Feature Articles and Resources

• Investment Strategies for the Current Economy
  
• Four Portfolio Strategies for Small Governments
  
• Cash Handling Tips and Traps
  
• Eleven Common Errors Leading to Out-of-Balance Situations
  
• Useful Resources on Cash Handling

• Panel of Economists: Where Are We in the Business Cycle?
  
• 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. The market story remains a complicated one as investors struggle to project what direction the economy will take. Sluggish growth combined with moderate inflation has provided a challenge to Federal Reserve policymakers, who have held the fed funds rate steady for six consecutive meetings. Having removed language indicating a bias toward tightening from the last Federal Open Markets Committee meeting statement, the Fed seems poised to at least consider future rate hikes, but that is entirely dependent upon upcoming economic data.

The weakness in the housing market has also held steady, with foreclosures for the first three months of 2007 doubling from the same time period in 2006. This increase has moved the news on foreclosures from the business page to the front page of many newspapers across the country, sparking worries among the public about housing price stability. Additionally, 50 sub-prime mortgage companies failed or were sold this year due to the protracted weakness affecting that sector. Housing pundits have wondered if the sub-prime lending problems would spread to other lending sectors. This difficult environment could restrict the growth of the economy throughout 2007 and beyond as spending generated by home ownership activity (e.g., purchases of furniture, durable goods, and building supplies) will slow along with home price appreciation.

Investment Strategies. The Federal Reserve has maintained its policy stance that “incoming data have supported the view that the current stance of policy is likely to foster economic growth and a gradual ebbing of core inflation.” While the mortgage finance and home price issues are a concern, global growth will help buoy the economy in the near term. Employment has also remained strong and that will help consumers support their spending habits, although not at the same level as in recent years. Below are some approaches for this economic climate.

• Maintain a defensive short duration bias. Since current market conditions do not adequately reward investors for purchasing securities with longer durations, we believe that callable securities are an effective means to boost yield in the core portion of portfolios. In addition, a defensive purchase or two of longer-dated debt could prove to be an effective hedge against any market easing later in 2007.
  
  
• One-to-three month maturities and six-to-nine month securities are still good choices as the economic story continues to unfold. Extending duration to the 180-to-270 day range, for example, provides minimal added value at this point and will restrict one’s ability to maximize returns on the operating cash portion of a portfolio.

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.

Four Portfolio Strategies for Smaller Governments

By Linda T. Patterson, CTP

After preparing your cash flow, reviewing the fundamentals, and choosing the appropriate and acceptable investments for your portfolio, you are ready to create your portfolio. Most small entities should construct their portfolio so that their investments match their liabilities at least six months out.

An easy tool for daily use with your investing is a simple calendar. Mark the calendar in red with every payroll, debt service, and other major liability on the date due. Your cash flow analysis will tell you what average payables and payroll amounts you need to supplement the larger scheduled liabilities. As securities are purchased, mark the maturity amount in black on the maturity date. At a quick glance you can see each liability being loosely matched to an investment.

1. Laddering a Portfolio

The process of buying securities spaced out equally to match liabilities is called laddering. It is a very passive and defensive method. As securities mature they are reinvested on the longest maturities of the range thereby receiving the highest yields (in an upward sloping yield curve environment).

The liability ladder accurately addresses funding issues and provides a safety net for funding, but also extends the portfolio slightly to use higher yields farther out the yield curve. The calendar does not have to be filled in specifically in maturity order however. Chose your time horizon (say three months at a time) and chose the best yielding investments in that time period until you fill all the liabilities. Then move on to the next time horizon. Using this market timed ladder lets the market show you the best yields as you complete your ladder.

In building a ladder also remember that you do not need to have a security mature on the exact date of your liability. The best security may mature several days or weeks before that date. Just never pick a date beyond the liability date. Several liquidity options, like pools and money funds, then can be used for investment of the funds until the date of the liability. This allows you to chose the best rate and compound the interest you just earned.

Where is the value if you need funds in eight or 10 months in this example?

The value is in the eight-month area because of the jump from 5.4 to 5.8 not 5.8 to 6.0.

Barbells: The laddered portfolio is much safer than another portfolio strategy called the barbell. Smaller entities should rarely use the barbell method because it can seriously impair liquidity during rate changes and it demands much more active investing. It requires you to make a market call on rates. A barbell concentrates the securities in two points: the long and short ends of the maturity range available, for example, placing half in cash and half in the two-year Treasury note. This structure is designed to gain from liquidity and the higher, longer yields. It usually produces higher yields. However, if the rates rise you may not be able to liquidate your longer maturities for funding purposes.

2. Finding Relative Value - Shopping the Yield Curve

The process of finding relative value (i.e., the best deal) is straightforward but requires effort by the investor. Every time an investment is made the investor looks for relative value. First, if we do not have a specific maturity need, we must identify where value is on the curve. Second, if a specific liability must be funded, we must look for value in that maturity range.

As a first step, a small entity (with a one-year portfolio horizon) should always be aware of the Bill yields. Check the Wall Street Journal to determine at least the "current" three-, six-, and 12-month yields. This is the standard against which you will judge value. If other securities do not offer a spread over these yields they do not represent value. (An investor with greater access to market information would then look at the relative historical spreads.) You will see value at this time point only, which is sufficient.

Once market value points are identified, you examine your own portfolio and cash flow to see what fits your needs. If you know what dates you need, you might choose the six-month area in curve #2. Now you know the rate to beat is 5.80 percent. The second step is to look at other investment options and comparison shop.

In this process it is important to have a general idea of the direction of rates. If you believe rates will rise significantly you would probably go to a pool or fund to ride the rates up. If rates are expected to drop you would want to lock in the rates available in securities. Having a cash flow analysis allows you to make that decision easily and quickly.

This process of researching what is available, comparing it against the Bills, and making a general rate call will be repeated every time you make an investment decision. A good broker will do the comparisons and research for you. Just let the broker know your maximum maturity horizon and what you are investing in, then the broker will offer you alternatives from which to choose.

3. Riding the Yield Curve

The idea of "riding the curve" on a positively sloped curve is to increase returns. You buy a security out on the shoulder of the curve and hold it until it can be sold at a gain because its current maturity and yield has decreased (prices increased). This strategy is not fool proof because it assumes that short rates will not rise. It also has become more difficult because of the volatility in the markets. It also assumes that you are able to sell positions for a profit.

4. Swapping

A swap results from selling a security you own and buying another with higher yield or better cash flow with the same approximate maturity date. Sometimes these are done for profit or to change the make-up of the portfolio. It does allow you to use the securities profit for reinvestment. This is a more active strategy because it requires book and market value information on your securities and requires a solid analysis. Both the yield and the financial impact of a swap must be analyzed. A short example is shown below.

1. Sell T-Note 3.5% 4/30/08 for 5.56% at 99.30 (book is 99.30)
2. Buy T-Note 5.375% 5/15/08 for 5.56% at 101.20

This looks like a good swap moving out at breakeven and into a higher coupon, but the evaluation must include a review of the full financial impact. The buy and sell sides must be compared using prices, coupon flow, and final maturity amounts. Swapping can increase your returns, but like all strategies and investments you must have full information and if you can't explain it - don't do it.

Linda Patterson is the president of Patterson & Associates.

Cash Handling Tips and Traps

By Anthony Francisco

The process of cash handling is the actual receipt of funds by a government. The government may receive funds in the form of currency, coins, checks, credit cards, debit cards, and on-line payments. It is important to note that, while the chief financial officer usually has the custodial responsibility for all of the government's cash, they usually do not physically handle the cash. Usually, most of the cash is actually handled by first-line cashiers, utility customer service representatives, landfill operators, recreation center leaders, swimming pool lifeguards, permit counter representatives, or court clerks. Thus, it is absolutely essential that the finance director/treasurer make certain that all of the individuals in their organization who actually handle the cash have been adequately trained on cash handling procedures, including the timely deposit of cash with the treasury or a bank approved by the treasury.

Cash Handling Tips. It is absolutely essential that local legislation (ordinance, charter, code, adopted administrative or personnel policy) empower the finance director/treasurer to mandate the following:

1. Employees who handle cash in areas outside the finance department must receive adequate training on that part of their jobs that involve the handling of cash.
2. Disciplinary action should be taken for violations of cash handling policies.
3. The finance director/treasurer should review and approve written internal control procedures that are established for every location where cash is accepted in the organization.
4. The finance director/treasurer should monitor compliance with internal control policies and procedures.
5. The finance director/treasurer must regularly visit locations where cash is being taken and implement training programs for cash handlers. This is necessary to avoid cash handling errors or fraud that result in losses to the government or prevent cash from being invested in a timely fashion.

Anthony Francisco is the treasurer of the City of Norman, Oklahoma . He is the author of the Cash Handling Training Manual, 2nd Edition, published by the Association of Public Treasurers.

Still Time to Register for GFOA Annual Conference

Last-minute registrants are still welcome for the GFOA Annual Conference in Anaheim, California, on June 10-13, 2007. State and local treasurers and finance officers will have the opportunity to hear an array of experts on treasury management and investment topics. More information on the GFOA conference is available on GFOA's Web site.

Where Are We in the Business Cycle?

This month, Treasury Management asked its panel of economists where the economy is right now in the business cycle. We also asked the economists to provide their forecast of the economy over the next six months.

According to John Silvia of Wachovia Securities, the economy is now in the mid-cycle period. For the second half of this year, he predicts economic growth of 3 percent and CPI inflation of 2.3 percent. He expects that the Federal Reserve will keep the Fed Funds rate unchanged and for long term interest rates to move upward.

Carl Tannenbaum of LaSalle Bank/ABN-Amro states that the economy is currently in a mature phase of the business cycle, which is why the economy is currently experiencing inflationary pressures and uncertainty in the outlook for business spending. Tannenbaum expects the expansion to continue after the imbalances in the housing market are slowly absorbed. He anticipates that the Federal Reserve will keep the Fed funds rate unchanged, but for long-term interest rates to drift upward.

Lacy Hunt of Hoisington Investment Management predicts that a recession could occur either later this year or in 2008. He notes that the index of leading indicators is close to posting a decline for four quarters in a row. In nearly all of the cases when this occurred in the past, a recession or slowdown occurred. If a recession is to be avoided, Hunt states that the Federal Reserve will need to quickly and substantially ease monetary conditions.