December 3, 2004 Volume 22, Number 12

Inside This Issue Break-Even Analysis for Maturity Selection Surety Bonds as an Alternative for Collateralizing Bank Deposits Congress Raises Debt Limit GFOA to Offer New Investment Seminar Performance Benchmarks Panel of Economists Databank Interest Rate Outlook Break-Even Analysis for Maturity Selection By Ned Connolly City Treasurer Terry took a sip of her coffee as she looked over the computer screen displaying activity in the bond market. There was little activity to check out since the U.S. bond market was closed for Veterans Day. Terry liked an occasional quasi-holiday. Repos would not have to be changed. Maturities would not have to be reinvested. Brokers weren't calling with the latest new agency issue. Now was a good time to step back and re-assess the city's portfolio. Operating in a Rising Interest Rate Environment. Sitting in the quiet of a usually hectic office, Terry began reviewing the city's portfolio and its performance for the year. Much had happened during the year. The Federal Reserve had raised the Federal Funds rate four times from 1.00 percent to 2.00 percent in 25-basis-point increments. Strong employment numbers in March, April, and May had caused interest rates to rise rapidly into June, only to have them move lower through the summer as the economy hit what Fed Chairman Greenspan called a “soft patch.” In the first 10 days of November, the re-election of President Bush, strong employment numbers for October, and a Fed rate hike at the November Federal Reserve Open Market Committee meeting all contributed to higher interest rates, with the yield on the two-year Treasury note approaching the yearly high reached in June. Oil prices hit record highs during the year creating a potential drag on economic growth. The direction of the war in Iraq and its impact on the economy remain uncertain. What a difficult year for making investment decisions for the city's portfolio. Terry had taken over as Treasurer/Chief Investment Officer for the city in 2000. In her first several years in the position, the primary challenge was falling interest rates that hit historic lows in 2003. Attractive yields were hard to find. Only callable securities seemed to offer attractive yields, but they did not stay in the portfolio very long with the issuers exercising their redemption options as yields continued to fall. Paging through her current portfolio report, Terry thought about the new challenges she faces in a rising interest rate environment. She has very little experience in this kind of market. She has heard some advisors say “stay short” or “keep liquid” and wait for rates to go higher. But they have already risen significantly. The two-year Treasury note today at 2.85 percent has almost doubled in yield from its low of 1.46 percent in March. Other people say the yield curve is steep and there is good yield pickup extending out the curve into “longer maturities.” “Invest some of your money in the two-year to five-year range,” they advise. How can she know when it's the right time to buy longer maturities? Using Break-Even Analysis as a Selection Tool. Just then her phone rang—her first phone call on a quiet day. The voice on the other end belonged to Doug, a peer who is the investment officer for another city. Doug has been in his position for about the same time Terry has been in hers. They talk frequently to discuss ideas on managing their investments. As the conversation progressed Terry asked Doug the question that had been on her mind when he called. “Now that rates are moving higher again, how do you know when it's a good time to invest in longer maturities?” Doug went on to tell her about a tool that he had begun using to help him make that very decision. “It's called Break-Even Analysis. It's a calculator to analyze two securities with different maturities and determine under what circumstances their yields would be equal. There are three dates you input into the calculator: the ‘start date,’ which is the settlement date; the ‘end date,’ which is the maturity date for the longer security; and the ‘center date,’ which is the maturity date for the shorter maturity.” “For instance, let's say you are trying to decide whether to invest in a one-year security or a two-year security. You would input the maturity of the two-year security as the end date and the maturity of the one-year security as the center date. Then there are two yields you have to input. The yield for the longer security, in this example the two-year, is input as the ‘term yield.’ The yield for the shorter security, the one year in this case, is input as the ‘head yield.’ Break-even analysis then calculates the reinvestment rate that's required for the proceeds from the maturity of the shorter security to be reinvested to the end date in order for both investment options to have equal yields. This is called the break-even yield or tail yield in some calculators.” “I don't understand how that helps me decide if I should invest in the shorter or longer maturity,” Terry said. “The break-even yield is the reinvestment yield that would make you indifferent as to which investment you made,” Doug went on to explain. “In the example we are talking about, either the two-year term investment or the two one-year investments would yield you the same at the break-even yield at the end of two years. If, however, your market analysis leads you to believe the one-year rate one year from now will be lower than the break-even rate, then you are better off buying the two-year security. On the other hand, if you think the rate will be higher than the break-even rate, then it's better to buy the one-year security and reinvest the maturing proceeds in a year. While we've been talking, I e-mailed you a screenshot from Bloomberg. Open it up and it will help you understand what I'm trying to explain.” Exhibit 1 Bond Yield: Gap Break-Even Analysis TERM DAYS 718 START DATE 11/12/04 END DATE 10/31/06   HEAD/TAIL   CENTER DATE 10/31/05     ENTER A RATE FOR TWO OF THE THREE PERIODS   YIELD # of COMPOUNDING PERIODS TERM 2.850 3.933702 HEAD 2.480 1.933720 TAIL 3.200 2.000000 SUMMARY Settle One-Year: 2.48% Two-Year: 2.85% B/E: 3.21% Information provided by Bloomberg L.P. with permission. “In the example I've sent you, the settlement date is November 12, the end date is the maturing date for the current two-year Treasury note, which is October 31, 2006, and the center date is October 31, 2005, the maturity for a one-year Treasury note,” Doug explained. “The yield on the one-year is 2.48 percent, the yield on the two-year is 2.85 percent and the break-even yield, or tail yield, is 3.21 percent. If the yield for a one-year Treasury note on October 31, 2005, the center date, is 3.21 percent, then either investment strategy will yield me the same. However, if I think the one-year yield will be lower than a 3.21 percent on October 31, 2005, then I would get a higher yield by investing in the two-year note. If I think it will be higher than a 3.21 percent, then I would get a higher yield by investing in the two one-year securities.” “It doesn't tell me what the yield will be on October 31, 2005,” Terry was quick to point out. “No, only a real good crystal ball can do that and I've yet to find one of those,” Doug chuckled. “But it does give me an accurate break-even yield that I can use as a target yield in my analysis. Then I ask myself, based on my current market analysis, do I think the actual yield will be higher or lower than the break-even yield when the shorter security matures? Break-even analysis allows me to evaluate the attractiveness of two maturity alternatives based upon a reasonable set of assumptions about future interest rate levels.” As their phone call wrapped up, Terry thanked Doug for the new tool she can use to help her make some of her investment decisions. She liked the fact that break-even analysis can be performed on any two maturity alternatives. She also found it beneficial that the break-even analysis screen can be easily e-mailed to others for review. Now it's time for her to meet a friend for lunch, a luxury she doesn't get to enjoy when the bond market is open. Ned Connolly, CCM, is vice president of Governmental Client Relations for Chandler Asset Management, Inc., a San Diego-based investment advisory firm specializing in managing public funds. Top

Surety Bonds as an Alternative for Collateralizing Bank Deposits By Corinne Larson In many states, governments are permitted to use a surety bond in lieu of collateral. A surety bond is an agreement issued by an insurance company to guarantee the payment of principal and interest on public deposits. If a bank defaults, the public entity can draw on the surety bond and receive its funds within 24-48 hours. Surety bonds eliminate the need for custodial agreements, security agreements and valuing collateral securities. The advantage to the entity is that it would not have to wait to take possession of the collateral securities and then liquidate them to be made whole for its deposits. Because surety bonds are direct obligations of the insurance company that issues them, it is important for finance officials to verify the credit quality of the insurance company and to only accept surety bonds from high credit quality companies. Essentially, the public entity is trading exposure from the bank's credit risk to the insurance company's credit risk. Surety bonds are economical for banks because the bank does not have to tie up securities by pledging collateral. The bank pays a premium to the insurance company. Finance officials should be aware, however, that the agreement is between the bank and the insurance company. The public entity is a named insured but does not participate in negotiating the agreement. To date, this method of securing deposits has not been tested in a court of law, and many governments prefer to collateralize their deposits. States Permitting Use of Surety Bonds Alabama Arizona Arkansas Connecticut Georgia Illinois Iowa Kansas Kentucky Maine Maryland Minnesota Missouri Montana Nebraska Nevada New Jersey New Mexico New York North Carolina Ohio Oklahoma Pennsylvania South Carolina Tennessee Texas Vermont West Virginia Wisconsin Wyoming Source: GFOA, An Introduction to Collateralizing Public Deposits for State and Local Governments, by Corinne Larson Note: Some restrictions may exist, such as being limited to a certain percentage of deposits or allowed for state funds but not local funds.

As an example, the State of Maryland permits localities to use a surety bond, with the following statutory provisos:

1) subject to the terms and conditions of the bond, it is irrevocable and absolute;
2) the surety bond is issued by an insurance company authorized to do business in this state;
3) the issuer of the surety bonds does not provide surety bonds for any one financial institution in an amount that exceeds 10 percent of the surety bond insurer’s policyholders’ surplus and contingency reserve, net of reinsurance; and
4) the claims-paying ability of the authorized insurance company is rated, at all relevant times, in the highest category by at least two nationally recognized rating agencies acceptable to the Treasurer.

Corinne Larson is vice president with MBIA Asset Management Group and can be reached at 888/637-2662.

Congress Raises Debt Limit

Late last month, Congress enacted legislation that raises the federal debt limit, paving the way for further debt issuance by the U.S. Department of Treasury. Lawmakers agreed to raise the statutory debt limit by $800 billion. Other action focused on wrapping up appropriations bills so the 108th Congress could adjourn.

Treasury reached the debt limit on October 14 forcing it to suspend the state and local government securities (SLGS) program until Congress passed an increase. According to the Bond Market Association, when President Bush took office January 2001, the debt ceiling was $5.95 trillion, $1.434 trillion less than the current limit of $7.384 trillion. After S. 2986 is signed by the President the national public debt limit will be $8.184 trillion.

GFOA to Offer New Investment Seminar

GFOA will be unveiling a new seminar on advanced public investing in May 2005. The seminar, led by Ned Connolly of Chandler Asset Management, Inc., will cover advanced investment topics for seasoned professionals that are responsible for investment public funds. Additional information on the seminar will be at www.gfoa.org and sent via mail.

Panel of Economists

Gauging the Impact of the Election on the Economy

Some have suggested that the outcome of the election may have a significant effect on future interest rates and the economy. This month, Public Investor asked its panel of economists to comment on how the results of the presidential and congressional elections will affect interest rates, inflation, and economic growth. We also asked the panel if political gridlock is a plus or a minus for public investors.

Neal Soss states that the larger Republican party majority in the U.S. House and Senate will probably lead to large federal budget deficits. He notes that the Bush administration has been very tolerant of U.S. trade deficits. He also expects a weaker U.S. dollar. In industrial policy, Soss expects that greater Republican majorities will raise the probability of tort and liability reform and of greater regulation of the role of the government sponsored enterprises in mortgage finance.

According to Carl Tannenbaum, the results of the elections will have a minimal impact on the economic outlook. He states that presidential power over the economy is often overstated. This is especially true in the current fiscal situation because the large federal deficit will limit budgetary choices. Tannenbaum notes that some like political gridlock because it limits new spending and regulation. However, he feels that at this time gridlock would be negative because it would limit progress toward addressing critical long-term issues such as Social Security and Medicare.

Dr. Lacy Hunt states that the critical factor affecting interest rates is the possibility for sharply lower economic growth next year. He notes that the Index of Leading Economic Indicators has decreased for five consecutive months. (In addition, the leading index developed by the Economic Cycle Research Institute dropped into negative territory, off very sharply from a peak of 12 recorded late last year and again early in 2004.) Hunt highlights five factors that may lead to slower economic growth next year: 1) tighter monetary conditions; 2) very high energy prices; 3) structural imbalances are the worst since the end of World War II; 4) the end of the fiscal stimulus generated by the tax cuts of the past three years; and 5) more intense foreign competition due to wavering foreign economic conditions. RGM

Forecasters Foresee More Growth

The most recent Federal Reserve “Beige Book” reports that economic activity generally continued to expand in all Fed districts in September and October. Specifically, the Richmond and Dallas districts reported that the pace of economic activity has quickened, while the New York, Cleveland, and San Francisco districts suggested that economic growth has moderated somewhat.

Looking ahead, the National Association of Business Economics (NABE) survey predicts that real GDP growth will average 4.4 percent in 2004 and 3.6 percent in 2005. A separate Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, made very similar predictions for GDP growth.

In recent months, employment growth has been robust. The October non-farm payroll increased by 337,000 jobs, and estimates for previous months were revised upwards. The NABE survey predicts further improvement in the labor market, with the unemployment rate falling to 5.2 percent in 2005.

Although on a growth trajectory, the economy shows no signs of inflation heating up. The NABE survey predicts that CPI inflation will average 2.7 percent in 2004 and 2.4 percent in 2005. Looking at inflation over the long term, the Survey of Professional Forecasters predicts that CPI inflation will average 2.5 percent over the next 10 years.

RGM

Fed Continues to Inch Up Rates

As expected, the Federal Reserve Open Market Committee decided to raise the Fed Funds rate by 25 basis points to 2.00 percent at its most recent meeting in November. The Fed has raised rates 100 basis points since it began tightening in June. Many expect the Fed to raise rates again by 25 basis points at its December 14 meeting. The Fed funds futures market predicts that the Fed funds rate will rise to 3.25 percent by the end of 2005. Some Fed watchers anticipate that the Fed will raise rates even more aggressively, raising the Fed funds rate to 4.00 percent by the end of next year.

The most recent National Association of Business Economics (NABE) survey predicts that the three-month Treasury bill will rise to 2.01 percent by December 2004 and 3.30 percent by December 2005. The NABE survey predicts that the 10-year Treasury bond will reach 4.34 percent by December 2004 and 5.11 percent by December 2005. The Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, made similar predictions. The latter survey predicts that the three-month Treasury bill will increase to 3.3 percent by the fourth quarter of 2005 and the ten-year Treasury bond will increase to 5.1 percent by the fourth quarter of 2005.

RGM

6-Month Treasury Bill
2-Year Treasury Note
30-Year Treasury Bond

The Public Investor is published monthly by the Government Finance Officers Association (GFOA), 203 N. LaSalle Street, Suite 2700, Chicago, IL 60601. (312/977-9700; email: PublicInvestor@gfoa.org) Annual subscription rates are $55 for active GFOA members, $70 for associate GFOA members, and $85 for nonmembers. For reprint permission contact GFOA.

The information and opinions printed herein are from sources believed to be reliable, but GFOA makes no guarantee of accuracy. Opinions, forecasts and recommendations are offered by individuals and do not represent official GFOA policy positions. Nothing herein should be construed as a specific recommendation to buy or sell a financial security.