivery versus payment. For more information, see the following GFOA recommended practices:

• Repurchase Agreements & Reverse Repurchase Agreements
• Frequency of Purchased Securities Valuation in Repurchase Agreements

A crucial point with pools and funds is to understand the two types of vehicles available and how to use them for investments. The first type, the constant dollar structure or money market fund equivalent, is designed for liquidity. In this type, the manager strives to keep the net asset value (NAV) at a constant $1 value. Unrecognized gains and losses are not calculated into the NAV. The value is quoted as yield and the interest accumulates daily and is paid monthly. These are normally stable and have great liquidity because they are relatively short in weighted average maturity with most restricted to 90 days. These types are perfect for liquid funds. They will not fluctuate greatly and most pools now have protection in place that will assure that the manager takes action if the NAV market value drops below a certain level.

The second type of pool or fund has a fluctuating NAV and is built for yield. In this type of investment, the net asset value fluctuates as unrecognized gains and losses are calculated into the value of the shares (market value). As market values change daily, the value of your shares can swing greatly. The portfolios are typically longer maturity to capture yield, and therefore more volatile. They are not as liquid because their goal is yield. This means if you buy shares at $10/share you can quickly own shares worth, for example, either $12 or $8. Obviously, these types of pools or funds are not intended for liquid money. Smaller entities that use fluctuating NAV pools or funds must realize that these should be evaluated like securities. If you have a specific liability to fund, about six months before that liability date you should start watching the NAV and withdraw at a comfortable level. Otherwise, you may incur a loss when the funds are needed. For more information on this topic, see the GFOA recommended practice, “Use of Various Types of Mutual Funds by Public Cash Managers.”

Commercial Paper. Commercial paper is an alternative available to some smaller investors. It is highly liquid and normally offers a spread above the comparable treasuries because of the credit risk involved. That credit risk can be minimized by only buying commercial paper with a maximum maturity of 90 days and by requiring the highest rating. A rating of A-1/P-1 will rarely change in such a short period. Just remember to diversify your holdings and not limit the portfolio to only one issuer. (For more information, see the GFOA recommended practice, “Commercial Paper.”)

Linda Patterson is president of Patterson & Associates.

Tips for Reducing Costs and Maximizing Revenues

1. Improve Cash Flow Forecasting. A good forecast gives you control over your cash flow so you can avoid the cost of borrowing and maximize investment earnings. (For more information on cash flow forecasting, see the GFOA recommended practice, “Use of Cash Flow Forecasts in Operations.”)

2. Securities Lending. Security lending is the loan of securities from a lender to a broker/dealer, generally accomplished through a third party agent of the lender. To protect the lender’s position the borrower puts up collateral, generally in cash, at 100 percent to 103 percent of the market value of the securities. Funds received from the borrower as collateral are invested by the lender’s agent according to guidelines established or agreed to by the lender.

Caution: Make sure the agent is investing the collateral according to agreed-upon investment guidelines. Also, make sure the collateral is marked-to-market on a daily basis. We monitor the investment of collateral on a daily basis. (For more information on securities lending, see the GFOA recommended practice, “Security Lending Programs – Master, Trust, Custodial and Safekeeping Considerations.”)

3. Control Banking Costs. Here are some ways to reduce banking costs:

• Use zero balance accounts to eliminate the need to fund bank balances.
• Identify users of costly bank services and charge appropriately.
• Eliminate low paying bank accounts and costly overdrafts.

If you choose to use compensating balances, keep the balance at the minimum amount required to obtain free services. A compensating balance is the amount of money a bank requires a customer to maintain in a non-interest bearing account, in exchange for which the bank provides free services. Compensating balances are very expensive because of the low interest rates paid by banks on the compensating balances. A comparison of the interest rate paid by banks and overnight rates will give you a good indication of how expensive compensating balances really are.

4. Recoup Banking Costs from Investment Pool Participants. We recoup enough revenue to pay for the costs of our banking and investment operations. For example, heavy users of the banking system pay fixed and variable banking costs plus our fee, light users pay fixed banking costs plus our fee, and investors who do not use the banking system pay only our fee.

5. Use Your Bank Account Analysis Statement. Always require a detailed bank analysis to identify services for which you are being charged, there may be services you do not need or are not using. Your bank analysis is a good place to identify expensive users of your banking system and identify new costs such as merchant fees from credit cards. (See the June 2006 issue for more information on account analysis statements.)

6. Take Advantage of Competition. Always be aware of competitive banking costs and services. You do not need to change vendors to take advantage of the competitive market. A competitor’s costs and services can be very effective in negotiating costs and services with your own bank during, or at the end of, an existing contract.

Lee Buffington is the tax collector-treasurer of San Mateo County, California.

What Are Other Governments Doing?

2006 Public Investor Index of Articles

GFOA Conference and New Seminar Offerings

• March 12-13 (Reno, Nevada)
• July 16-17 (Salt Lake City, Utah)

Upcoming Investing Public Funds seminars are scheduled for:

• March 14-15 (Reno, Nevada)
• October 3-4 ( Sacramento, California)
• December 3-4 (Austin, Texas)