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Policy Questions

  • There are many commonalities between public sector investing and "other" investing: the way markets and instruments behave, the nature of risk and how risk is measured and managed, how returns and performance are measured and evaluated. Classic portfolio management rules apply equally to public funds. There are many commonalities between public sector investing and "other" investing: the way markets and instruments behave, the nature of risk and how risk is measured and managed, how returns and performance are measured and evaluated. However, while investing public funds is similar to investing other funds from a technical standpoint, the restrictive nature of state statutes that govern the investment of public funds, the fiduciary duty that attaches to these funds, and the fishbowl nature of government all make investing public funds fundamentally different than other forms of investing. The differences are attributable to the unique concerns of investing public funds. These funds are to be safeguarded pending their ultimate use. They are subject to state statutes that govern their activity, and restrict the investment universe to relatively conservative, high quality, short duration investments. On the risk-return spectrum, such investments, typically, limit risk, but also return possibilities. Risk and return go hand-in-hand. The investment portfolios of public funds are not the property of the treasurer, the finance director or the investment officer, but, instead, are collected from citizens, taxpayers, and service users and are invested for the benefit of those parties. This fiduciary reality places public funds investing in a different category. The public nature of government business requires heightened transparency. The fishbowl nature of being an elected official or having a political appointment, of serving the public interest places unique parameters on investing public funds. Public perception and understanding, or “how something looks” are as important as reality. 

  • The investment of public funds is strictly governed by state statutes, local ordinances, and a government’s own investment policy. Federal laws govern the financial markets. For special funds, such as bond proceeds, or funds held in trust, bond and trust documents provide governance. Similarly, pension funds or other benefit funds are governed by their own statutes and separate investment policies.

  • The governance of public funds investment is primarily determined by state statutes. Local governments derive their authority either from state statute or “home rule.” Many home rule governments choose to follow state statute in the management of their investments as a good practice. State laws vary widely leading to a patchwork of practices and investments. Many state statutes include a statement of prudence, a list of permissible investments, identification of appropriate financial service providers and a requirement for an investment policy.

    In Illinois, the primary state statute governing investing public funds, the Illinois Public Funds Investment Act, is very detailed and provides a useful roadmap for governments to draft their own investment policies and structure their investment programs. Another statue that governs the investment of public funds in Illinois is the Illinois Public Funds Deposit Act.

  • A well-written investment policy serves as a comprehensive checklist or roadmap to guide a government’s investment program. In its development, it obliges a government to consider its entire investing situation. As a completed document, it recognizes and assigns responsibility, identifies objectives, articulates safeguards and controls, identifies partners, provides selection and decision-making procedures, and confers protection for the parties responsible for investing. The policy basically serves to define the parameters – including policies and practices - within which funds are to be managed. An investment policy should strike a balance between being broad enough to allow the treasurer/finance officer to function properly within the parameters of responsibility and authority, yet specific enough to adequately safeguard a government’s investment assets.

    An investment policy should stand the test of time, remaining relevant as markets change, economies go through different phases, staffs change, and providers and technologies emerge. While the review of an investment policy on an annual basis is a best practice, this review does not mandate that changes must be made. A review identified by date assures readers that the investment policy remains fresh.

  • Investment policies derive from state statutes. Sometimes federal laws and local ordinances play a role. There are issues unique to each government that may influence its investment policy. These may include resources, expertise and sophistication, and politics.

  • The political environment and community engagement of a government play roles in creating an investment policy. A government’s experience with risk or loss may also affect its investment policy. The political environment includes the pulse of the citizenry. Some jurisdictions or governments may have a more involved electorate. Such an engaged group of stakeholders may drive certain aspects of the policy, such as permissible or restricted investments or authorized financial institutions.

    Elected officials’ preferences may be important. For example, elected officials may prefer keeping activities in-house as opposed to engaging external providers, or using partners with a local or regional presence, or a belief in a limited role for government. These views may be reflected in a government’s investment program and investment policy.

  • The size and stability of a government’s finances and of its investable assets may  play a role in its investment policy. A smaller portfolio with less predictable liquidity needs may call for an investment policy of a more restrictive nature. The resources available to a government to manage its investment program also affect policy; these resources include both intellectual capital in terms of staffing and expertise, as well as tools, like information resources, such as pricing sources, research and tools such as software or other technical assets. More limited resources may call for a more restrictive investment policy as well.

  • Share your government’s investment policy with all its investment related service providers – banks, broker-dealers, investment advisers or custodians. This ensures they are knowledgeable about your investment policy.

    Some governments go so far as to require a signed certification of these providers that they have read the investment policy and have appropriate controls in place to ensure that the provider’s employees or representatives follow the government’s investment policy. Securing such a certification from a service provider may prove challenging and a government must decide if this certification requirement is necessary.

    Along with a government’s other financial policies, an investment policy, serves witness of good stewardship. As such, it should be made available to nationally recognized statistical rating organizations (NRSROs), investors, interested constituents, such as residents, taxpayers and other stakeholders. An investment policy is one component of a government’s policies for effective and efficient management. Having these available on a government’s web site is a practice that promotes transparency.

  • The scope section of an investment policy identifies the funds governed by the policy. The funds that are outside of the scope of a typical operating funds investment policy, such as pension funds, certain funds held in trust and certain other funds require their own investment policies. These funds have different objectives, statutory constraints, liquidity needs and risk tolerances. Accordingly, separate investment policies should be in place for their governance. 

  • A government’s investment program derives from the government’s investment policy (which is also a part of the investment program). It adds "the meat to the bones" which is the investment policy.

    GFOA recommends that all governments establish a public funds investment program following the steps: 

    • Review all applicable laws and regulations
    • Establish an investment leadership team.This team will provide oversight, set policy and strategy, and identify appropriate individuals to administer the program.
    • Create an investment policy.
    • Determine a portfolio management team.
    • Establish risk and return objectives.
    • Identify the funds being invested and develop a cash flow forecast for each

Policy Components

  • An investment policy may include the following components:

    1. Introduction
    2. Scope
    3. Objectives
    4. Standards of Care
    5. Delegation of Authority
    6. Authorized Investments
    7. Authorized Financial Institutions
    8. Safekeeping and Custody
    9. Investment Parameters
      • diversification
      • maturity parameters
    10. Internal Control
    11. Performance Standards
    12. Reporting
    13. Policy Adoption
  • A general introduction section is used to describe the government’s intent in creating its investment policy.  It can be as basic as describing the government’s commitment to having a formal framework that is detailed enough to provide a structure, yet broad enough to allow the treasurer or assigned officer flexibility in its implementation.

  • The scope section describes the specific funds covered by the investment policy. Some governments may choose to explicitly identify funds that are excluded from governance by the policy. Excluded funds may encompass pension funds, capital projects and bond proceeds. Keep in mind, funds not included in the scope are, by definition, excluded. It is not necessary to specify how excluded funds are governed, or to get too detailed.

    If a government pools its funds for the investment process to take advantage of economies of scale in terms of investment pricing, or favorable terms for safekeeping and administration, such pooling may be specified in the scope section. Governments may use different methods to allocate investment income from such pooled investments.

  • A government should identify the objectives of its investment program simply.  The three key objectives for investment of government investment funds, in order of importance, are:  safety of principal, liquidity for anticipated obligations (and a cushion for unexpected expenses) and appropriate return (or yield).

    Some governments may include the objective local considerations. This objective aims to invest funds, where possible, for the betterment of the local economy or that of local entities within the state/county/municipality. While placing geographic restrictions may serve to limit return opportunities available to a government, there may be valid reasons for such an objective.

    Be clear and explicit to avoid common pitfalls.  Consider whether an objective is actually an objective or something else. For example, having legality as an objective is a cautious approach.  An investment policy must comply with all federal, state, and local laws; otherwise, it is not legal on its face, so specifying this as an objective may not be necessary. Similarly, some governments may include diversification as an objective. However, diversification is actually a means to the objective of safety, and not an objective in itself.  Be careful of general statements such as “to invest in the safest way while getting the highest return" as these may be self-contradicting and risk and return are related. As always, make sure to heed any statutorily required objectives.

  • In this section, the government specifies the care with which the investment program is to be managed. Standards of care include the level of prudence, and rules for ethical behavior and the avoidance of conflicts.

    Prudence

    Typically specified by state statute, the standard of prudence identifies a standard that the treasurer or designated investment official must follow in managing the investment portfolio.

    Governments collect money from the public - residents, taxpayers, consumers, or other involved parties - to conduct government business. A special relationship attaches to funds managed for the benefit of another – not for one’s own benefit. This is statutorily assigned. So those investing such funds have a fiduciary duty.  Fiduciaries must manage the assets or investment portfolios in their care for the benefit of the beneficiary of those funds. Fiduciaries must act prudently, always act in the interest of the beneficiary and never put their own interests first. There are different standards of care to which fiduciaries are held, but, currently, most states (not all) follow the prudent person standard.   

    “Investments shall be made with judgment and care, under circumstances then prevailing, which persons of prudence, discretion and intelligence exercise in the management of their own affairs, not for speculation, but for investment, considering the probable safety of their capital as well as the probable income to be derived.”

    A higher standard of prudence is the prudent investor rule which incorporates modern portfolio theory. It focuses on the entire portfolio not just individual investments and recognizes the importance of diversification to manage return and risk simultaneously. Some state statutes place this standard of care on those managing public funds. Governments should confirm with their own state statute which standard applies to their situation and include that in their policy and follow it in their activities.

    The most stringent standard of prudence is the prudent expert rule which applies to professional investment advisers.  Because of the expertise claimed by an investment professional, statutes compel him or her to follow the highest standard. When engaging investment advisers, treasurers or investment officials should confirm their contracts stipulate that this, the highest standard, is to be followed. 

    The state of Illinois mandates that investors of public funds follow the prudent person standard.

    Ethics and conflicts of interest

    Under the standards of care section, treasurers or finance directors my include subsections on ethical standards and prohibition of conflicts of interest. These provisions are intended to restrict those investing public funds from engaging in or profiting from outside activities that could conflict or unduly influence their investment of the public funds in their care.

    A government may require periodic reporting to protect against or disclose potential conflicts. Some governments have prohibitions in place, whereas other governments may be comfortable with periodic disclosures.

  • Environmental, Social, and Governance (ESG) investing considers the non-financial factors of environment, social and governance as part of the analysis process to identify material risks and growth opportunities. ESG metrics are not commonly part of mandatory financial reporting, but government investors are increasingly including these in their investment policies,  disclosures reports and in standalone sustainability reporting.

  • This component identifies the specific laws from which the governing authority for investing derives and that designate officials responsible for the investment function. This section can specify how authority is delegated within the office. An investment policy may seek to clarify who is responsible for oversight of the portfolio and who has responsibility for the day-to-day management of the investment program and exactly what responsibilities they may have.

    Indemnification

    A government may add a section under governing authority specifically on the topic of indemnification.  Indemnification may relieve the person responsible for investing the government's funds, such as the treasurer or finance director, or staff from personal responsibility so long as they act in accordance with written procedures and the investment policy and exercise due diligence, and as long as deviations are reported within a given period and appropriate action is taken to control adverse developments.

  • This component specifies that investments are authorized for inclusion. A government can be detailed about the investments that are authorized, permissible or allowable for the government’s portfolio under its investment policy.  Keep in mind that authorized or allowable investments derive from state statutes. State statutes are a good place to start, but a government may wish to clarify or place limits on authorized investments. An investment policy can be more restrictive than state statute, but never more expansive. Statutory authority is just one consideration; portfolio size, expertise, resources, and preferences are other considerations. Some governments may wish to list out every investment per state statute, other governments only refer to the state statute, deeming the citation to be adequate.

    In considering this section, whether for a new policy or for review of an existing investment policy, take care not to be either too broad or too limiting. Identifying permissible investments is a balancing act. A government should retain its flexibility and bear in mind, just because an investment is listed as authorized or permissible does not mean a treasurer or finance director is required to or, in fact, will include the investment in the investment portfolio. Circumstances may change in which inclusion of a certain investment becomes a prudent option or circumstances may change where the action becomes imprudent.

    Governments should use caution in drafting and evaluating the allowable investments component. Make sure the investments identified are appropriate for your own situation.

    Some governments may wish to specify that just because state statute may change and additional securities or investments become permissible for investment by public funds in a state, such new investments will not automatically be authorized for investment by the government.  Language may be added to specify that any new investments will become permissible only after review and at the discretion of the government and as an active decision only when the policy is amended, and the amended version adopted by the governing body or the specified elected official (in the case of counties) or as appropriate. Alternatively, a government may have an investment policy that follows state statute regardless.

    Another consideration for this component is the question of what happens when a downgrade occurs to an investment or a specific investment becomes out of compliance with the policy for whatever reason. The government may require an immediate sale or liquidation of the investment, or, alternatively, the government may make allowance for consideration on a case-by-case basis as long as specific steps are followed. Some investment policies specify that the investment policy covers the investment portfolio from a certain point forward, such as when the investment policy becomes effective, and that it does not apply retroactively to existing investments in the portfolio.

    Restricted or prohibited investments

    An investment policy may specifically identify securities or investments that are prohibited or not allowed.  This is a particularly cautious approach because if an investment is not expressly included it is a given that it is not authorized. 

    Collateralization

    Collateralization can be a separate component or a subsection of authorized investments.  Collateral is the security provided to investors for certain investments. Typically, in the context of public funds investing, the pledging of appropriate securities provides collateral or security, as can surety bonds or letters of credit.  Such protection is an important safeguard for deposits such as certificates of deposit or certain other depository accounts. Collateral also provides security for repurchase agreements. 

    Many states have statutes that specify collateralization requirements for public funds. There are different type of collateralization arrangements and some states, although not Illinois, have collateral pools to be shared by government entities within a state, while other states provide great leeway for collateralization to the governments. State statutes often have requirements regarding the level and forms of acceptable collateral. The investment policy should specify what forms of collateral are acceptable and include credit quality or maturity restrictions. Forms of acceptable collateral include obligations of the U.S. government, its agencies and GSEs, including mortgage backed securities, and municipal bonds. These securities should be held by a third party. Illinois governments can check the Illinois Public Funds Deposit Act.

    Selection and purchase of investments or competitive transactions

    Some governments may wish to include a section that specifically addresses how investments are selected and made. This can be a subsection of investments or a stand-alone section of the investment policy.  It can address how competitive bid information will be collected. For example, a government can implement a competitive bidding process involving at least three separate brokers/financial institutions or it could elect to use an electronic trading platform.

  • A government may enter into relationships or agreements with financial institutions for a variety of treasury services, depository and/or investment transactions as well as for advisory services. Selecting, engaging and maintaining relationships with appropriate financial partners (financially sound, knowledgeable and trustworthy) is key. This component of an investment policy specifies the requirements that a financial institution - whether bank, broker-dealer or investment adviser - must meet in order to transact business with the government. 

    The component may provide an overview of the due diligence process the government requires for each category of financial professional:  banks, broker-dealers and investment advisers. The due diligence process can range the gamut and it may require a financial institution to certify it has reviewed the government’s investment policy and has procedures in place to ensure the financial institution remains in compliance with the policy.

    Minority, disadvantaged, emerging and community financial institutions

    If the government has any requirements for minority, emerging and community financial institution participation, a subsection in this area of the investment policy can address those requirements. The investment policy can detail the requirements and how such firms will be selected.

  • Requiring that a government’s investment securities and collateral for deposits be held by a third-party custodian or safekeeping agent is one of the most important safeguards of a public sector investment portfolio. The investment policy should specify the government’s requirements for safekeeping and custody. 

    In a third-party safekeeping arrangement, an entity other than the financial institution that sold a security to a government provides transfer and custody of the securities. This financial institution can be a separate financial institution that provides such services or it can be a trust department of a given financial institution, as long as it is a legally separate entity. 

    This component of the investment policy specifies how a safekeeping agent or custodian is selected and the need for a safekeeping agreement. The agreement should specify that securities must be held in the government’s name and delivered on a delivery-versus-payment basis. Having the securities in a government’s name protects against loss in the event of safekeeping agent default and ensures immediate access to the securities in case of such default.

    Both banks and brokerage firms offer customers custody services. Investors should make sure an entity other than the one that sold a security has custody of the security. 

    Delivery-versus-payment (DVP)

    Delivery-versus-payment (DVP) is a delivery practice where the third-party custodian or safe-keeping agent acting on behalf of a government investor, does not release funds until securities have been delivered. Accordingly, the government always has in its control either securities or cash. A mention of delivery-versus-payment requirement in the safe-keeping section of the investment policy can address this requirement. Governments should also require an acknowledgement of a DVP requirement acknowledged by broker-dealers that work with a government.

  • Internal control provides protection. In this section of the investment policy, the government may include a general statement requiring the development of internal controls and may mention that detailed controls exist in the form of a separate investment procedures manual. Responsibility for identifying and creating internal controls can be specified in the general statement. There should be brief explanation of the purpose of the controls. A requirement for periodic review and monitoring of controls, either by the governing body or auditor, itself a component of internal control, can be included in this section.

    Controls that may be included in a separate procedures manual include:

    • an overview of daily treasury and investing operations/activities
    • control of collusion
    • segregation of duties
    • delegation of authority
    • supervisory control structure
    • names of the government's financial partners

    Having these in a separate document allows flexibility for changes that may be required without a formal process that requires approval. A requirement for periodic review and monitoring of controls, either by the governing body or auditor, itself a component of internal control, can be included in this section.

  • This section of the investment policy identifies parameters that are to be followed in the investment program.  Historically, these were often found in the objectives section, and served to clutter a section that should be precise.  A separate section, later in the investment policy, may be a more appropriate placement.  Two prominent risks in public funds investing are credit risk and market risk.

    Mitigating credit risk

    In this risk component of investment parameters, a government may present techniques it uses to protect against credit risk. Such techniques may include diversification, placing absolute limits on the percentage of the portfolio that can be invested in any one issuer (except U.S. Treasuries), allowing for the sale of a security prior to maturity in the interest of improving the credit quality (or liquidity or yield) of the portfolio in response to market conditions and having a policy for dealing with downgraded securities. 

    Historically, diversification was presented as a list of maximum allowed allocation, in terms of asset class, security type, structure, and maturity. There has been a shift away from that practice given the recognition that situations may change and hard limits may constrain a treasurer, finance director or investment officer, as opposed to allowing them the flexibility to adequately manage the portfolio.

    Collateralization requirements can be included in this section or in the instruments section as well.

    Mitigating market risk / interest rate risk

    Market risk is another risk component in the parameters section. This is the risk that the portfolio value will fluctuate due to changes in the market, and usually refers to interest rate changes. The investment policy can include techniques that address market risk, such as providing liquidity for short-term needs,  limiting longer-term investments to funds that are not needed for current cash flow purposes, and matching longer-term asset to expected liability due dates. Limits can be placed on callable securities, and final maturity of securities can be constrained to a specified maturity or duration.

    For more on risks, check Fixed 101 What is risk and what are types of risk in government fund investing.

  • This component of the investment policy is critical in maintaining transparency and accountability. Reports are an effective means to track investment activity and assess how investment activity conforms to the investment policy.

    The reporting section of the investment policy should address the format and content of reports, frequency and who should prepare, receive and review the reports. Specified frequency might be monthly, quarterly, and annually.  All reporting should be done in conformance with Governmental Accounting Standards Board (GASB) requirements.  

    There might be different formats for different audiences with less-technical, easy-to-comprehend reports made available to the public.

  • Evaluating performance and the standards that help evaluation should be included as a component of the investment policy. The evaluation of performance goes beyond considering safety and prudence and includes return. Some government investors include benchmarks within the investment policy.  A reasonable alternative is to clarfy how benchmarks might be selected. For example, an investment policy may state that a series of appropriate benchmarks will be identified against which the portfolio’s performance will be compared on a regular basis. As well, the policy should specify the benchmarks selected will be reflective of the objectives, constraints and risks of the government’s portfolio.  This component should also include the frequency of such evaluation.

  • The last section of a government’s investment policy should address how the investment policy is to be reviewed and approved. It is prudent to review a government’s investment policy periodically and ideally, annually. Such a review provides an opportunity to review the entire investment program, using the investment policy as a checklist. Remember that an investment policy should stand the test of time, and changes to the policy should not be undertaken lightly. When changes are proposed, the governing board should approve these except in the case of county treasurers or the state treasurer who are authorized to make such changes. The investment policy should be updated with the date of the most recent approval. However, even if no changes result from a review, the most recent review date should be recorded.  This gives assurance to all parties – both internal and external – that the policy is ever-fresh and that the appropriate parties have reviewed it.  While management can review the policy annually and bring proposed changes to the governing board’s (or county or state treasurer in those cases) attention, the policy can assign a less frequent review by an oversight person or body as a check and balance.

Partners

  • Investment officials

    Often, state statutes specify the office within a government that has authority to invest the government’s funds. If this is not the case, a government may identify in its investment policy or a resolution or order from the governing body, the position with this responsibility. 

    In some governments, responsibility for the investment portfolio rests with an elected office, a clerk, a trustee, or often, a treasurer.  Placing responsibility in an elected office stems from the expectation that this office would be subject to the voters and have direct accountability, separate from the government administrator, who also may be an elected official.  Other governments place the responsibility with an appointed professional, such as a finance director, or chief financial officer, with the appropriate technical expertise. Responsibility for day-to-day investing may be delegated within the investment policy.

    Oversight body

    Typically, there is an oversight body – whether the governing body or smaller committee that reports to it. 

    In general, governing boards are comprised of elected officials who may not have the expertise to monitor or provide supervisory guidance to an investment program. Some governments have investment committees or subcommittees of a finance committee. Such a committee may be comprised of an elected treasurer, a government administrator, and certain members of the governing board.  Sometimes, there may be volunteers from the community who may have an expertise they are willing to share. The role for such a committee is to provide guidance to the treasurer or investment officer in the management of the portfolio. The role is not one of active involvement in day-to-day implementation or activities. 

    This committee may meet monthly or quarterly, depending on the size and sophistication of the portfolio, the expertise among the members and the expectations of the members. 

    While a small number of individuals within a government may be responsible for the investment function, there are many roles and departments internally within a government that interact with them.  These may include the operational departments with input for budgeting and cash flow forecasting, operations, engineering and community development; the technology department, accounting and auditing in the reporting function, legal counsel that may draft and/or review many of the agreements the government may need to realize the investment program, as well as other departments or functions. 

     

  • There are three major types of institutions: banks, thrifts (which include savings and loan associations and savings banks) and credit unions. Funds cannot be collected, deposited and safekept without services from one of these three. These three types of institutions have become more like each other in recent decades.

    Banks

    A bank is an entity, usually a corporation, that is chartered by a state or the federal government, regulated  by state or federal regulators, receives various deposits, for which it pays interest, makes loans, and invests in securities, from which it collects interest, and offers various collection and disbursement services, as well as a range of non-traditional offerings for which it collects fees. Historically, banks generated revenue from the difference between the interest they collected on loans and investments, and the interest they paid on deposits, which they supplemented by fees on various products. The role of fees has increased over time. 

    Savings & Loans/Savings Banks

    A savings and loan association and a savings bank, also known as a thrift, is a financial institution that specializes in accepting  savings deposits and making mortgage and other loans. They can be owned by shareholders or by their depositors. They are known as thrifts because they originally offered only savings accounts. Today, generally, governments, get the same products from S&Ls and banks. 

    Credit unions

    A credit union is a member owned financial cooperative, controlled by its members like a mutual S&L, and operated for the purpose of promoting savings, providing credit and other financial services to its members. Credit unions are not-for-profit enterprises that enjoy tax-exempt status which may allow them to pay higher  interest rates on deposits while charging lower fees for other services. Credit unions are regulated under a different regulatory structure and their deposits are insured by the National Credit Union Share Insurance Fund (the “NCUSIF”), not the FDIC.

    The NCUSAIF is administered by the National Credit Union Association to protect deposits of credit union members at insured credit unions in the United States. It was created in 1970 shortly after the creation of the NCUA as an independent regulator of credit unions.The NCUSAIF is funded completely by participating credit unions, with no taxpayer support. However, the NCUSAIF is backed by the full faith and credit of the U.S. government. It is structured and operates in a capacity similar to that of the FDIC.

    Depositors should make sure their credit union is covered by NCUSAIF as there are certain exceptions.

  • The Federal Deposit Insurance Corporation (FDIC) provides insurance coverage for certain depository funds in banks and thrifts, including CDs. The FDIC also covers:

    • checking accounts
    • Negotiable Order of Withdrawal (NOW) accounts
    • savings accounts
    • Money Market Deposit Accounts (MMDAs)
    • time deposits such as certificates of deposit (CDs)
    • cashier's checks, money orders and other official items issued by a bank

    An independent agency of the federal government, the FDIC was created in 1933 in response to the bank failures that occurred in the 1920s and early 1930s. Since the start of FDIC insurance coverage on January 1, 1934, no depositor has lost any insured funds as a result of a failure.  FDIC receives no Congressional appropriations. It is funded by premiums that banks and thrift institutions pay for the deposit insurance coverage it provides and from earnings on investments in U.S. treasuries. The FDIC is backed by the full faith and credit of the U.S. government.

    By providing a level of coverage, the FDIC promotes public confidence in the U.S. financial system and limits the effect on the economy and the financial system when a bank does fail. The amount of coverage has increased through the years and since 2015, covers at least $250,000 per depositor, per insured bank or thrift, for each account ownership category (ownership, trust status and beneficiaries alter the ownership category). 

    The FDIC directly examines and supervises more than 4,500 banks and savings banks for operational safety and soundness, more than half of the institutions in the banking system. Banks and thrifts an be chartered by the states or by the federal government. Those chartered by states also have the choice of whether to join the Federal Reserve System. The FDIC is the primary federal regulator of banks or thrifts that are chartered by the states that do not join the Federal Reserve System. In addition, the FDIC is the back-up supervisor for the remaining insured banks and thrift institutions.

    The FDIC also examines banks for compliance with consumer protection laws, including the Community Reinvestment Act (CRA), which requires banks to help meet the credit needs of the communities they were chartered to serve.  A bank’s CRA Rating is important to many government investors.

    To protect insured depositors, the FDIC responds immediately when a bank or thrift institution fails. Institutions generally are closed by their chartering authority - the state regulator or the Office of the Comptroller of the Currency (OCC). The FDIC has several options for resolving institution failures, but the one most used is to sell deposits and loans of the failed institution to another institution. Customers of the failed institution automatically become customers of the assuming institution. Most of the time, the transition is seamless from the customer's point of view.

    National Credit Union Share Insurance Fund (NCUSIF)

    Much like the FDIC provides insurance coverage for deposits held in bank or thrift members, the National Credit Union Share Insurance Fund (NCUSIF) provides coverage for deposits held in credit unions, which some governments use for depository services.

    The National Credit Union Administration (NCUA) administers the NCUSIF.  It serves as the independent regulator of credit unions. The NCUA is structured and operates in a capacity similar to that of the FDIC.

  • Banks and S&Ls submit reports to the Federal Deposit Insurance Corporation (FDIC), which investors can find on the FDIC website.  Government investors can require that financial submit to them the appropriate report as part of their due diligence process.

    The FDIC is an agency of the federal government, created in 1933 in response to the bank failures that occurred in the 1920s and early 1930s. The FDIC directly examines and supervises more than 4,500 banks and savings banks for operational safety and soundness. Banks can be chartered by the states or by the federal government. Banks chartered by states also have the choice of whether to join the Federal Reserve System (FRS). The FDIC is the primary federal regulator of banks that are chartered by the states that do not join the Federal Reserve System. In addition, the FDIC is the back-up supervisor for the remaining insured banks and thrift institutions

  • FDIC insurance coverage of government deposits depends on the type of deposit and the location of the insured depository. All time and savings deposits of a government, referred to as a "public unit" in FDIC regulations and held by the public unit's official custodian in an insured depository within the State in which the public unit is located are added together and insured up to $250,000. Separately, all demand deposits owned by a public unit and held by the public unit's official custodian in an insured depository institution within the State in which the public unit is located are added together and insured up to $250,000. The insurance coverage of accounts held by government depositors is different if the depository institution is located outside the State in which the public unit is located. In that case, all deposits, both time and savings deposits and demand deposits, owned by the public unit and held by the public unit's official custodian are added together and insured up to $250,000. Time and savings deposits are not insured separately from demand deposits.

    Collateralization of Public Unit Deposits
    The FDIC allows for securing public deposits by collateral or assets of a  bank. In the event of a bank failure, the FDIC will honor the collateralization agreement if the agreement is valid and enforceable under applicable law. Although collateralization does not increase the insurance coverage of the public unit deposits, it provides an avenue of recovery in the unlikely event of the failure of an insured bank.

    Depositors can read more at https://www.fdic.gov/deposit/deposits/factsheet.html.

  • A broker-dealer is a firm that buys and sells securities. Broker-dealers facilitate trades for investors.  A government investor cannot buy or sell a security without the services of a broker-dealer with certain exceptions. However, “broker” and “dealer” refer to two different functions. A broker acts in the capacity of agent when it executes or brokers orders on behalf of its customers. It brokers transactions between a buyer and a seller of a given security for a commission. Alternatively, a firm acts as dealer when it trades for its own account. It may sell securities it owns to its customer or other brokers or dealers. Dealers are compensated by the difference in the bid and asked, the price at which they are willing to buy a security and the price at which they are willing to sell the same security. Investors often use the term broker regardless of which role the broker-dealer plays.  

    Sometimes broker-dealers may offer investment advice. Government investors should bear in mind that the advice a broker imparts is not given in a fiduciary capacity, but may still be useful and valuable and must meet the "suitability" standard

    Governments should always use third-party safekeeping for their investments.  The institution that sells an investor an investment should not also be safekeeping the investment.  For more information, see the question "What is safekeeping or custody?"

    “Suitability” clause

    Broker-dealers must know their client and are subject to the suitability clause. This rule requires that the broker-dealer firm or the registered representative (the term the individual brokers are known by) to have a reasonable basis to believe when it recommends a transaction or an investment strategy that it is suitable for the customer. This is based on information broker-dealers are required to obtain to do their reasonable diligence according to the customer’s investment profile.

    While they are subject to the suitability clause, they are not bound by a fiduciary obligation. There has been much discussion and controversy swirling since the financial crisis of 2008 to come up with a unified standard where all firms are held to a fiduciary standard, but this has not occurred. Broker-dealers are subject to other antifraud provisions, including duty of fair dealing, best execution, customer confirmation rule, credit terms disclosure, short sale restrictions, trading during offering rules, and insider trading prohibitions. 

  • Primary dealers

    Primary dealers are the firms that serve as trading counterparties of the New York Federal Reserve (the NY Fed) in its implementation of U.S. monetary policy. They are the only institutions that buy U.S. Treasuries directly from the Federal Reserve (the “Fed”).  When the Fed wants to implement restrictive monetary policy, it sells to the primary dealers, thereby drawing reserves.  When it seeks to implement an expansive monetary policy, it may buy treasuries from the primary dealers, adding to reserves.  

    The role of a primary dealer includes obligations to:

    • participate consistently in Open Market Operations
    • provide the New York Fed's trading desk with market information and analysis helpful in the formulation and implementation of monetary policy.

    Primary dealers are also required to participate in all auctions of U.S. government debt and to make reasonable markets for the NY Fed.

    While primary dealers must apply and be accepted to participate as a primary dealer, a government investor should not accept this designation as a replacement for its own due diligence of a broker-dealer. Governments have, historically, interpreted the designation as inferring strength and stability and opted to do business only with primary dealers. The caveat is that such firms may not be suited to meet every government’s needs. Limiting transacting with only primary dealers may negatively impact a government’s access to investments and service. Governments should undertake their own due diligence process and be mindful of whether a particular firm can appropriately meet its needs.

    The number of primary dealers has decreased from a high in the mid-30s and fluctuated over time. To confirm that a firm is a primary dealer, governments can check the list of primary dealers that is maintained by the NY Fed at the website New York Fed list of Primary Dealers

    Regional, “secondary,” or “non-primary” dealers

    Regional dealers simply refer to dealers that do not deal directly with the Federal Reserve in its open market operations.  This designation includes a very wide range of firms that vary in size, capitalization level, product focus and specialization, and geographical presence. Regional dealers are also called “secondary” or “non-primary” dealers.  Numerous regional dealers are active in underwriting and making markets in certain securities or markets. Regional, secondary, or non-primary should not be taken as anything other than a designation whether or not a firm trades directly with the NY Fed.

  • Broker-dealers help government investors execute investment transactions. Whether or not a government makes its own investment decisions or has engaged an investment adviser that manages its investment portfolio, broker-dealers facilitate securities purchases or sale.

    Market inventory

    Either by bringing sellers and buyers together or by making markets using their own capital, broker-dealers provide access to markets – to securities. For most but the largest investors, it is not practical to deal directly with issuers.  Broker-dealers serve as the important link of intermediary.

    Useable information

    Broker-dealers provide information on financial markets, the economy, interest rate trends, asset, sector, and security news. With analysts and research capabilities, they can digest and summarize this information and present it in meaningful form for their clients.

    Practical investment ideas

    Broker-dealers provide actionable ideas for government investors. This can be beneficial for those who may be generalists wearing multiple hats and do not have any expertise about investing.  Keep in mind that broker-dealers do not have a fiduciary duty to their customers, and recommendations they make need only be “suitable.”  Even without the fiduciary duty, brokers can be a valuable resource for government investors and many provide sound recommendations to their clients.

    Portfolio analysis

    Some broker-dealers may have the analytical tools to structure or modify an investment portfolio to enhance return, improve credit quality, or alter duration. A government may not be able to conduct such analyses on its own.

  • Broker-dealers are regulated by both government regulators and a network of self-regulation.

    The mission of the Securities and Exchange Commission (the “SEC”) is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. The laws and rules that govern the securities industry in the United States derive from one concept: all investors should have access to certain basic facts about an investment prior to buying it, and so long as they hold it. To achieve this, the SEC requires meaningful disclosure of financial and certain other information. This provides a common pool of knowledge for all investors to use to judge for themselves whether to buy, sell, or hold a particular security. Only through the steady flow of timely, comprehensive, and accurate information can people make sound investment decisions. 

    The SEC oversees the key participants, including the securities exchanges, broker-dealers, investment advisers, and mutual funds amongst others. Crucial to the SEC's effectiveness is its enforcement authority.  While the SEC is the primary overseer and regulator of the U.S. securities markets, it works closely with other institutions, including Congress, other federal departments and agencies, the self-regulatory organizations (SROs) like FINRA, state securities regulators, and various private sector organizations. The SEC also works with other governmental bodies, including the Federal Reserve, the Treasury, and the banking regulators. 

  • The United States has a self-regulatory structure for broker-dealer regulation.  Before a broker-dealer may begin doing business, that broker-dealer must become a member of a self-regulatory organization (SRO).  SROs assist the SEC in regulating the activities of broker-dealers.   The national securities exchanges are all SROs. If a broker-dealer restricts its transactions to the national securities exchanges of which it is a member and meets certain other conditions, it may be required only to be a member of those exchanges. However, if a broker-dealer affects securities transactions other than on a national securities exchange of which it is a member, including any over-the-counter (OTC) business it transacts, it must become a member of FINRA, with certain exceptions.

  • FINRA is responsible for regulating every broker and brokerage firm doing business with the public. Historically, the National Association of Securities Dealers (NASD) regulated all brokers. FINRA was created in 2007 when the NASD consolidated with the member regulation, enforcement, and arbitration functions of the New York Stock Exchange (NYSE). FINRA’s core mission is to pursue investor protection and market integrity, which it carries out by overseeing virtually every aspect of the securities industry.  

    FINRA issues a series of guidelines to members in the following areas:

    • Conduct Rules
    • Uniform Practice Code
    • Code of Procedures
    • Code of Arbitration for Customer Disputes
  • FINRA maintains a database of information, BrokerCheck. The Central Registration Depository (CRD)is a computerized database that contains information about most brokers, their representatives, and the firms they work for. BrokerCheck is a useful resource to access information for due diligence prior to engaging in business with a broker-dealer or a specific representative of the firm. Investors can find out if their broker-dealer and representative are registered, any regulatory actions or discipline against them, the firm’s and registered representative’s experience and educational background, what services they can perform, and their employment history. BrokerCheck is also useful for an annual broker review process to ensure no troubling complaints or judgments have taken place in the previous year.

  • Each state has its own requirements for broker-dealers that conduct business within that state. Each state’s securities regulator can provide investors with information about that state’s requirements. Contact information for these regulators can be found through the North American Securities Administrators Association, Inc. (NASAA). NASAA is the voice of state securities agencies responsible for efficient capital formation and grass-roots investor protection.

  • Broker-dealers must know their client and are subject to the suitability clause. This rule requires that the broker-dealer firm or the registered representative (the term the individual brokers are known by) to have a reasonable basis to believe when it recommends a transaction or an investment strategy that it is suitable for the customer. This is based on information broker-dealers are required to obtain to do their reasonable diligence according to the customer’s investment profile.

    While they are subject to the suitability clause, they are not bound by a fiduciary obligation. There has been much discussion and controversy swirling since the Great Recession of 2008 to come up with a unified standard where all firms are held to a fiduciary standard, but this has not occurred.  Broker-dealers are subject to other antifraud provisions, including duty of fair dealing, best execution, customer confirmation rule, credit terms disclosure, short sale restrictions, trading during offering rules, and insider trading prohibitions. 

    Investors should remain aware of the different standards investment professionals operate by.

  • Some governments require that the broker-dealers they transact business with sign a certification attesting that the broker-dealer has read the government’s investment policy and has a system of controls in place to prevent (reduce) inappropriate or non-compliant investments. In some states, this is mandated by state statute. The goal is to protect the investor from inappropriate recommendations. This is a belt-and-suspender’s control, however, as all broker-dealers are required to know their client and adhere to the “suitability” rule.

  • In general, broker-dealers are compensated by the net profit generated from trades (purchases and sales). For new issues, brokers are compensated by a selling concession, paid for by the issuer. A key source of profit is the spread between the bid and asked price. When this spread is widest, that is when the bid, or the price a broker pays for a security, is less than the asked price, or the price at which the broker sells the security, the broker’s compensation tends to be greatest. For many securities or investments appropriate for government investors, the spread, in general, is not excessive. Ultimately, what matters is the yield the investor gets at a given price. 

  • A registered representative is an individual who is licensed to sell securities. To become a registered representative, in addition to passing the Series 7 and any other exams, one must be sponsored by a broker-dealer which means one cannot become a registered representative independently. 

    To sell or recommend securities, one must be a registered representative.

  • Any partner, officer, director, branch manager, or employee of the broker-dealer, any person performing similar functions, or any person controlling, controlled by, or under common control with, the broker-dealer is an “associated person.” The broker-dealer must file a Form U-4 with the applicable SRO for each associated person who will effect transactions in securities.  Form U-4 is used to register individuals and to record prior employment and disciplinary history.

    An associated person who transacts or is involved in effecting securities transactions also must meet qualification requirements. These include passing an SRO securities qualification examination. Many individuals take the comprehensive “Series 7” exam and other special exams as appropriate.  But the other examinations require the Series 7 exam as a prerequisite.

  • The answer to this question depends on several factors. The more complicated a government’s investment portfolio, the more brokers it may require. For example, a government that invests in agencies, CDs, corporate securities and municipal bonds likely requires more relationships because of the specialization the different asset classes require. Ultimately, a government should have as many broker-dealer relationships as it can manage, in terms of having meaningful dialogue and getting timely and competitive recommendations. This is a balancing act between the need to have robust competition and competitive bidding on the one hand with the time and effort required to nurture relationships with each broker-dealer that will be mutually beneficial. Too few and the investor may not have access to competitive pricing. Too many and the government may not have opportunity to develop relationships where broker-dealers understand the government’s goals. Too many and all broker-dealers may not generate enough sales to continue to generate ideas for the investor.

  • Broker-dealers require customers to sign agreements to open an account.  Government investors should require that their agreements with broker-dealers include the following information:

    • fees outside standard mark-ups
    • contact info for their primary representative
    • the government’s investment policy should be part of the agreement, requiring recommendations be made as per the investment policy
    • separation of custody of customer assets
  • Every registered broker-dealer must be a member of the SIPC, with certain exceptions. SIPC insures that its members’ customers receive back their cash and securities in the event of a member's liquidation. This coverage is up to $500,000 per customer for cash and securities with a $250,000 cash limit. SIPC protects the custody of the customer’s assets, not the value. In this respect it is different than the FDIC, which protects the value of deposits in FDIC member institutions under certain circumstances.

    Many securities firms elect to carry additional protection for their clients as well.

  • Sometimes investors may not have the internal expertise or resources to fully evaluate financial institutions.  

    The Nationally Recognized Statistical Rating Organizations (NRSROs) rate publicly traded financial institutions. These firms are known as the "rating agencies."

    There are also firms that focus exclusively on banks. Among these firms, depositors may wish to consider the following:

    IDC Financial Publishing, Inc. (IDC), a bank rating agency, has been rating the safety and soundness of banks, thrifts, and credit unions since 1985. Every quarter, IDC calculates a one-number rank for over 13,000 financial institutions, using its own CAMEL based analysis of 24 key financial ratios. Its categories range from 1 (the lowest) to 300 (the highest) and fall into one of six categories: Superior, Excellent, Average, Below Average, Lowest Ratios, and Rank of One.

    VERIBANC, Inc. has developed its own methodology of CAMELS factors and considers two additional factors:  Opportunity Risk and Regulatory Risk. It has color codes: Green, Yellow and Red, combined with Stars - 3,2,1 and 0.

    Bauer Financial has been analyzing and evaluating the financial condition of the banking industry since 1983.  Its ratings have six categories: Superior, Excellent, Good, Adequate, Problematic, Troubled and Zero Stars (the lowest).

  • Investment advisers, also known as money managers and investment managers, are professionals with expertise in managing investment portfolios.  Investment advisers receive a fee directly from the investor for their services that is typically based on assets under their management.   While their services can range from project-based consulting to comprehensive management of a government’s entire investment portfolio, they are always held to a fiduciary standard. 

  • Many governments engage investment advisers. Their reasons are varied:

    • Higher returns. The expectation is that expert management with research and tools will result in greater returns.
    • Better risk management. Equally important to expectations of higher returns is the expectation that an investment adviser will be able to manage the risk in the portfolio more effectively.
    • Continuity in the investment function. An external investment adviser can provide a continuity to a government’s investment function as staff moves, and retirements and elections take place. A key staff change can wreak havoc on an investment department, especially when the investment function has been the responsibility of one individual. This is not the case with an investment adviser whose entire staff focuses on managing investment portfolios.
    • Robust reporting. Many investment advisers provide clients with robust reporting, which is often customizable. An individual government may not have the resources to enjoy the reporting services or analytical tools that an adviser may have as the cost may be spread across all the adviser’s clients.
    • Learning. When an investment adviser is engaged, the government employee responsible for the investment function can benefit and learn from the investment adviser’s decisions and activity. Some investment advisers provide formal learning opportunities as part of their engagement by clients, including classes, sessions, or webcasts they put on for their clients’ benefit. This process can result in a knowledge transfer that can accrue to the government’s benefit.
  • When a government has made the decision to engage an investment adviser for portfolio management services, it must decide whether it wants to grant discretionary authority, or if it prefers a non-discretionary engagement. In certain states, statutes restrict the granting of discretionary authority to certain financial institutions. For example, a trust of a bank may enjoy discretionary authority whereas investment advisers registered under the 1940 Act cannot enjoy the same arrangement. Assuming there are no restrictions under state statute, the government needs to make this decision.

    Discretionary authority

    Discretionary authority refers to granting an investment adviser discretionary authority over the management of the investment portfolio, including decision-making and trade execution, subject, of course, to the government’s investment policy and any other provisions included in the engagement agreement. Under a discretionary authority arrangement, the government investor enjoys the professional management of its portfolio and quicker response time to the market.  In a discretionary arrangement, the investor is not involved in security-by-security decisions for the portfolio.   Whether or not an investment adviser is granted discretionary authority does not free the responsible investment official from their own fiduciary duty over the portfolio. 

    Non-discretionary authority

    In a non-discretionary arrangement, the investment official maintains control over the investment portfolio. The investment adviser must obtain approval for each transaction.  A government can require authorization of each trade, or it can use the “negative communication” approach, that unless the government opposes a suggestion within a certain amount of time, the adviser can consider that the government’s approval for a suggested trade. Disadvantages of this approach include possible lost market opportunities due to added time, difficulty of evaluating the adviser’s performance and increased government staff time.

    Regardless of the arrangement, an investment adviser should never have custody of the government client’s assets. Third-party custody is essential.  Depending on the arrangement, the government can let the custodian know of the investment adviser’s involvement and authority.

  • Investment advisers are subject to federal and state regulation. The Securities and Exchange Commission (SEC) has broad authority over investment advisers under the Investment Advisers Act of 1940 (the “1940 Act”). While historically all advisers registered with and were regulated by the SEC, changes through the years and, recently through Dodd-Frank, have left the SEC in charge of the largest advisers and delegated authority to the states. Investment advisers with assets under management of $110 million or more are registered with and regulated by SEC. The SEC can sanction advisers that break laws and conducts inspections.

  • Custody and safekeeping originated in a time when banks provided safe places to hold bearer bonds or physical instruments. Today, most securities do not exist in actual, physical form, but in electronic or book entry form. Custody or safekeeping refers to a bank or financial institution provides transfer and custodial services for securities. It is a best practice for government investors that a bank or financial; institution other than the financial institution that sold a security to an investor to provide custody.

  • Form ADV is the form used by investment advisers to register with both the SEC and the state regulatory authorities. The form consists of two parts:   Part 1 which is organized as a check-the-box format and Part 2 which is a “narrative brochure” that describes the firm’s services, fee schedule, and disciplinary history.   The brochure is the primary disclosure document that investment advisers provide to their clients. When filed, the brochures are available to the public on the IAPD website.  Before hiring an investment adviser, investors should always ask for, and read carefully, both parts of the adviser's Form ADV. Pay close attention to risks disclosed, material changes and disciplinary info.    

    Being registered does not confer any significance. Investors need to be aware the regulatory authorities do not approve an adviser or representative. Authorities only make sure the advisers follow the law, so investors should pay close attention to any citations or issues raised.

  • Requiring that a government’s investment securities and deposit collateral be held by a third-party custodian or safekeeping agent is one of the most important safeguards of a public sector investment portfolio. 

    The critical point in custody is to have an entity other than the financial institution that sold a security to a government provide transfer and custody of the securities.

    Selecting a custodian to safeguard your securities is an important task.  Both banks and brokerage firms provide custody services. However, they are governed by different rules.

    Brokerage custodians

    Brokerage custodians are regulated by the SEC, with supplemental oversight by a self-regulatory organizations (SROs), such as FINRA.

    Typically, brokerage firms pool their customers’ assets and include them on their own balance sheet, which is called holding the assets in “street name.” When assets are held in street name, they are often used for a variety of brokerage activities and are potentially subject to seizure by creditors in the event of the brokerage firm’s insolvency.

    To protect investors from such seizures, Congress passed the Securities Investment Protection Act in 1970, which created the Securities Investor Protection Corporation (SIPC). SIPC protects against the loss of cash and securities up to $500,000, with a $250,000 limit for cash. Many brokerage firms provide their clients with additional private insurance, which is known as “excess SIPC.” This coverage varies from firm to firm.

    Another safeguard for brokerage firms is they must satisfy the regulatory capital requirements of the SEC’s Net Capital Rule (Rule 15c3-1) which requires liquidation prior to greater loss, formal proceedings and financial assistance from SIPC.  

    Bank custodians

    National bank custodians are regulated by the Office of the Comptroller of the Currency (OCC), and their parent bank-holding companies are supervised and examined by the Federal Reserve Board. To ensure compliance with Federal consumer financial laws, the Consumer Financial Protection Bureau supervises and examines certain depository institutions as well.

    Generally, customer assets held in custody are registered in the bank’s name or the bank’s “nominee” name. Securities held by the bank in custody for customers are kept separate and apart from the bank’s assets, are not included on the bank’s balance sheet, and are not subject to the claims of that bank’s creditors. Under such a scenario, even in the case of a bank’s insolvency, custodied securities would be returned to the investor.

    Cash is treated differently, even if it is held in a custody account. Cash appears on the bank’s balance sheet and is subject to claims made by the bank’s creditors. The Federal Deposit Insurance Corporation provides coverage, up to certain limits.

    Bank custodians must also satisfy regulatory capital requirements. Bank regulatory capital is graded against a risk-based standard and a leverage standard, measuring a bank’s financial health. The OCC analyzes a bank’s capital and assigns it a category, determining if the bank is well-capitalized, undercapitalized or adequately capitalized. In assigning a grade, the OCC considers the potential impact that events, expected or unexpected, may have on a bank's capital or earnings. In addition to the requirements of the OCC, the FDIC sets high standards for minimum capital levels. The FDIC’s standards are intended to strengthen the quality and quantity of bank capital and promote a stronger financial sector, and in general, one that is more resilient to economic stress.

    Brokers may offer custody as part of a broad suite of services, including trade execution, performance reporting, research and margin lending. Bundling these services offers a convenient and comprehensive solution for a client’s safekeeping and investment needs but can be cost-prohibitive, in the event a customer does not want to partake all the service in the bundle. Alternatively, a customer may determine that the cost is attractive in a bundle as the customer does not have an out-of-pocket custody cost. However, the investor must always ensure the appropriate steps are in place to ensure  third party custody is in place and protects the investor’s investment assets.

    Banks, typically, offer custody as a stand-alone product. In such instances, investors forego bundled services for more flexibility to choose the individual services they need and the specific providers they prefer. This flexibility can help clients who use more than one broker-dealer or investment advisor. Using a single bank custodian for multiple accounts can save significant time for customers on a re porting basis. 

     

Procedures

  • The test of compliance with fiduciary duty for investors of government funds is based on conduct, and not necessarily performance or outcome. Some ways to assess compliance with fiduciary duty include:

    • establishment of a formal investment policy
    • adherence to the investment policy
    • making prudent investment decisions
    • having best price executions
    • diversification of risk
    • avoidance of conflicts of interest
  • Public sector investors should employee a formal procurement process for the selection of the various financial institutions they use. Good procurement practices also require the reevaluation of banking services on a periodic, on-going basis. In addition, continual changes in technology, treasury management practices and banking industry structure and regulation, as well as changing competitive landscapes and changes in the economy require public funds investors to reevaluate banking services and costs, formally on a periodic basis, but also to stay informed on an on-going basis. Governments can establish such a procurement process and assure periodic reviews of banking services. A defined process in selecting banking services and establishing proper controls will help a government achieve its objectives of appropriate and cost-effective banking services while protecting its funds and reducing risk to its reputation.

    Thorough internal review – looking inside first

    A good place to start is with a thorough review and evaluation of a government’s treasury management function and structure to get a sense of what services the government needs. This step ensures that the government fully understands its needs and conducts the search around its needs. The process should ideally use a request for proposals (RFP) that considers services, technology, fees, earnings credit rates and availability schedules for deposited funds. It may also be beneficial for a government to determine the top two or three important factors relating to treasury management functions.  If the most important factor is cost, that can be weighted appropriately during any selection process. It may make sense to use independent bank evaluation services to verify the creditworthiness of the financial institution prior to award of a contract and throughout the contract period.  Price alone should not be the deciding factor. 

    Due diligence for selection of banking service providers

    Banks and related financial institutions are heavily regulated, at both the state and federal level. As a consequence, there is much publicly available information available for investors as they conduct their due diligence process. 

    Also, NRSROs rate some of the larger banks, and there are firms that analyze and evaluate banks.

  • Having a solid appreciation of a government’s liquidity needs is an important consideration in investing public funds.  Liquidity is second (and related) to safety. Creating an accurate cash flow forecast is useful to understand liquidity requirements and key to a successful investment program. Public funds investing may be considered a balancing act between retaining enough liquidity with being as “invested” as possible.  A forecast estimates receipts (inbound) and expenses (outbound) over a given period. While there are many uses for a cash flow forecast in the finance office, from the perspective of the investment portfolio, the cash flow forecast helps determine the maturity structure of the portfolio, including the portion that needs to stay liquid and how liquid, and the portion of the portfolio that can be invested out longer-term. Over time, longer term investments can generate meaningfully higher returns.

    Benefits of forecasting cash flows include:

    • improved investment earnings
    • appropriate liquidity
    • identification of potential shortfalls
    • avoidance of being too “short”

    The cash flow forecast can help achieve all three primary public funds investment objectives:  safety, liquidity and return. 

    The frequency and granularity of a forecast depend on the predictability of a government’s cash revenues and cash expenses and its reserves. Irregular inflows and outflows, or volatile economic or demographic changes may require more detail to achieve a level of comfort.

    Where to start

    To create a cash flow forecast, the following are required:

    • beginning cash and investment balances
    • projections of cash receipts
    • projections of cash disbursements

    Sources of information include bank statements, general ledger balances, budgets, capital project spending, debt schedule, and investments.

    The 80-20 rule applies to cash flow forecasting, or approximately 80 percent of cash flows come from 20 percent of categories.  Accordingly, in creating a forecast, governments are advised to identify the top three to five categories in each area.   Using this approach simplifies the forecasting process, and does not skew the forecast results.

    Inflows/Revenues

    On the revenue side, start by gathering three years of historical data (no more than five).  Identify the most important categories. Major recurring revenue sources may include:

    • taxes
    • special assessments
    • user fees
    • grants
    • intergovernmental revenue

    Do not use budget data, but rather, cash data. 

    Non-recurring revenue sources may include:

    • bond sale proceeds
    • asset sales
    • one-time grants
    • suits or settlements

    Expenses/outflow

    Gather an equal history on the expense side.  Major categories of recurring expenses may include:

    • salaries and benefits
    • commodities
    • capital projects
    • debt payments

    Non-recurring expenses may include:

    • construction projects
    • equipment or land purchases
    • suits or settlements

    Watching out for changes – when trends turn

    In reviewing historical information, be aware of changes in the economy, laws, project lifespan, and similar items that may cause the past data to mislead regarding future projections.  Be conscious of such changes to avoid inaccurate projections.

    Up to this point, historical information has been gathered.  Projecting the future activity on both the receipt and expense side is based on what has happened in the past.  So to prepare a forecast from this historical data, calculate a simple three-year average.  With the simple average, the percentage each revenue source or disbursement contributes to the total can be calculated.  Then this percentage can be applied to future projections to come up with specific category amounts.

    Forecasts should be compared to actual cash flows and updated to reflect experience.  Significant variances may reflect error in the forecast or meaningful changes in the government’s financial and liquidity position.  Whatever the reason – large variances should be explored further.

    Cash flow take aways

    • be conservative
    • focus on major categories
    • look out for patterns, trends
    • keep it simple
    • retain documents for future forecasting improvements
    • compare actual to forecast
    • update regularly
  • Internal control is an important part of managing risk and of the investment function. It includes identifying and inventorying potential risks, weighing the probability of occurrence of each risk, and creating appropriate, cost-effective controls to manage the risks. Government funds need to be protected not only from theft, fraud and embezzlement, but also from inappropriate or poor decision-making. Investment management is a specialized form of risk management, so internal control is an important component of safeguarding public funds and protecting the integrity of a government’s investment program.

    Creating an investment procedures and controls manual

    While an investment policy provides the overall framework and guiding principles, or the “big picture,” a manual for procedures and controls serves as a how-to operating guide for day-to-day activities. Creating a manual of controls and procedures, separate from the formal investment policy, which describes components of the government’s internal control framework is a trend that has increased in usage. The procedures manual includes items that are fluid and may change during the course of the year but that do not necessarily require governing board approval or authorization like the investment policy does.

    Generally, the procedures manual may include the following:

    • organizational design
    • duties and responsibilities of staff (specified by title rather than name)
    • pre-employment and ongoing screening
    • training protocols
    • decision-making processes
    • programs or apps used to track investments
    • authorization process (personnel and limits)
    • ethics and conflicts of interest policy (if different than general government ethics policy)
    • reporting requirements
      • frequency
      • format
      • calculations
      • methodologies and formulas for allocations, distributions, other calculations
      • market valuation
    • timeline and assignment of preparation
    • identification of distribution/recipients
    • accounting for investment transactions
      • reconciliations
        • statements provided directly from custodian
        • investment software to general ledger
    • wires
    • securities confirmations
    • safekeeping procedures
    • selection process for financial institutions
      • banks, depositories
      • broker-dealers
      • investment advisers
      • safekeeping agent/custodian
    • lists of authorized financial institutions
      • banks, depositories
      • broker-dealers
      • investment adviser

    Appropriate contacts for each should be included, as well as supervisory and back-up information.

    • questionnaires and certifications used in financial institution authorization
    • security/investment selection process
    • documentation of competitive bids
    • identify the institution that serves as safekeeping agent/custodian
      • services provided
      • delivery instructions
    • back-up and disaster recovery procedures
    • audit policy
      • internal
      • external

    The manual should include forms and documents used in the investment function.  It also may include sample reports that the office generates. Other items that a government investor may find beneficial:

    • governing statutes, regulations, ordinances, resolutions, policies
    • Government Finance Officers Association (GFOA) best practices for treasury and investment management
    • flowchart of investment activity from decision to purchase to reporting to reconciliation
    • list of account numbers

    A manual of procedures and controls institutionalizes knowledge that may be concentrated in one or two individuals.  Problems that may arise from having information concentrated in one or two people become apparent in smaller offices when there are retirements or simple employee turn-over.  A manual also serves as a level of control – it serves to codify the roles and functions that have been identified as best practice and expected in the office.  All personnel involved in the investment function should have a copy of the procedures manual.  Such a manual can be extremely helpful in training – either initial or on-going.  The manual should be reviewed periodically, as responsibilities may change, as can financial institution relationships, documents or agreements, or actual procedures themselves.  Like the investment policy itself, dates of the most recent review or revision should be noted in the manual (on the front cover is a useful spot to include this information).

  • Separating or segregating duties is a basic internal control process. Effectively, to separate duties, processes are created and implemented where one individual is not responsible for a task from beginning to end. Instead there is a system of checks and balances. Critical duties are categorized into four types of function: 

    • authorization
    • custody
    • record keeping
    • reconciliation

    Ideally, no one person would handle more than one type of function. This is not always feasible in smaller offices. Then other controls like rotating functions or mandatory vacations may compensate. 

    Some of the separations that may help include:

    • sequential separation (two signatures principle)
    • individual separation
    • spatial separation (separate action in separate locations)
    • factorial separation (several factors contribute to completion)

    Practical steps include:

    • identify a function that is crucial, but potentially subject to abuse (buying investments)
    • divide the function into separate steps, (authorizing, transacting, reporting, reconciling)
    • assign each step to a different person or organization.

    General categories of functions to be separated:

    • authorization function
    • recording function, e.g. preparing source documents or code or performance reports
    • custody of asset whether directly or indirectly (receiving checks in mail)
    • reconciliation or audit
  • The Uniform Bank Performance Report (UBPR) is a tool that investors can use to help evaluate banks. It was created for bank supervisory, examination, and management purposes. In a concise format, it shows the impact of management decisions and economic conditions on a bank's performance and balance-sheet composition. The performance and composition data contained in the report can be used as an aid in evaluating the adequacy of  capital, assets, earnings, liquidity, asset and liability management, and growth management. Bankers and examiners alike can use this report to further their understanding of a bank's financial condition, and through such understanding, perform their duties more effectively.

    Created by the Federal Financial Institutions Examination Council (FFEIC), the information includes summary reports, balance sheet, income statement, capital, liquidity, and funding information and analyses, as well as trend and peer analyses to place the data in context. 

    The FFIEC is a formal interagency body empowered to prescribe uniform principles, standards, and report forms for the federal examination of financial institutions by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Office of the Comptroller of the Currency (OCC), and the Consumer Financial Protection Bureau (CFPB) and to make recommendations to promote uniformity in the supervision of financial institutions.

    The FFIEC is responsible for developing uniform reporting systems for federally supervised financial institutions, their holding companies, and the nonfinancial institution subsidiaries of those institutions and holding companies. It conducts education for examiners employed by the five federal member agencies represented on the Council and makes those schools available to employees of state agencies that supervise financial institutions as well. Its efforts go a long way to creating uniformity.

  • Due diligence on broker-dealers should include obtaining information on:

    • the financial strength of the firm
    • areas of expertise and trading activity
    • a broker-dealer’s experience and knowledge of public funds investing
    • all contact information for the primary contact, backup and operations staff
    • contact info for a broker’s manager/supervisor
    • registration with FINRA
    • any regulatory citations and complaints
    • the names and contact information for references of similar customers (public sector entities of similar size and objectives) and
    • potential conflicts of interest
  • A government’s evaluation of its broker-dealer performance is both qualitative and quantitative.  How active is the broker in making meaningful recommendations? Does the broker have a solid understanding of the statutes pertaining to public funds investing?  Does the broker understand the government’s investment goals?  How competitive is the broker? Operationally, are securities sold to the government successfully settled?  How often are transactions delayed or failed? Is the information the broker provides regarding the market timely and useful? Is the broker responsive to government requests or inquiries in a timely fashion?  The answers to these questions may change over time, so this due diligence needs to be on-going.

  • As with other government procurement processes, the process for selecting investment advisers should begin with consideration of the government’s investment situation, including its objectives in seeking to engage an investment adviser. Does the government want to delegate complete portfolio management, partial or does it want simply occasional consulting? Does the government want a discretionary or non-discretionary arrangement, subject to state statutes?   

    After the goals have been identified, the government investor should consider use of an impartial procurement process with a Request for Proposal (RFP), ideally. Governments should identify the factors that will determine its selection and consider the importance or weighting of each. 

    The RFP should include the following:

    • firm’s background and experience with public sector funds investing (and, of course, with applicable statutes)
    • background and experience of individuals who will be assigned to the government’s portfolio
    • adviser’s understanding of the government’s goals, constraints and, overall, investment program
    • firm’s portfolio management expertise, including philosophy, approach and process, tools and other various resources
    • firm’s recommended approach for the portfolio
    • fees
    • any other services the firm offers that the government may find beneficial

    While cost is an important consideration, it should not be the driving factor. Requiring submission of the fee or a cost response section separate from the rest of the RFP, the technical section, is a good way to ensure the decision is not solely about cost. Governments may consider having one individual rate the fee section separately, and then add the fee score to the technical component scores at the end. 

    In identifying firms to invite to participate in its procurement process, public funds investors should be mindful that the universe of firms that focus primarily on government portfolios is limited. It can turn to professional government associations such as the Government Finance Officers Association of the United State and Canada of the National Association of County Officials or state finance or treasurers' associations. Consulting with other local, comparable governments to identify which firms they may be using is another option. Some governments may decide to invite local investment management firms or the investment arms of local banks to participate. As long as the government confirms these firms have an understanding of the requirements and restrictions of public funds investing and applicable state statutes, and have appropriate experience, this should not be a limitation, but beneficial in enhancing the competition of the procurement.  

    While a government may have a good sense of which firm meets its needs, having a face-to-face interview as part of the RFP process can add valuable insight. The involved parties will get a good sense of the “chemistry.” Will they feel comfortable working with the individuals assigned to the account?

  • A well-executed agreement between the government and its investment adviser is a starting point for a positive relationship. This agreement spells out expectations and requirements of both parties and includes the government’s investment policy by reference. Also, confirming the investment adviser is registered under the Securities Act of 1940 (the 1940 Act) ensures the adviser is subject to a fiduciary duty over the portfolio and is held to the highest standard of prudence, that of the prudent expert. Having an independent third-party custodian where the government’s assets are held in its name is another fundamental safeguard. Assets should never be held by the investment adviser. Conflicts of interest where an adviser acts as a broker-dealer in addition to its advisory capacity should be avoided. Scheduling periodic meetings to review, more frequently initially, also helps set everyone’s expectations. With basic controls in place, the government investor can enjoy a positive experience in engaging an investment adviser.

  • Competitive procurement, often through a bidding process or a formal Request for Proposal (RFP) process, is important in the public sector. This is no different in the selection of counter parties or financial partners. Requiring fair and open competition based on carefully developed bid specifications, helps assure that the goods and services offered by vendors and purchased meet a government’s needs. This holds true for the investment function, both in terms of financial institutions with which a government investor transacts business (banks, broker-dealers, investment advisers, custodians), and the products or investments a government buys or makes.  Competitive selection of financial institutions is a best practice identified by the Government Finance Officers Association in general and in various specific best practices for external relationships. 

    The benefits of competition from a government’s viewpoint are many.  Having a formal process diminished any appearance of favoritism. When vendors or bidders are confident the process is fair, they are more likely to participate, and even when they lose, they are more likely to continue their relationship with the government and participate in future opportunities. An RFP process also helps result in lower costs.  Respondent feedback can help identify unrealistic expectations or inform the government of new products, technologies and services. Reviewing the proposals in their entirety lets a government know if expectations are out of line with current technology, the budget provided, or the time-frame estimated. Governments, typically, learn in the process.

Investment Products

  • The United States federal government is the world’s largest debt issuer, and Treasuries are the securities the government issues as its debt. The market for U.S. Treasury securities is immense – in terms of buyers and sellers and the attention it garners as a reflection of the world’s largest economy, that of the United States. U.S. Treasury securities are the primary securities the U.S. Federal Reserve, through the New York Federal Reserve Bank (the NY Fed), uses to conduct monetary policy through the Federal Open Market Committee (FOMC) actions.

    Historically, U.S. Treasuries have been the standard for debt issuance throughout the world. Backed by the “full faith and credit” of the U.S. government, they are considered risk-less investments. In this usage, risk-less or risk-free refers to the expectation the security is free of default or credit risk. So, if the security is held to maturity, the rate of return will be the stated yield. The price of a treasury can fluctuate over time before maturity as is the case for other fixed income securities. In times of unrest, investors turn to U.S. government debt as a safe haven. This continues to be the case, despite the lowering of the credit rating of U.S. Treasuries below AAA by one of the NRSROs in 2011. 

    The market for treasuries is very liquid and provides great marketability for these securities. Consequently, transaction costs are very limited.

    The interest earned on Treasuries is exempt from state and local taxes. Federal taxes, however, are still due on the earned interest.

    The federal government sells Treasuries by auction in the primary market, but they are marketable and therefore can be purchased through a broker in the very active secondary market. A broker will charge a fee for such a transaction, but there are no fees to participate in the auctions. Interest rates determine the prices of treasuries on the secondary market.

    Characteristics of treasuries:

    • Safe
    • Liquid
    • Low yield relative to other securities
    • Backed by full faith and credit of federal government
    • Variety of maturities

    Bills, notes and bonds

    There are three types of securities issued by the U.S. Treasury (bills, bonds, and notes). The difference between these is their maturity. Treasury bills are short term securities, maturing in one year or less. Treasury bills bear no coupon. They are issued at a discount from maturity (par or face) value. Investors do not receive periodic interest payments as they do with many other instruments, but they receive their return at maturity or at a resale after purchase.

    Treasury notes and bonds are longer term coupon securities. Treasury bonds are currently available in one maturity, 30 years. Interest is payable every six months at a rate one-half the annual coupon. A Treasury note with a 6% coupon, pays interest of $30 per $1,000 face value every six months.

  • Treasury auctions

    To finance the public debt, the U.S. Treasury sells various debt instruments to institutional and individual investors through public auctions. Treasury auctions occur regularly and have a set schedule. There are three steps to an auction:

    • announcement of the auction
    • bidding, and
    • issuance of the purchased securities

    Announcement

    The auction announcement details the following:

    • amount of the security being offered
    • auction date
    • issue date
    • maturity date
    • terms and conditions of the offering
    • noncompetitive and competitive bidding close times
    • other pertinent information

    Bidding

    When participating in an auction, there are two bidding options - competitive and noncompetitive.

    • Noncompetitive bidding is limited to purchases of $5 million per auction. With a noncompetitive bid, a bidder agrees to accept the rate, yield, or discount margin determined at auction
    • Competitive bidding is limited to 35 percent of the offering amount for each bidder, and a bidder specifies the rate, yield, or discount margin that is acceptable. The following three alternatives can result of bids in an auction:
    • accepted in the full amount if the rate specified is less than the discount rate set at the auction;
    • accepted in less than the full amount requested if the bid is equal to the high discount rate set at auction; or
    • not awarded if the rate specified is higher than the discount rate set at in the auction.

    Bidding limits apply cumulatively to all methods (noncompetitive and competitive) that are used for bidding in a single auction.

    To bid noncompetitively, investor may use TreasuryDirect®, a financial institution or a broker-dealer. Individuals and various types of entities including trusts, estates, corporations, and partnerships use TreasuryDirect®.

     

  • TreasuryDirect® is the online portal investors can have with the Treasury to purchase, hold, manage and redeem securities directly with the U.S. Treasury. In a TreasuryDirect® account, an investor can purchase the entire range of U.S. Treasury securities: Treasury bills,Treasury notes,Treasury Inflation-Protected Securities (TIPS),Treasury bonds, Floating Rate Notes, and savings bonds. It is available 24 hours a day, seven days a week. These are not physical securities but are issued in electronic format. The TreasuryDirect® account is password-protected. The system allows for online transacting directly with the issuer and bypasses a broker.

    To access more information about TreasuryDirect, visit TreasuryDirect Factsheet.

  • An FRN is a security that has an interest payment that can change over time. As interest rates rise, the security’s interest payments increase.  Similarly, as interest rates fall, the security’s interest payments decrease.  On July 31, 2013, the U.S. Treasury published amendments to its marketable securities auction rules to accommodate the auction and issuance of floating rate notes (FRNs). 

    Treasury FRNs are indexed to the most recent 13-week Treasury bill auction high rate prior to the lockout period, which is the highest accepted discount rate in a Treasury bill auction.

    Treasury’s introduction of FRNs provides several benefits, including it:

    • assists the Treasury in managing the maturity profile of the nation’s marketable debt outstanding,
    • expands Treasury’s investor base, and
    • helps finance the government at the lowest cost over time.
  • The U.S. Treasury has been issuing Treasury Inflation-Protected Securities (TIPS) since 1997. TIPS provide investors with protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Bureau of Labor Statistics (BLS) Consumer Price Index (CPI).

    When a TIPS issue matures, the investor is paid the inflation adjusted principal or original principal, whichever is greater. Since a TIPS investor will not receive less than the original principal, the investor’s original principal amount is protected against deflation as well. 

    TIPS pay interest semiannually at a fixed rate. The rate is applied to the adjusted principal;  so, like the principal, interest payments rise with inflation and fall with deflation.

  • Agencies describes two types of bonds:

    • bonds issued or guaranteed by U.S. federal government agencies; and
    • bonds issued by government-sponsored enterprises (GSEs)—corporations created by Congress to foster a public purpose, such as affordable housing.

    Bonds issued or guaranteed by federal agencies such as the Government National Mortgage Association (Ginnie Mae) are backed by the "full faith and credit of the U.S. government," just like Treasuries. This is an unconditional commitment to pay interest payments, and to return the principal investment in full to you when a debt security reaches maturity.

    Government Sponsored Enterprises (GSEs)

    Government sponsored enterprise (GSE) debt is high quality and income generating, with a competitive return over Treasuries. 

    GSEs were established by acts of Congress to support various public policies, such as home ownership, farming, education and resource development. To support the various public policies, the GSEs purchase mortgages and loans from issuers, who use the proceeds to fund additional loans. GSE debt is not guaranteed by the federal government as is the case with Treasuries or agency debt. Payments of interest and principal are backed only by the issuer. Fannie Mae and Freddie Mac are the exceptions as they were taken over after the Great Recession of 2008 and have an implied federal government backing.

    The following GSEs issue new debt:

    • Federal Farm Credit Bank System (FFCB) provides credit for agriculture. It issues both discount notes and semi-annual pay coupon debt.
    • Federal Agricultural Mortgage Corporation (Farmer Mac) provides agricultural credit.
    • Federal Home Loan Banks (FHLB) provides support for housing. It issues both discount notes and semi-annual pay coupon debt.
    • Federal Home Loan Mortgage Corporation (Freddie Mac) also provides support for housing. It issues discount notes, semi-annual pay coupon debt and mortgage-backed securities.
      • Federal National Mortgage Association (Fannie Mae) also supports housing. It issues discount notes, semi-annual pay coupon debt and mortgage-backed securities.

    The various GSEs issue notes, bonds and mortgage-backed securities through periodic auctions and through securities dealers. The amount of their debt issuances depends on each GSE’s funding needs. GSE securities are offered in a range of maturities and features, including options and variable rates (floating and step-up coupons).

    Typically, agencies:

    • are safe
    • are liquid but this varies by issue
    • tend to have yields higher than treasuries
    • are backed by full faith and credit of federal government
    • come in a variety of maturities
  • Federal Deposit Insurance Corporation (FDIC) insured banks and National Credit Union Administration (NCUA) insured credit unions provide a wide range of deposit products and services suitable for government investment portfolios. In general, these products consist of demand accounts used for daily liquidity and operation needs; and time deposits (CDs) used as investment vehicles. Contrasted to demand deposit, time deposits are not immediately accessible, but remain on deposit until maturity, with certain exceptions. 

    Such depository products are a popular investment option in public funds portfolios because of their safety, availability and yield compared to other fixed-income investments.  The CD investment decision is driven by insurance coverage, sometimes collateralization, and the rate which may be driven by the credit quality of the bank and its funding needs.

  • FDIC or other applicable insurance coverage only protects a specified part of a government’s deposit. Collateralization can be used to protect deposits not covered by such insurance coverage. Collateralization is support or security provided in certain investments. It can take many forms, including certain acceptable securities, surety bonds, letters of credit or support by a third party. It is an important safeguard for public funds.

    Generally, states require some form of collateralization of public funds over the FDIC insurance coverage. Appropriate forms of collateral may include:  obligations of the U.S. government, its agencies and GSEs, including mortgage backed securities and municipal bonds. There may be credit quality and maturity requirements for the collateral. Investors of public deposits should understand their state’s laws requiring collateralization of their funds.  As well, some states have a statewide collateral pool that provides partial collateralization of public fund deposits.

    Governments should take certain steps in ensuring proper collateralization of their funds:

    • fully understand state statutes pertaining to public funds
    • understand federal requirements to ensure enforceability of their security interest in the collateral pledged in support of their deposits
    • have a third party safe-keep the collateral securities
    • recognize the ramifications of non-security type collateral such as surety bonds and letters of credit
      • limit surety bonds to those of insurers of the highest credit quality
      • understand terms of letters of credit

    Governments should carefully consider their requirements for collateral. The government’s investment policy should specify acceptable forms of collateral, including issuer and security type, and credit and maturity requirements. As well, governments should weigh what over-collateralization levels are acceptable for its deposits. A level of over-collateralization protects the government from market price fluctuation of the collateral, and also covers interest which may accrue and compound. Some state statutes specify required collateralization levels, and this may be different for collateral of different maturities. Securities used as collateral should be held by a third party. 

    The FDIC specifies certain provisions that must be followed to ensure an investor’s collateralization is valid and serves as intended. Those provisions include that the collateralization:

    • is in writing
    • was approved by the board of directors of the depository or its loan committee and
    • has been continuously, from the time of its execution, an official record of the depository institution

    Governments should enter into collateralization agreements with their depositories.  A written agreement specifies the collateral protections and is much easier to enforce.

     

  • In their collateralization agreements, governments and depository institutions must adhere to state and federal laws, including FDIC regulations. Otherwise, the agreement may not be enforceable.

    A written collateralization agreement must specify pledging requirements as protection for state or local government's deposits. A government depositor should establish adequate and efficient administrative systems to monitor such pledged collateral, including state or locally administered collateral pledging or collateral pools.

  • Developing a portfolio of CDs can be a relatively effective way to keep public funds safe while generating return. There are two basic types of CDs: non-negotiable and negotiable.

    Direct or physical CD (Non-negotiable CDs)

    This type of CD is familiar to investors. These are often offered by local banks (but sometimes national banks) for local customers. Purchases of this type of CD are made directly with the issuing institution, an account is established, and any required documentation is provided directly between the depositor/investor and the bank. An investor’s CD positions are documented by a safekeeping receipt issued by the financial institution. These CDs are non-negotiable instruments and, typically, have a stated penalty for early withdrawals.  FDIC coverage applies and sometimes the CDs are collateralized.

    Listing services

    Listing Services provide another option to purchase non-negotiable CDs.  Listing services offer subscription-based platforms that aggregate rates from several banks across the country. Listing services or internet bulletin boards continue to evolve to offer banks a national, web-based platform to distribute their CDs; and provide settlement efficiencies to investor looking for opportunities beyond their local footprint of issuers.

    Depository Trust Corporation (DTC) eligible or “brokered” CDs (Negotiable CDs)

    DTC eligible CDs are certificates of deposit offered by insured financial institutions and distributed by underwriters and broker-dealers in primary or secondary markets. Whereas non-negotiable cannot be liquidated prior to maturity without penalties, these CDs are negotiable instruments, get a CUSIP and are purchased (and settled) as book-entry securities.  Most book entry securities (including DTC eligible CDs) use CUSIP numbers to track and manage trades and reporting.  Settlement of the CD purchase is performed with a safekeeping agent rather than the issuing bank. Usually this agent is a registered broker-dealer. Positions are documented by receipt of a trade confirm and monthly statement issued by the agent or custodian. 

    This type of CD is not collateralized although it can benefit from FDIC coverage.  A given bank's CDs are uniform and are evaluated based on the financial strength of issuing financial institution. An investor of public funds can evaluate a specific negotiable CD using ratings by NRSROs, other bank evaluation agencies or using its own analysis if it has such expertise. Some states do not allow brokered CDs to be purchased by public funds investors.

    Custodial (non-DTC eligible) CDs

    This type of CD investment is very similar to the DTC eligible CD.  It is issued with one “Master” certificate and is sold in insured amounts to investors.  With this type of CD, the custodian is usually an FDIC insured bank and is designated by the underwriter or seller of the CDs.  The investor needs to verify that the custodian is an unrelated third-party.  Settlement of this type of CD usually takes place at the custodian bank. These CDs differ from DTC eligible CDs in that they do not have a CUSIP.  Nor do they have a secondary market.

    CD placement services

    Certain private firms have created CD placement services as ways to improve funding for banks, and enhance and simplify investors’ access to CDs. Public fund investors should confirm state statutes permit use of such placement services and whether their own investment policies need to be modified.

    Certificate of Deposit Account Registry Service (CDARS)

    Certificate of Deposit Account Registry Service (CDARS), created by Promontory Interfinancial Network, is one such service provider. Using CDARS, investors can place large deposits and still enjoy FDIC coverage because their bank, as a member of the CDARS network, can spread out their funds into FDIC insured CDs at different banks within the network.

    Whenever customer deposits are sent out of the bank, an equal amount of deposits are brought back into the bank from other institutions within the network, creating a reciprocal arrangement, which is a consideration for some governments: to keep funds locally to advance the local economy or local businesses. Each bank sets its own interest rates, according to its own local market.

    Investors should keep in mind that CDs placed through CDARS are non-negotiable with no active secondary market.

  • Repos are short-term investments.  Repos are financial arrangements in which an investor purchases securities from a financial institution such as a bank or a broker-dealer.  As part of the repo agreement, the selling party, the counter-party, agrees to “repurchase” or to buy back the securities underlying the repo at a future date at an agreed upon date and price. The price is, typically, higher than the price the investor buys the repo to account for the interest earned on the repo.  When the repo is entered into, the investor and the counter-party (the bank or broker-dealer) agree to an interest rate, which is the “repo rate.”  

    The securities purchased or backing a repo most often are U.S. government securities such as Treasuries or agency debt. The securities are very liquid and marketable.  While other forms of collateral may be allowed as repo collateral under state statute, government investors should stay wary of collateral that may be less liquid or less marketable, despite a possible pick-up in yield. 

    Government investors should insist on third-party safekeeping in the government’s name and insist on delivery-versus-payment settlement for all repo collateral.

    Valuation

    The repo collateral securities should have value in excess of the repo agreement. This margin or over collateralization protects against value changes. For a short-term repo, a 102 percent level may be appropriate with higher overcollateralization for longer term securities or those that may fluctuate more in value. Managing the risk of default in repo transactions requires valuation of the securities. The value of the securities must be monitored frequently to insure the market value remains at least equal to the invested amount plus margin percentage in case of default of the counterparty. If the value of the purchased securities falls below the invested amount plus margin percentage, then the counterparty is required to deliver additional securities to the investor upon the investor’s request.  The frequency of the valuation depends on:

    • the maturity of the purchased securities, since longer maturities have greater price volatility
    • the security types, since certain securities have greater price volatility
    • market volatility
    • the margin percentage that is required by the investor; the lower the margin percentage, the more frequent the valuation of the purchased securities

    Acceptable securities for a repo transaction are those that have readily available pricing information from an independent pricing source (not the counter-party) and could include:

    • a broker or other financial institution that was not a counterparty to the transaction,
    • the custodial bank if the bank was not a counterparty to the transaction,
    • publicly available publications such as the Wall Street Journal, or
    • other pricing services for which a separate fee would be paid.

    When valuing securities, the purchased securities are valued using their current market price plus accrued interest to compute their total value. The total value is then compared to the repo value multiplied by any margin percentage. If the total value of the purchased securities is less than the repo value plus the margin percentage, then the investor/buyer should request sufficient additional securities on a same-day or next-day basis from the counterparty to bring the total value up to the proper level.

    Flexible repurchase agreements (flex repos)

    Flexible repos (flex repos) are a type of repo used for bond proceed reinvestment. The flexibility offers multiple draw-down options to fund different parts of a project or uses of the bond proceeds that come due.

    Master repurchase agreement

    Governments should require master repurchase agreements with any financial institutions with whom they want to enter into repos with agreements.  This agreement governs all aspects of the individual repo transactions with the particular financial institution, and should include:

    • governing law citation
    • definition of transaction
    • identification of the relationship between the government and the counter-party financial institution
    • establishment of legal obligations
    • specification of ownership of securities during the duration of the agreement
    • remedies in a default scenario
  • A reverse repurchase agreement (“reverse repo”) works the opposite of a repo. The investor owns the securities, and the counter-party or the financial institution exchanges cash for the securities, for a specified period at an agreed-upon interest rate. 

    There are two main purposes for reverse repurchase.  First, reverse repos can be used for liquidity.  For example, instead of liquidating securities to meet a cash flow requirement, an investor can enter into a reverse repo, thereby borrowing against the securities owned. This use of the reverse repo is, generally, accepted as a legitimate means of liquidity management. 

    The second use of the reverse repo is controversial in the context of public funds investing. In the second type of use, the reverse repo is used to enhance investment portfolio returns. The cash the investor receives from its securities is invested in securities that have a higher yield than that agreed to in the reverse repo. This is a type of leveraging transaction.

    Reverse repo investments have resulted in losses and the public sector investor has not been immune to these losses. Generally, proceeds from reverse repurchase arrangements should be invested only in securities with matching maturities. However, there are other risks that may affect the reinvestment and could result in a loss even if maturities are matched. 

    Some state statutes specifically prohibit reverse repurchase transactions. As well, some governments include a specific restriction in their own investment policy restricting the use of reverse repos.  Regardless, governments should confirm whether reverse repurchase agreements are allowed by state statutes.  Only government investors with the expertise and appropriate resources should consider these investments.

  • Commercial paper (CP) is a short-term, unsecured promissory instrument. It is a funding alternative for corporations and other entities. The maturity of commercial paper ranges from one to 270 days. This upper limit is determined by special provisions in the Securities and Exchange (SEC) Act of 1933 that exempt CP with maturities shorter than 270 days from registration. 

    Maturing commercial paper is usually “rolled over,” meaning investors are repaid with proceeds from new issues. “Roll over” risk is the risk that unexpected circumstances interfere with the CP market and outstanding CP cannot be replaced with new paper, new issuance. This happened with certain CP structures during the financial crisis of 2008 with investors unwilling to purchase new issue CP.

    CP is sold at a discount with the difference between the price paid and the maturity value being the interest earned by the investor. Most CP investors are institutional. 

    Credit quality varies among CP issues depending on the issuer’s strength and other factors. The creation and evolution of liquidity programs, credit enhancements and various legal structures have rendered commercial paper a viable financing option for entities rated lower than the highest categories. Historically, only the highest-rated companies had access to commercial paper as a funding source.  From the investor’s perspective, it is now important to evaluate not only the issuer’s financial strength, but other aspects of the structure of a commercial paper issue as well. 

    Commercial paper may be purchased directly from the issuing company but also, and more likely for the typical government investor, from an underwriting firm. Most government investors purchase CP with a buy and hold strategy.  While a secondary market does exist, investors should not count on it providing acceptable liquidity.

  • Corporate notes are debt instruments issued by corporations. The notes are generally unsecured, meaning they are backed by an entity’s credit-worthiness, not a specific pledge of assets or collateral. They have maturities greater than one year but less than 10 years. Not all states allow for the investment of public funds in corporate securities. The types, credit quality and maturities that are acceptable also vary.

    Corporate notes can be senior unsecured or subordinated debt, with one key difference being senior debt gets repaid before subordinated debt. Interest rates can be fixed or variable. There are different credit and liquidity supports.

    Medium-term notes (MTNs)

    Certain state statutes allow for investment in a subset of corporate notes, specifically, medium term notes. Typically, they have maturities ranging from nine months to 30 years and are issued under an SEC “shelf registration” filing. In a shelf registration, the issuing company registers a certain amount of debt with the SEC -- but does not issue the debt. The investment bank then uses this as inventory, and then considers the issuer’s needs and the investor’s appetite to issue the debt. When the investment bank has an investor who wants to buy debt with a maturity of one to 10 years, the investment bank sells the amount that the investor wants to buy (up to the limit) and structures the maturity based on the needs of the investor and sets the coupon using prevailing rates.

    The main advantage to the issuer in spreading the sale over time is that the issuer can avoid increasing the supply too quickly and depressing the price as may happen if the issuer issued the entire debt issue at the same time. Shelf registrations also entail savings on issuance costs, since a shelf registration is typically cheaper to do than a series of registrations.
     
    The advantage to investors is that they can purchase the exact maturity they need. However, MTNs are not as liquid as other debt issues.

  • A mortgage-backed security is an instrument whose cash flow depends on the cash flow from an underlying pool of mortgages. A key risk with mortgage-backed securities is that cash flows are not known definitely because of prepayments, known as “prepayment risk.”  Prepayments increase when interest rates fall, and mortgage holders are likely to refinance their mortgages at the new prevailing lower rates. There are various types of mortgage-backed securities.  Several are used by some public funds investors:

    • Mortgage pass-throughs
    • Collateralized mortgage obligations 
    • Mortgage-backed bonds
    • Mortgage pass-through securities

    Mortgage pass-through securities are created when a group of mortgages are pooled together and participations in the pool are sold. The cash flow of the securities depends on the cash flow of the underlying mortgages. The mortgages are comprised of interest, principal repayment and prepayments.

    In general, these are complex securities whose characteristics are determined by the mortgages that are pooled together. There are three main types of pass-through securities guaranteed by the following organizations:  the Government National Mortgage Association (Ginnie Mae), Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) issue mortgage pass-through securities. 

    Collateralized mortgage obligations (CMO)

    A collateralized mortgage obligation (“CMO”) is a special purpose entity that receives the mortgage repayments and owns the mortgages it receives cash flows from (called a pool). The mortgages serve as collateral and are organized into classes based on their risk profile. These securities are “structured” and income received from the mortgages is passed to investors based on a predetermined set of rules, and investors receive money based on the specific slice of mortgages invested in (called a tranche with varying characteristics and risk).

    They are derivatives because their cash flows derive from the underlying mortgage collateral.  Collateralized mortgage obligations are complex financial instruments. Each CMO tranche can have different principal balances, interest rates, maturities and repayment risks. They are sensitive to interest rate changes as well as changes in economic conditions, such as foreclosure rates, refinance rates and the rate at which properties are sold.

    Many government investment policies explicitly restrict such securities from their portfolios.

    Mortgage-backed bonds

    Mortgage-backed bonds are general obligations of the issuer, which may be an entity that originates mortgages or another financial institution. 

  • Many states authorize either the state, another authorized governing board or a group of local governments to create and operate a pooled investment fund that operates much like a money market mutual fund. These are, typically, for the benefit of the governments within the state, within a defined area or a specific group. LGIPs may be state sponsored or set up through intergovernmental agreements known as “joint powers” agreements. Their benefits are similar to those of money market mutual funds. By coming together and pooling investment funds, these governments may benefit from economies of scale, diversification and liquidity that they could not realize on their own. 

    LGIPs operated by local governments are authorized by statutes that permit the state treasurer or appropriate agency to pool investments and distribute income to pool participants. In some cases, state funds may be commingled with local funds. Generally, the pool’s portfolio manager may purchase only the same investment instruments permitted for state and local governments in that state. A few states permit a broader list of allowable investments. Governments considering investing in their state LGIP or another LGIP in their state should consider whether the investments it makes are authorized in the government’s own investment policy, or ensure that the LGIP is a permissible investment by policy.  This is important because a government’s investment policy may be more restrictive than state code.

    Many LGIPs permit check writing and wire transfers, which makes them an attractive cash management tool.

    Most LGIPs follow the investment guidelines of SEC Rule 2a-7 and are managed like money market mutual funds with the objective of providing a “constant” net asset value (NAV) of $1 and providing liquidity.  Although most LGIPs follow Rule 2a-7 closely, they are exempt from SEC registration and regulatory protocol.  Investors, consequently, do not enjoy the protections afforded from registration and regulation.

    Always keep in mind that while an LGIP might be diversified, an investor that invests solely in an LGIP may not enjoy appropriate diversification. In other words, while the LGIP holds various securities, forming a diversified portfolio, the investor, alternatively, holds only shares of the LGIP, so that investor’s portfolio is not diversified, but rather, concentrated in the LGIP. 

    Investors should treat LGIPs like other investments they make and take appropriate care in doing their due diligence.  There have been cases of government investors losing money in LGIPs.  Red flags are if the LGIP is getting meaningfully different returns than other LGIPs or from its own benchmark. This would suggest key differences in portfolio characteristics. Investors should explore such situations and not assume all’s well. 

  • Money market mutual funds (MMMFs) are a type of mutual fund that invests exclusively in money market instruments.  MMMF portfolios are short-term, and they seek preservation of capital and income along the lines of money market rates. 

    MMMFs are sponsored by private companies, unlike LGIPs that are sponsored by a state, county or other group.  MMMFs have a board of directors, must adhere to an investment policy and are offered through a prospectus. There are two categories: government MMMFs that invest in government securities and prime MMMFs that invest in corporate securities.

    Rule 2a-7

    MMMFs must register with and are regulated by the SEC Investment Company Act of 1940 and must comply with SEC Rule 2a-7. The rule governs credit quality, diversification, and maturities of the instruments within the portfolio and of the portfolio.

    Changes since 2007

    Rule 2a-7 was substantially amended after the financial crisis of 2008 to prevent future runs or dislocations as follows:

    • enhanced portfolio quality
    • limits on lesser quality investments
    • concentration limits in single issuers
    • NRSRO designation and annual determination of rating reliability
    • maturity restrictions
    • weighted average maturity (WAM) reduction
    • weighted average life limit
    • liquidity requirements
    • limits on illiquid securities
    • stress testing requirements
    • repurchase agreement limits
    • enhanced disclosures
  • Municipal notes, bonds and other obligations are securities issued by state and local governments to finance operating and capital expenses. 

    Traditionally, the interest income generated by state and local government debt has been “tax-free,” meaning the interest was excluded from an investor’s federal income tax. Certain states exempt the interest from state income taxes as well.  While most municipal debt has been tax-free, in recent years, state and local governments have increased the issuance of taxable debt.  These taxable bonds may be attractive to government investors. Tax-free bonds have rarely offered value to public funds investors because they are not subject to taxation anyway.  However, the taxable rates may be attractive compared to rates of other money market instruments. Some government investors may feel comfortable with the credit risk of other municipal debt issuers and issues, being knowledgeable with municipal finances, the municipal market and specific municipal issuers. 

    Munis have specific maturity dates, coupons and set payment schedules, similar to other bonds in the market. Some states have restrictions on the municipal securities that may be purchased by public funds investors.

    A key way to evaluate munis is to consider how they will be repaid and what collateral is provided. The two primary types of municipal bonds are general obligation (GOs) and revenue bonds.

    General obligation (GOs)

    General obligation bonds are considered the most secure muni because the issuing government gives a general pledge of its taxing authority to repay the debt.  Often, there are no limits on this taxing authority, making GO debt the most secure municipal debt.

    Revenue bonds

    Revenue bonds, in contrast, are secured by a specific source of revenue or source of funds, such as water revenues or a special revenue and may be restricted by certain limitations.  An evaluation of the revenue source is required to adequately evaluate such bonds.

     

     

     

Portfolio Management

  • This is the non-diversifiable risk in investing. Its opposite is non-systemic risk. Non-systemic risk is the risk that can be eliminated or mitigated through proper diversification (of issuers, sectors, asset classes, structures). Systemic risk is the risk that remains.

  • Measuring performance or return on an absolute basis is not sufficient. Return is only part of the equation. Return must always be considered along with the risk assumed to achieve the return. For this reason, return should be measured on a risk-adjusted basis.

    A statistic that does this is the Sharpe ratio, which is defined by the following equation

    Portfolio return minus the risk-free rate divided by portfolio standard deviation.

  • A benchmark is a standard or reference used to evaluate performance of an investment portfolio. It is a composite of securities with specific characteristics in terms of credit quality and duration.

    To provide a valid reference for comparison of an investment portfolio, it is important to select a benchmark that closely resembles policy constraints and management practice of a portfolio. Benchmarks should:

    1. Be unambiguous and transparent – The names and weights of securities that constitute a benchmark should be clearly defined;
    2. Be investable – The benchmark should contain securities that an investor can purchase in the market or easily replicate;
    3. Be priced on a regular basis – The benchmark’s return should be calculated regularly;
    4. Be supported by historical data – Past returns of the benchmark should be available in order to gauge historical returns;
    5. Be specified in advance – The benchmark should be adopted prior to the start of evaluation;
    6. Be consistent – Consistently keep the same benchmark for comparison purposes;
    7. Have published risk characteristics – The benchmark provider should regularly publish detailed risk metrics of the benchmark so an investor can compare his/her portfolio risks against the benchmark risks; and
    8. Have a composition that is similar to the portfolio holdings.
  • There are two major uses of benchmarks. First, investors can use a benchmark to help manage their own portfolio; that is, they can select a benchmark that reflects their own risk tolerance (focusing on credit quality and maturity) and use the characteristics of the benchmark to structure their own portfolio. Second, investors can use that benchmark to measure the performance of their own portfolio. They can gauge the performance of their own portfolio over that of the benchmark.  Importantly, the goal is never to significantly outperform the benchmark, but to perform comparable to the benchmark.  Over or under-performance raises questions such as what is the government investor doing differently than the benchmark?  Is there too much risk in the portfolio?

    There is no universal benchmark for a public funds investment portfolio. The particular benchmark selected should be reflective closely of the government’s investment horizon and risk profile.  It is not appropriate to use a short-term benchmark for an investment portfolio comprised of long-term investments. This should be a red flag that the benchmark is specifically selected to underperform the government’s portfolio. Benchmarking a public funds portfolio is difficult because the main objective of a public fund portfolio is safety, while the objective of the benchmark may be return.  As conditions, goals and influences change, an investor may need to review and potentially change a benchmark.

  • An asset class is a group of securities that have similar characteristics. They tend to behave similarly to market conditions and are subject to the same laws and regulations. 

    While there are many asset classes, for the sake of simplicity, the two basic asset classes are:

    • equities or stocks
    • fixed income or bonds

    Sometimes, investors of public funds will discuss asset classes within fixed income or money markets. These investors may describe their portfolios as being allocated amongst different asset classes such as Treasuries, agencies and CDs as examples. These are sometimes referred to as sectors. While these are not considered separate asset classes in the broader realm of investing, in the public funds realm, there is such an understanding.

    Asset allocation

    Asset allocation or allocating between assets (or even sub-assets within the world of public funds investing), is an important factor in determining returns for a portfolio. This is based on the principle that assets' (and sub-assets such as treasuries versus agencies versus depository products for example) performance varies in different market and economic conditions. This is the basis for diversification. Different asset classes offer returns that are not perfectly correlated so diversification can reduce the overall risk, or variability of returns for a given level of expected return.

  • Passive

    In passive investment management, the investor seeks to replicate the performance of the market or of an index of the market. This approach does not take a stance on various aspects of the market, such as interest rates, the yield curve or shifts in spreads. It minimizes, if not fully negates, any expectation inputs.  Examples of passive approaches include:  buy and hold, laddering, benchmarking and cash horizon investing.

    Active

    Active investment management seeks to identify and take advantage of opportunities in the market to beat the performance of the market. Unlike passive investing that has no expectations, active investing takes positions on interest rates, the yield curve and spreads.

     

  • After an investor has identified and adequately addressed its liquidity needs, it can divide its total portfolio into a liquidity and a core component. The core portfolio can be invested in diversified securities of longer maturities. Extending a portfolio’s maturity has historically resulted in additional earnings over time. 

    An important part of prudent investing is establishing an investing discipline. This includes identifying an investment strategy to be followed consistently.  Selecting a suitable benchmark is one way of achieving this.  Keeping within benchmark ranges is important, but identifying opportunities to adjust within ranges can help optimize the portfolio.  The following techniques can help optimize portfolio performance relative to its benchmark.

    Duration management

    With duration management, if the investor believes interest rates will rise, then the portfolio may be shortened, and, in a falling rate environment, the investor may extend the duration.  Such changes should never be drastic, but within modest ranges.

    Sector management

    This technique refers to the selection of securities or asset classes that provide the best relative value in a given period.  The relative value of securities or asset classes changes over time. When opportunities present themselves, the investor may make adjustments, again within the acceptable range.

    Yield curve placement 

    This technique adds value to a portfolio by over or underweighting areas of the yield curve where maturities offer the greatest value.  Again this should be a modest adjustment to the benchmark positions. 

    Issue selection

    Yields vary meaningfully among issuers. This may be due to real or perceived quality differences, supply/demand disequilibrium, market inefficiencies or simply anomalies.  For investors with the resources and expertise to analyze issuers, the actual selection may be a method of adding value.  

  • Passive

    In passive investment management, the investor seeks to replicate the performance of the market or of an index of the market. This portfolio management strategy or approach does not take a stance on various aspects of the market, such as interest rates, the yield curve or shifts in spreads. It minimizes, if not fully negates, any expectation inputs.  Examples of passive approaches include:  buy and hold, laddering, benchmarking and cash horizon investing.

    Buy and Hold

    In this strategy, securities are purchased with the intent of holding them to maturity, or to “buy and hold.”  This portfolio management strategy does not count on capital appreciation as all securities are held to maturity when they are sold at face or par. Governments that may not have internal expertise, time or other resources may opt for this strategy. 

    Laddering

    A laddered portfolio is structured by purchasing investments (for example, bonds or CDs) with consecutive maturities. This can be monthly, bi-monthly, quarterly or whatever period the investor finds suitable for its own portfolio.  As each investment matures, proceeds are reinvested in an investment having the longest maturity corresponding to the longest term or “rung” on the ladder.

    Benchmarking

    Benchmarking, also referred to as indexing, strives to replicate the benchmark and does not take positions different than the risk profile of the benchmark. However, in selecting one benchmark over another, the investor is definitely making a decision as to which risk profile and strategy align with its own goals.

    Cash horizon investing

    Using the horizon identified from a government’s cash flow forecast, funds are consistently invested out as long as is feasible with the goal of picking up extra yield. In a normal interest rate environment, which is an upward sloping yield curve, longer maturities offer higher yields.

  • Active strategies include taking positions on:

    • interest rates
    • yield curve spreads
    • sector allocation
    • security selection
    • timing        

    Example of active strategies include:

    Barbell

    A barbell strategy involves investing at the short and long ends of the yield curve. This strategy typically is employed by investors who expect the yield curve to flatten.  So, the investments made at the shorter end of the yield curve provide liquidity and less risk as rates rise.  At the same time, the longer-term maturities provide potential for capital gains as rates fall. 

    Rolling down the yield curve

    This investment strategy takes a total return approach that includes capturing both income and price changes. Rolling down the yield curve involves buying longer bonds and selling them after a given period to profit from their rise in value during that time.  The shape of the yield curve is the key to this strategy.  In a normal yield curve environment, upward sloping curve:

    • the longer maturity bonds pay more interest than shorter maturity bonds
    • the longer maturity bonds rise in value over time

    Investors are willing to pay more, or accept a lower yield, on a shorter-term bond because there is less risk.  The value of the bond does not rise forever. All else being equal, as a bond moves closer and closer to its maturity date, its yield moves closer and closer to zero.  As its yield falls the value of the bond rises.  However, as the bond moves closer and closer to maturity the total amount of interest that the bond will pay during its remaining lifetime is also moving closer and closer to zero.

    At a certain point the decrease in the value of the bond from the shrinking total amount of interest left to be paid on the bond, more than offsets the increase in the value of the bond that comes from the bond’s falling yield to maturity.  This is also the point in time where there is no longer an opportunity to make money from rolling down the yield curve.

    For example, consider the following investments:  3 $1,000 par bonds as follows

    1 year $1,000 bond yields 1.00%,

    1 two year $1,000 bond yields 1.50%, and

    1 three year $1,000 bond yields 2.00%.

    Compare the following scenarios:

            A.  Buying a one year bond and holding to maturity (buy & hold)

            B.  Buying a 3 year bond and selling after one year  (rolling down the yield curve)

    For strategy A, at maturity, the bond will receive the face value of the bond. In addition, the bondholder will receive $10.00 in interest for a total of $1,010.00 based on a $1,000 investment.

    For strategy B, the bond which was bought for $1,000 is sold at $999.00. During the year, the bondholder will receive $20.00 in interest for a total of $1,019.00. That’s $9.00 more than strategy A.

    Essentially, this is a preferred strategy when the yield curve is upward sloping or steep.

  • In situations where there are two alternatives, a tool called gap or break-even analysis may prove useful in comparing the investor's options. It compares two different performance outcomes, or it cold be used to compare actual performance to expected or an alternative outcome.

  • Reporting is of critical importance in public funds investing. Reports help fulfill a government investor’s fiduciary duty over funds invested, and advance disclosure and transparency of the government’s investment program. There are different interested parties in a government’s investment program – ranging from the governing body to ratings agencies and investors, other governments and citizens and taxpayers. The unique perspective of each group dictates different formats and frequencies of the reports.

    Reports for oversight

    Government investors should prepare investment reports for their governing boards, board of trustees, or oversight committees that provide investment portfolio information in a format that is conducive for the oversight function to make decisions. Sometimes, state statutes specify the format and frequency of government investment reports, as well as what should be included. Regardless, reports should be thorough, complete and touch on all aspects of the investment program.  Importantly, reports should include a summary or high level dashboard to give busy professionals the information they need to make decisions. The frequency depends on the size, complexity and other factors of the investment program.  Many governments have monthly reports for the oversight or governing authority but some limit these reports to a quarterly basis. The year-end report should provide an annual recap of the investment portfolio. 

    Dashboard report

    A summary or dashboard may include all the data useful to give decision-makers a snapshot of the portfolio status and performance for the period: 

    • total portfolio book and market value
    • investments by asset class and sector
    • maturity distribution (investments categorized by maturity range using ranges relevant for particular government)
    • credit quality distribution
    • relevant yield and total return calculations for specific period

    Detailed reports

    In addition to the summary report, the information given to the governing board or oversight committee should include:

    • listing of all securities or instruments in the portfolio
    • cost of each investment (dollar amount invested), yield, accrued interest and maturity date
    • par value
    • market value of each investment
    • returns for prior periods (quarter, fiscal year)
    • current period income compared to budget
    • relevant performance statistics compared to those of benchmark
    • breakdown of portfolios managed by investment advisers of the portfolio

    Detailed reports may include a short economic, interest rate commentary, or inclusion of any qualitative info the investment officer believes will assist the oversight board in understanding and overseeing the portfolio.

    General investment reports for the public

    Some governments prepare an annual report that is available to the public and is posted on the government website.  These reports may include a summary of the activity of the investment program and an overview of economic conditions that affected the portfolio’s performance over the specified period (usually annually).  Importantly, these reports often include goals a government wishes to achieve in addition to safety, liquidity, return.  For example, a government may discuss its goals of ensuring minority, women, disabled or veteran- owned business participation.  It can discuss the government’s efforts and success in reaching these goals. Other goals may include local financial institution participation or linked deposit type programs to improve community economic conditions.   Such a document, attractively presented, can effectively communicate quantitative and qualitative messages the government would like to send to its public.

  • Marking-to-market is an accounting requirement for public funds investing. Since GASB Statement 31 was adopted in 1997, governments have been required to report certain of their investments at fair value, with any change in market value reported as revenue during the specific period. This statement continues to generate controversy even today, years after its adoption and initial implementation.

    Marking-to-market is the practice of adjusting the value of investments to reflect their market or fair value.  As discussed in the section on risks, market risk or interest rate risk is significant in public funds investment portfolios.  Public funds investment portfolios are often primarily composed of fixed income type securities.  A basic tenet of fixed income securities is the inverse relationship between interest rates and price or value of the security.  So the price or market value of fixed income securities falls when interest rates increase and rises when rates decrease. The price volatility of fixed income securities requires the practice of marking-to-market to provide a realistic measure of a portfolio’s true liquidation value.

    The lingering controversy stems from the fact that many government investment portfolios use a “buy-and-hold” strategy. Investments are bought with the intention of holding to maturity and are not to be sold prior to maturity, so any changes in value would be moot at maturity date. They are “unrealized” rather than “realized” losses.  However, “marking-to-market” ensures an informed government, including the governing board, oversight committee, taxpayer, citizen base and other interested parties. The movements in value should be known regardless of the intention of the investor. This provides valuable information regarding how much risk is in the portfolio, and whether the government investor is being adequately compensated for that risk. Investment officials may have to spend time educating their various audiences about the differences in unrealized versus realized losses. 

    It is an accepted best practice to mark-to-market on at least a quarterly basis, if not monthly. Market values can be obtained from a reputable and independent source such as a custodial bank, the Wall Street Journal or a fee-based pricing service, but never a financial institution that served as counterparty to a specific transaction. 

    Example of marking-to-market

    An investor purchases a 2 percent Treasury note at par $1,000,000.  Approximately 18 months after the purchase, interest rates increase significantly, and the independent sources provide the investor with a value of $850,000 for the note.  Although the investor plans to hold this security until its final maturity and expects to receive the par value of $1,000,000, which was the initial investment, the financial statements will reflect the following information for the current year:

    Income from the 2% coupon                                $  20,000

    Marked-to-market (unrealized) loss                     (150,000)

    Annual performance of note                              $(130,000)

    Showing such a loss – primarily caused by the unrealized loss – is disconcerting and thus the ongoing controversy. However, governments should explain this to the public or their boards and oversight committees. This is not a valid excuse to exclude or even bury this information.

  • GASB 40 mandates certain disclosure requirements pertaining to deposit and investment risk in the portfolio.  The specific risks, GASB 40 centers on:

    • custodial (credit)
    • issuer (credit)
    • concentration risk
    • interest rate risk
    • foreign currency risk (minimal in the government portfolio)
  • Measuring and evaluating the performance of an investment portfolio is a key task. Is the portfolio achieving safety, liquidity and return? Is the portfolio managed in compliance with the portfolio’s investment policy? Is the performance in line with the risks found within the investment portfolio?  This is especially important for portfolios managed by external investment advisers. How are they managing the portfolio? How well are they performing relative to the benchmark that has been identified? Identifying and using an appropriate benchmark can provide meaningful information regarding the portfolio’s performance.  How does the performance of the investment managers compare to that of other investment advisers the government may be using?

    Measuring portfolio risk and return results against appropriate market benchmarks is a technique to verify that all the investment objectives are being met and that portfolio investment returns are appropriate for the risk incurred. Comparing a portfolio’s total return to that of a proper benchmark or is the preferred method to assess performance (relative to risk and investment objectives.

    Total return

    Total return is the compounded rate of return of a portfolio during a period identified for the evaluation.  It assumes all cash flows are reinvested in the portfolio.  For periods over one year, the total return is expressed as an annualized figure.  So over periods of multiple years, the total return is the annual figure that applied to the beginning portfolio value grows to the final value.

    Yield

    Yield is the income from a security as a percentage of the value of a security.   Yield alone is not sufficient to assess risk and performance.  Investment yield measures the percentage increase or decrease that a portfolio generates during a given period, and, while useful for budgeting purposes, it is unreliable in assessing the portfolio’s risk and return.  There are many definitions of yield;  yield results can be distorted by the timing of investing relative to the current level of interest rates; and, yield calculations also lend themselves to manipulation to generate more income or show higher yield in one particular period as opposed to another.

    Different measures of yield include the following:

    Yield to maturity at cost

    This yield measure is the constant interest rate that equates the present value of future interest payments and principal repayment to the purchase price (at cost).

    Yield to maturity at market

    This measure of yield is likely the most commonly used.  It is the interest rate that equates future interest payments and principal repayment to the current market price of a security.  At purchase, yield to maturity at cost and yield to maturity at market are identical. 

    Yield to call

    Yield to call is the interest rate that equates the net present value of interest payments and principal repayment to the security’s current market price, assuming the security gets called. 

    Yield to worst

    Yield to worst compares yield to maturity at cost, yield to maturity at market and yield to call (at each call date) and the yield to worst is whichever yield measure is the lowest among these.  It is a useful consideration for investors considering purchases with call options.

    Current yield (cost)

    The annual income of a security divided by its cost.

    Current yield (market)

    The annual income of a security divided by its market value.

  • Governments have funds other than their operating funds that they are sometimes tasked with investing. These other funds may include:  bond proceeds, trust and escrow and pension funds.

    Bond proceeds

    Bond proceeds are the funds governments get from issuing debt.  Because of timing differences between issuing debt and the ultimate use of the bond proceeds, there is an opportunity to reinvest those funds.  The debt that governments, typically, issue, is tax-exempt which means investors in municipal debt do not have a federal tax obligation on the interest they earn on this debt.  This means that governments can issue debt at lower rates than they otherwise would be able to because on a tax-equivalent basis municipal debt can be attractive in certain conditions.

    Municipal Advisor Rule

    As part of the Dodd-Frank Act, the SEC created a new class of participants required to register with and be regulated with the regulatory body, the Municipal Securities Rule-Making Authority (MSRB).  The new class is Municipal Advisors, or any professional giving advice or counsel to entities regarding their debt issuance and the investment of such funds.  While there are exemptions and exclusions, any firm that gives advice relating to debt issuance is held to a fiduciary standard, one that requires the interest of the municipal or government client be placed foremost.

    Key differences in investing bond process

    Compliance with federal laws regarding arbitrage is a key difference.  Effectively, the arbitrage regulations alter the incentive of seeking higher yields typical in investing funds.  For these funds, investors simply seek to match the bond yield.  Secondly, bond proceeds have longer investment horizons than operating funds.  Often, the proceeds are dedicated to multi-year projects and may be invested in longer-term securities, parallel to their own use schedule.

    Trust and escrow funds

    Trust funds are set up for a specific purpose. Typically, these are long-life funds. They may be for funds held by the government for the benefit of another group, such as OPEB Trust funds. Trust agreements or documents specify the responsibilities of the trustees or investment parameters, including allowable instruments and maturities. Generally, investments are limited to government securities and matched to fund cash outflows. 

    Escrow funds are similar to trust funds and may be used for public works projects or municipal debt refundings. The escrow agreement specifies the statutory authority governing investment of the funds, how the funds are to be managed and under whose authority.  Responsibility may be assigned to an escrow agent or to the government’s investment staff.  Interest earned on escrow funds may be subject to arbitrage rebate requirements. 

    Pension funds

    In general, treasurers or finance directors who have direct responsibility over operating funds do not have direct responsibility over pension funds. Some may sit as trustees or in a similar capacity for a police or fire or similar pension plan.

    Pension funds require special expertise to manage. Similarities between operating fund investing and pensions are few.  The objectives are different. While safety is important, the rate of return must be higher to ensure future pension requirements are achieved. The investment horizon for pension funds is typically much longer, and, along with that, the tolerance for risk is much greater. To meet their return expectations, pension funds are invested in a range of asset classes, of which fixed income is only a part. Pension fund investing is governed by its own statutory framework and includes different investment service providers. Investment consultants assist pension fund investors with developing and reviewing their investment policies, determining appropriate asset allocation, engaging custodians, selecting investment managers and reviewing manager performance on an ongoing basis.

     

     

  • Most governments are limited in their investment horizon by state statutes, or by their own investment policy.  Using the cash flow forecast can help determine an investment horizon by ensuring a solid appreciation of liquidity requirements.  Of course, how far to extend maturities even in the core portfolio may be constrained by the interest rate outlook.  If interest rates are expected to rise, investors may reject longer maturities, opting for a shorter horizon. However, investors should always be careful trying to predict rates.

Fixed Income 101

The following information is intended to give a high level introduction to debt or fixed-income investing.

  • A fixed income investment pays a fixed rate of return. Fixed income, typically, refers to government, corporate, or municipal bonds which pay a fixed rate of interest until the bonds mature.

  • By its very nature, investing involves risk. Risk and return are related, and, generally, there is a trade-off between risk and return. Even though public sector investing is limited to investments on the low end of the risk spectrum, those with high credit quality and low market risk, risks still remain. The key to prudent investing is identifying and recognizing the risks, and managing them in a way that yields appropriate risk-adjusted returns, given the government’s risk tolerance.  Understanding a government’s appetite or tolerance for risk is fundamental in determining the risk/return make-up of the government’s portfolio.

    There are several risks that investors of public funds must understand.

    Credit (default) risk

    This may be one of the easiest risks to understand. Credit or default risk is the risk that a part or all of a government’s investment – both principal and the interest due – will be lost. This risk involves an issuer’s credit-worthiness. It is the risk that the issuer will not be able to pay the interest or repay the principal when they are due. This risk also involves the perception by the market of weakness of an issuer or of a security. This may also negatively affect a security's price, resulting in a loss for an investor.

    While the instruments public funds are allowed to invest in are considered amongst the safest, there are differences in the credit risk they carry and, typically, in the yields they provide to compensate for that spectrum of risk. Investors should always be aware of the risks that they are taking and make sure they are adequately compensated for those risks.

    Credit risk can be managed by conducting due diligence on credit quality including issuer financial strength, the structure of an investment, the collateral securing the investment and by placing limits on the credit quality of investments. Risk involving the broker or financial institution selling an investment can be managed by having third-party safekeeping and requiring delivery-versus-payment on all securities purchased.

    Making use of third-party evaluation can be helpful in the credit due diligence process. Nationally recognized statistical ratings organizations (NRSROs), such as Standard & Poors, Moody’s, and Fitch, provide ratings for some of issuers and securities public funds typically invest in, including agencies, GSEs, municipal bonds, commercial paper, corporate bonds and other securities. Private sector research firms such as IDC Financial Publishing, Inc., and VERIBANC, and Bauer Financial provide analyses of financial institutions such as banks and savings and loans (S&Ls). These can be useful to government investors in evaluating the issuers and securities they invest in, but also for evaluating the financial institutions they do business with (such as banks for depository products or broker-dealers).  While public funds investors can use such ratings, they should be mindful that they are not necessarily foolproof.  Assessments can change dramatically fast, and investors, including government investors of public funds, have lost money on securities/issuers that had previously been highly rated.

    Another source of research comes from the financial institution, such as the broker-dealer, that sells an investment. 

    Government investors should be conscious of the risks involved in investing in securities carrying credit risk and perhaps, limit their investment in these if they are not comfortable with the expertise, either internal or external, that they have to analyze these. Investors of public funds who have the expertise to evaluate credit risk should make sure the return they are getting compensates for the risk. 

    Market risk

    Market risk is the risk of a decline in value of an investment declines due to a change in the market.

    Interest rate risk

    A basic tenet of fixed income securities is that an inverse relationship exists between interest rates and the price or value of a security.  All other factors being equal,

    • fixed-income security prices fall when interest rates increase
    • fixed-income security prices or market value rise when rates decrease
    • longer-term securities are more heavily impacted than shorter term securities
    • securities with lower credit are more affected than highly-rated securities

    Put simply, interest risk is the risk of a decrease in the value of a security as a result of interest rates increasing. Modest ways to mitigate this risk include: 

    • developing and updating cash flow forecasts to have a sense of short and on-going liquidity requirements
    • structuring investment portfolio to meet obligations
    • understanding maturity structure of securities in the government’s portfolio (especially important for callable securities)
    • adopting average short and on-going liquidity needs maturity or average duration limitations (Duration measures the sensitivity of a fixed-income security’s price change as a result of changes in interest rates).
    • not investing in securities with maturities beyond those allowable in the government’s investment policy.

    Liquidity risk

    Liquidity risk is the risk of being unable to liquidate an investment prior to its maturity date. If no secondary market exists for an investment, the investor may experience a loss. Typically, non-negotiable certificates of deposit (CDs), and certain commercial paper issues are examples of investments that may not have an active market in which an investor can turn to sell a security if a need for this arises. What tends to happen in these situations is the price of the security would fall to where a willing buyer is interested in buying or there might be a penalty for an early sale, as is often the case for non-negotiable CDs.

    Reinvestment risk

    Reinvestment risk is the risk that cash flows from an investment, including interest payments and returned principal, will be invested at an interest rate less than that initially contemplated.  Downward trending interest rates create reinvestment risk.   Reinvestment risk is realized when interest rates fall, and interest payments are reinvested at the reduced interest rate.  This risk is an important consideration for investors in callable securities.  Some bonds are issued with call features that allow the issuer to call or repay the bonds prior to their maturity date.  Generally, this happens if interest rates fall low enough that the issuer saves money by calling the bonds, paying off the existing higher coupon bonds, and issuing new bonds at lower rates.  The issuer stops paying the higher coupon and the investor stops receiving the higher interest rate.  For a callable bond, when it is in the issuer’s benefit to call a bond, it is to the investor’s detriment because in these situations, the investor must then reinvest the returned principal also at a reduced interest rate.

    Reputational risk

    Reputational risk is the risk that an investment activity – loss, mismanagement, fraud, mistakes – negatively affects the reputation of the treasurer, finance director, the investment officer, or the government.  Such happenings are hard to overcome.  As the old adage goes, a lost reputation is hard to find.   While harm can come to one’s reputation or that of a government, despite the best laid out plans, having a well-thought out investment policy and remaining in compliance with it are safeguards against this risk.   

    Opportunity risk

    Opportunity risk is the risk of missing an opportunity, or the rate of return an alternative would provide.

  • A bond is an interest bearing or discounted government, corporate or municipal security that obligates the issuer to pay the bondholder a specified sum of money, at specific intervals and to repay the principal at maturity.

  • Principal

    Principal means the “face” amount, the “par” value, or the “maturity” price. This is important because interest accrues on the outstanding principal or face amount. Importantly, the principal or the “face” may and often does, differ from its purchase price. 

    Market value

    Market value or market price is the price of a security. It is the price which market participants – sellers and buyers – agree on. This value is contrasted with the “par” or “face” value is the nominal value of a security. It is the amount on which interest is calculated and the principal paid to the investor at maturity.

    Discount

    The discount is the difference between the price of a security and the face when the market price is below the par. 

    Example

    A government investor may purchase a U.S. Treasury note with a par value of $1 million for the price of $945,000.  The principal amount of this security is $1 million and the $55,000 represents the discount for the security.  At maturity, the government investor will receive the face value of $1 million and the discount will accrue over the life of the investment. 

    Premium

    Premium refers to the difference between the par or face value of a security and its market price when the market price is above the face.  Investors, typically, pay premiums when the coupon of the security is higher than the interest rates.

    Example

    A government investor may purchase a U.S. Treasury note with a par of $1 million for the price of $1,100,000. The principal amount of this security is $1 million and the $100,000 represents the premium for the security.  At maturity, the government investor will receive the face value of $1 million and the premium will be amortized over the life of the investment.

    Book value/amortized cost/adjusted cost

    Book value is the cost of a security adjusted to reflect the accretion of a discount or amortization of a premium. This value changes as a function of the passage of time.

    Interest

    A defining characteristic of debt securities is that they bear interest on the principal amount. This part of the security is the compensation by the issuer (as debtor/borrower) to the investor (as lender) for the money for a specific period of time. There is a time value to money. Interest includes coupon payments and interest accruing at an interest rate. Interest is calculated as a percentage of the principal amount borrowed over the specific period.

    The time period can be calculated various ways – on a 360 day year with 30 days per month or a 365-day year with actual days per month. The particular calculation depends on the instrument.

    Discount interest

    For instruments that pay interest on a discount basis like treasury bills, the investor pays the discounted amount and receives face or par value at maturity.  The difference is the interest earned and it is calculated as follows:

    The actual number of days until maturity / 360 days

    Example

    The discount amount invested and yield-to-maturity of a $1 million face value Treasury bill, purchased at a discount rate of 1.5 percent with a term to maturity of 312 days is calculated as follows:

    Discount interest =

     $1,000,000 X 312/360 X 1.5% = $13,000

    Amount invested =

    $1,000,000 – $13,000 = $987,000

    And the yield-to-maturity is calculated as follows

     $13,000/((312/360) x $987,000)) = 1.52%

    Investors in discounted securities invest less than the face amount, so the yield-to-maturity is higher than the discount rate. The yield-to-maturity is based on the amount invested while the discount rate is based on the face or par value.

    Interest-bearing

    30/360

    Some securities that have semi-annual interest use the 30/360 day convention. This is used regardless of the actual number of days in each month and the number of days in the year.

    Example

    To calculate the interest on a semi-annual agency with a 3 percent coupon from an August 1, 2016  issue date through the first coupon date of  January 1, 2017, we use the 30/360 convention.  So the five months between these dates result in 150 days for the period. Accordingly, interest for the period will be $12,500.

    $1,000,000 X 150/360 X 3% = $12,500

    Actual /Actual

    The convention used for Treasury notes and bonds is the actual days in a period over the actual number of days in the year. 

    Example

    An investor purchases a $1,000,000 face value Treasury bond with a 3.5% coupon. The investor buys the bond on May 1 and holds it to August 1.  Interest payments are made April 1 and October 1. The investor holds the bond (31+30+31) for a total of 92 days.The investor is entitled to receive interest as calculated below:

    $1,000,000 X (92/(2 X 183)) X 3.5% =   $8,797.81

  • Maturity

    Principal is payable at a specified date.  In fixed-income investing, “maturity” means the date the face or par value of a debt security become due and payable.

    Weighted average maturity (WAM)

    Also called average weighted life, weighted average maturity measures the average maturity of an investment portfolio as weighted by the market value of each investment in the portfolio.  It is a more accurate measure than average life because it accounts for the portion of the portfolio that each investment represents.

    Example

    An investment portfolio has three investments:

    1. A $300,000 market value security with 275 days to maturity
    2. A $10,0000 market value security with 365 days to maturity
    3. A $1,100,000 market value security with 10 days to maturity

    The average maturity of this portfolio is (275+365+10)/3 = 217 days

    The weighted average maturity is (($300,000 x 275) + ($10,000 x 365) + ($1,100,000 X 10))/$1,410,000 = 69 days. 

    Taking market value weightings into account produces a meaningfully different maturity calculation.

    Effective maturity

    The calculation of effective maturity is used for estimating average maturity when there are call features.  This calculation depends on the behavior of interest rates over time and makes various assumptions to calculate a maturity that is not known but depends on what interest rates do.

    Duration

    Duration is a useful concept in fixed income investing and measures price sensitivity of fixed-income investments.  Recall that movement in the value or price of a fixed income security is negatively related to the direction of interest rates.  As rates increase, prices fall, and conversely, as rates fall, prices increase.  Duration measures the weighted average of the present value of the cash flows of a security.  So in this/ respect, it is improvement over maturity that only considers future values. The greater the duration of a bond, the greater its volatility.  In general, duration rises with maturity, and falls with frequency and size/ of coupon payments.

    Modified duration is a multiplier that measures the approximate percentage change in the value or price of a security or portfolio given a 1% (100 basis points) movement in interest rates.

    Example

    For example, if a security has a modified duration of 2.5 and interest rates rise by 75 basis points, the security would experience approximately a -1.88% change in value.

    (-1%) X modified duration X (basis point change in yield/100)

    (-1%) X 2.5 X (75/100) = -1.88%

    Convexity

    While duration is a useful measure of sensitivity for small changes in interest rates, for larger yield changes, convexity is a useful measure of volatility. The term derives from the price yield curve of a bond, which is convex. A rule of thumb is the more convexity a bond has, the better. What this means is as interest rates increase, the price of a fixed income security falls more slowly and as rates decrease, the price of a fixed income security rises more quickly. As with duration, convexity of simple (noncallable) securities increases with lower coupons, lower yields and longer maturities.

    Convexity’s effect on price movement is measured by the equation: 

    Convexity X basis point change squared X 100

    Example

    If a security has a convexity of 86 and interest rates increase by 75 basis points, the security would experience approximately a 0.48% change in value

    86 X (0.0075*0.0075) X 100 = 0.48%

    To calculate the effects of duration and convexity together, simply add the results.  So assuming, the same bond has the modified duration (2.5) and convexity (86) illustrated above, the results would be as follows:

    Example

    Total Price change = Change from duration + change from convexity

    [(-1%) X modified duration x (basis point change in yield /100)] +

    [Convexity X basis point change squared x 100] =

    -1.88% +0.48% or - 1.39%

     

  • Yield measures the income from a security or portfolio as a percentage of the value of the security or of the portfolio. Assume the security is a bond. There are different ways to calculate yield. Some of the more common calculations are:

    Yield to maturity

    The yield to maturity is the rate of return or income an investor will receive if a bond is held to its maturity date. It considers purchase price, redemption value, time to maturity, coupons and the time between payments. Another way to consider yield to maturity is the rate at which present value of all payments equals the present price of the bond.

    Yield to call

    The yield to call of a bond assumes the bond will be called by the issuer of the bond at the first all date. The same calculations used for yield to maturity would be used in calculating yield to call but using the call date.

    Yield to worst

    This yield measure is the lesser of yield to maturity and yield to call.

  • Optionality are features that provide options in investing.

    Calls

    A call features is the most common form of optionality in investing public funds. A callable bond combines a bond with a call option. From the investor’s perspective, buying a callable bond is like buying a regular bond and selling a call option to the issuer. The investor gets a premium in the form of an interest rate higher than the rate on a non-callable bond equivalent.

    There are different types of calls:

    • European calls – have a one-time call option at a specified date, after a specified lockout period
    • Bermuda calls – bonds may be called per a specified schedule after initial lockout.
    • American calls – bonds are continuously callable after initial lock out.
    • Canary calls - A step-up bond that cannot be called after completing its first-step period. The issuer of the bond reserves the option to call back the bond until the first step is reached. A canary call may only be exercised on predetermined dates.
    • Make whole – a call option that allows the borrower to pay off remaining debt early by making the investor “whole.”  The payment is derived on discounting future coupon payments that will not be paid because of the call.
    • Sinking fund call – is the option to call bonds for a set rate, using money from a sinking fund created by the issuer specifically for such calls.
  • The yield curve is a line graph displaying the yield on bonds at different maturities within a market sector, such as Treasuries, agencies or corporates. The yield curve generally slopes upwards, and this is called a normal yield curve. Sometimes, the yield curve is inverted with short term rates higher than long term rates

Glossary

  • Agencies - debt issued by agency entities of the United States government.  They carry the U.S. government guarantee on their interest and principal payments.

    Arbitrage rebate

    In general, the federal government regulates closely how tax-exempt proceeds can be invested. There are two main reasons for this: 1) lost tax revenue to the federal government, and 2) the federal government’s desire to minimize opportunities of abuse by local governments issuing tax-exempt debt which they reinvest at higher rates for a profit.

    In the municipal finance industry, arbitrage is the ability to obtain tax-exempt bond proceeds and invest the funds in higher yielding taxable securities, resulting in a profit.

    Abuses associated with tax-exempt financings led the federal government to issue regulations to restrict the use of tax-exempt bond proceeds. The two primary purposes expressed by the regulations for establishing the arbitrage laws are: 1) to minimize the benefits of investing tax exempt bond proceeds, and 2) to remove the incentive to issue more bonds, issue bonds earlier or to leave bonds outstanding longer than necessary to carry out the governmental purpose of the issue. 

    Asset-backed securities – securities that are “backed” or supported by specific assets as opposed to being unsecured.  Asset-backed commercial paper is a category of commercial paper, where the paper is backed by specific assets, such as car loans, credit cards, recreational vehicles or other collateral. 

  • Bankers’ acceptance

    A draft drawn on and accepted by a bank. It is an unconditional liability of the accepting bank.  BAs are short-term, non-interest bearing investments redeemed at face value at maturity by the accepting bank. They are not as popular as they once were. 

    Basis point

    One (1) percent of one (1) percent (1/100 of 1%, or 1 bps).  The difference in bond yields is measured in basis points.

    Best execution

    Best execution is the duty of a broker-dealer to execute orders for customers in a way that ensures the best execution possible for these orders. Some of the factors the broker must consider when seeking best execution of their customers' orders include: the opportunity to get a better price than what Is currently quoted, and the likelihood and speed of execution.

    Bond

    An instrument of indebtedness of the issuer to the holder. In a debt security, the issuer owes the holder a debt and is obliged to pay interest (the coupon) and/or to repay the principal at maturity date.

    Broker-dealer

    A firm that buys and sells securities. Broker-dealers facilitate trades for investors.

    Bullet

    A debt instrument whose entire face value is paid at once on the maturity date. Bullet bonds are non-callable.

    Bullet strategy

    An investment strategy of intermediate, rather than long and short maturities. This strategy is based on buying a number of different types of securities over a period with all the securities maturing around the same target date. One of the main benefits of the bullet strategy is that it allows the investor to minimize the impact of fluctuations inn interest rates.

    Buy-and-hold strategy

    A strategy in which securities are purchased with the intent of holding them to maturity.

     

  • Callable security

    A security where the issuer has bought the option to call the bond or security at the issuer’s option.  It is not an obligation but an option so the holder of a callable security does not know whether the security will be called away.  The investor in a callable bond typically gets a higher interest rate as compensation for the call option.

    CAMELS

    The CAMELS rating system is a protocol created and used by federal banking regulators to evaluate the safety and soundness of a bank or a Savings & Loan institution (S&L), and can be used for credit unions as well. In undertaking their own bank/savings & loan due diligence, government investors may consider the same CAMELS methodology the federal regulators and/or examiners use in their due diligence. Many independent rating or analysis firms use a form of this methodology. This is an acronym for the six elements that are evaluated:

    • Capital
    • Asset quality
    • Management
    • Earnings
    • Liquidity
    • Sensitivity to risk

    Each of these elements is rated on a scale of 1 to 5 by the federal regulators, and an overall CAMELS rating is assigned to a financial institution following an examination. While the ratings are not made publicly available, an investor can follow the CAMELS outline in doing his or her own due diligence. 

    Certificate of deposit

    A form of time deposit.  It bears a specified interest rate, is for a specified amount and for a specified period.

    Chartered Financial Analyst (CFA) he professional designation offered by the CFA Institute to investment and financial professionals who have undergone a rigorous and encompassing course of study, testing and met other requirements. The CFA program covers a broad range of topics relating to investment management, financial analysis, stocks, bonds, derivatives and provides a generalist knowledge of other areas of finance.

    Chartered Financial Analyst Institute

    The CFA Institute is the trade association for investment management and research.    It sets codes, standards and guidelines for professional conduct in the investment management industry.  The CFA Institute was formerly known as the Association of Investment Management and Research (AIMR).  In certain RFPs based on older, outdated templates, the CFA Institute may still be referred to as AIMR. 

    Collateralization

    The process by which a borrower pledges securities, property, or other deposits for the purpose of securing the repayment of a loan and/or security. 

    Convexity

    A measure of a fixed income security’s price sensitivity to changing interest rates.  A high convexity indicates greater sensitivity of the security’s price to interest rate changes and is a positive, all else being equal.

    Cost of waiting

    Opting not to do anything has a very real cost. Each day that passes requires a higher yield to make up for the time that has passed without investing. After the financial crisis of 2008, with interest rates at historical lows, investors expected interest rates to rise in the near-term future and declined investing in longer-term securities, foregoing higher yields. Even when rates rise to a level where an investor is ready to invest, it is unlikely yields will have risen to the point where they make up for the time the investor spent waiting. The cost of waiting can be very hard to overcome. 

    Coupon rate

    The annual rate of interest payable on a coupon bond expressed as a percentage of the principal amount.

    CUSIP Number

    A nine-character alphanumeric code that identifies a North American financial security for the purposes of facilitating clearing and settlement of trades. All securities have a CUSIP number.

  • Delivery-versus-payment

    A settlement procedure where payment for a securities transaction is made simultaneously with the delivery  of the purchased securities. The same procedure takes place for a sale transaction, where the securities are transferred as the payment is received. DVP protects the government as it always has either securities or funds.

    Discount

    The difference between the price of a security and the face when the market price is below the par. 

    Discretionary management authority

    The authority or “discretion” over the management of an investment portfolio, including decision-making and trade execution.

    Diversification

    A risk mitigation strategy that spreads risk by investing in different asset classes, securities, structures and maturities.  This practice helps avoid overexposure to a given or concentrated risk. 

    Duration

    The measurement of the price sensitivity of fixed income investments. 

  • EMMA – The Electronic Municipal Market Access is the official repository for information on virtually all municipal bonds, providing free public access to official disclosures, trade data and other information about the municipal securities market.

  • Fiduciary is a legal concept in portfolio management. Those acting in a fiduciary capacity must:

        • make decisions in the best interest of the beneficiary
        • act prudently
        • always put the beneficiaries' interests before their own

    Fixed-income is a class of investment under which the issuer, as borrower, is obliged to make payments of a fixed amount on a fixed schedule: for example, the borrower has to pay interest at a fixed rate once a year, and to repay the principal amount on maturity.    While the term “fixed” is used, sometimes the interest payments are of a variable nature.

  • Global Investment Performance Standards (GIPS)

    The CFA Institute has identified and promulgates global investment performance standards. These are voluntary standards. However, when investment firms follow these global standards for presenting their investment performance, it gives investors the transparency and confidence that they require to compare and evaluate investment managers. GIPS is a set of standardized industry-wide principles that investment firms can use to calculate and present their investment performance. Performance that is calculated and presented in a consistent and uniform basis allows investors to have confidence in the figures they receive and also confidence in making meaningful comparisons between investment advisers. An investment adviser that claims to be in compliance with GIPs attests that if has followed certain steps.

    Government investors may consider requiring investment managers to comply with GIPS, or to inquire why a firm chooses to present non-compliant performance.

    Government Accounting Standards Board (GASB)

    The independent board whose mandate is to establish and improve standards of state and local governmental accounting and financial reporting that will provide useful information for users of financial reports, and guide and educate the public, including issuers, auditors, and users of those financial reports.

    Government Finance Officers Association (GFOA)

    The professional association of government finance officers. It seeks to advance the government finance profession through research, identifying and promulgating best practices, education and networking.

    Government Sponsored Enterprises (GSEs)

    Entities established by acts of Congress to support various public policies, such as home ownership, farming, education and resource development. To support the various public policies, the GSEs purchase mortgages and loans from issuers, who use the proceeds to fund additional loans. GSE debt is high quality and income generating, with a competitive return over Treasuries. GSEs are often lumped with agencies and referred to generically as “agency debt.” 

  • Interest

    This is a defining characteristic of debt securities. Debt securities bear interest on the principal amount. Interest is the “compensation” by the issuer (as debtor/borrower) to the investor (as lender) for money for a specific period of time. A security can provide discount interest or be interest-bearing. 

    Investment adviser

    An adviser that gives advice on securities and investments, and is, typically, registered under the Investment Securities Act of 1940, has a fiduciary obligation and is compensated on a fee basis based on assets under management.

  • Laddered portfolio 

    An investment strategy in which the investments are staggered among securities with different maturities, in order to receive regular income and to smooth out or "hedge" the effect of interest rate movements. This strategy is also called laddering. As the investments or rungs on the ladder mature, their principal is re-invested in the next maturity (or rung) in the ladder. 

    Letter of credit

    A document from a bank guaranteeing that a holder will receive payment in full. Sometimes banks provide a letter of credit instead of securities to collateralize (or support) public funds deposits. Before accepting a letter of credit, make sure you are comfortable with the issuer of the letter of credit.  

    Liquidity

    The ability to be converted easily and quickly into cash.

    Local Government Investment Pool (LGIP)

    An investment by local governments in which their money is pooled as a method for managing local funds.

  • Mark-to-Market i

    The process whereby the book value or collateral value of a security is adjusted to reflect its current market value.

    Market Value

    The current market price of a security.

    Maturity

    The date the face or par value of a debt security become due and payable.

    Medium-term notes

    A subset of corporate notes. Typically, they have maturities ranging from one to 10 years and are issued under an SEC “shelf registration” filing. In a shelf registration, the issuing company registers a certain amount of debt with the SEC -- but does not issue the debt immediately.  

     

    Money market mutual funds

    A type of mutual fund that invests exclusively in money market instruments. Their portfolios are short-term in nature, and they seek preservation of capital and income along the lines of money market rates.

    Municipal Securities Rule-Making Board (MSRB)

    A self-regulatory organization whose mission is to protect investors, municipal entities and the public interest by promoting a fair and efficient municipal market, regulating firms that engage in municipal securities and advisory activities, and promoting market transparency.

    Municipal bonds (also notes and other obligations)

    Securities issued by state and local governments to finance operating and capital expenses. Two primary types are general obligation and revenue bonds, distinguished by their backing.

  • Negotiable certificates of deposit

    A certificate of deposit, typically, issued by large financial institutions. They are not collateralized although they are subject to FDIC coverage. They are uniform and evaluation is based on the financial strength of the issuing financial institution. 

    Non-negotiable certificates of deposit

    A certificate of deposit which is not negotiable, meaning there is no secondary market. The CD cannot be liquidated prior to maturity outside of liquidation with the financial institution that provided the CD in the first place, often with penalties for the early liquidation. There is no secondary market where a sale price could be negotiated. These instruments are amongst the least liquid investments in public fund portfolios.

  • Off the run  

    Securities from earlier auctions are “off-the-run.” While the maturities may be identical, there can be meaningful yield differences between “on-the-run” and “off-the-run” issues. This may be because brokers are willing to pay a higher price for the greater liquidity of “on-the-run” issues.  Investors may be able to take advantage of this yield differential.

    On the run

    “On-the-run” issues are the most recently issued securities in each maturity range.  While the maturities of on the run and off the run issues may be identical, there can be meaningful yield differences between on-the-run and off-the-run issues.  This may be because brokers are willing to pay a higher price for the greater liquidity of “on-the-run” issues.  Investors may be able to take advantage of this yield differential.

    Opportunity Cost

    Opportunity cost is the loss of gain from opting for one alternative over another.

  • Passive investment strategy

    One of two investment management approaches, the other being active management.  In passive investment management, the investor seeks to replicate the performance of the market or of an index of the market. This approach does not take a stance on various aspects of the market, such as interest rates, the yield curve or shifts in spreads 

    Premium

    The difference between the par or face value of a security and its market price when the market price is above the face.  Investors, typically, pay premiums when the coupon of the security is higher than the interest rates.

    Primary dealers

    Firms that serve as trading counterparties of the New York Federal Reserve (the NY Fed) in its implementation of U.S. monetary policy. They are the only institutions that buy U.S. Treasuries directly from the Federal Reserve.

  • Regional dealers

    Dealers that do not deal directly with the Federal Reserve in its open market operations. This designation includes a very wide range of firms that vary in size, capitalization level, product focus and specialization, and geographical presence.  Regional dealers may also be referred to as “secondary” or “non-primary” dealers.

    Repurchase agreement

    A short-term investment. It is an agreement with an approved broker-dealer that provides for the sale and simultaneous purchase of an allowable collateral security. The difference in the sales and purchase price is the interest rate on the investment.

    Reverse repurchase agreements

    In the reverse repo, the investor owns the securities, and the counter-party or the financial institution exchanges cash for the securities, for a specified period at an agreed-upon interest rate. There are two main purposes for reverse repurchase:  liquidity and to enhance portfolio returns.

    Rule 2a-7

    The SEC Investment Company Act of 1940 rule that governs the credit quality, diversification, and maturities of the instruments within the portfolio of a money market mutual fund and of the fund itself.

  • Safekeeping is an arrangement where an entity provides transfer and custody of securities. In third-party safekeeping, an entity other than the one that sold an investor securities provides custody services and performs certain other related services.  

    Secondary market

    A market in which an investor purchases a security from another investor and not from the issuer. These are the trades that take place subsequent to original issuance in the primary market. This market is also called the aftermarket.

    Shelf registration

    Offerings where the issuing company registers a certain amount of debt with the SEC -- but does not issue the debt.   The investment bank then uses this as inventory, and then considers the issuer’s needs and the investor’s appetite to actually issue the debt.  When the investment bank has an investor who wants to buy debt with a maturity of five to 10 years, the investment bank sells the amount that the investor wants to buy (up to the limit) and structures the maturity based on the needs of the investor and sets the coupon using prevailing rates.

  • Total return

    Total return is the compounded rate of return of a portfolio or of a discrete investment during a period identified for the evaluation.  It assumes all cash flows are reinvested. For periods over one year, the total return is expressed as an annualized figure.  So over periods of multiple years, the total return is the annual figure that applied to the beginning portfolio value grows it to the final value.

  • U.S. Treasury securities

    Debt issued by the United States and is backed by the “full faith and credit” of the U.S. government.  They are considered risk-less investments (free of default or credit risk).

    Variable rate debt

    Debt with floating rate coupon payments which reprices at specific intervals based on a specified index and margin.

     

    Yield curve

    A line or graph that plots interest rates at a set point of time of bonds having the same credit quality – Typically, the treasury yield curve is the standard curve off of which other rates are determined.

Key Takeaways

  • Know who you are doing business with 

    The relationships you have with financial service providers are paramount. You cannot function without them. Implement appropriate due diligence processes to follow for entering into and continuing relationships with various external vendors, including banks, broker-dealers, investment advisers, custodians and others.

    Undertake competitive procurement

    Competitive procurement helps ensure you are aware of and understand all the alternatives available to your government and can make educated decisions. It ensures you are getting a value proposition. Cast a wide net and take inventory of what the market has to offer.

    Have competitive bidding

    Whether through collecting at least three bids for each trade, or through the use of robust electronic trading platforms, competitive bidding gives a firsthand look and understanding of the market. When tools such as Bloomberg may not make sense from a cost/benefit perspective, make sure you still know the market.

    Insist on third party custody

    The broker-dealers selling securities to a government should never have custody of the government’s assets.  Nor should investment advisers provide custody. They provide advice or management - not custody. Governments should always insist on a third-party custodian, ideally selected competitively, evidenced by a custody agreement with trades settled delivery-versus-payment.

    Require collateral for deposits

    Follow state statute in collateralizing your government’s funds. Pay close attention to what security types and maturities are appropriate for collateral. Make sure your collateralization agreements specify appropriate collateral, restrict unauthorized substitution of the collateral, mandate third-party safekeeping of the collateral and require notification if value fluctuates below “floor” or any changes made. Consider accepting letters of credit from a Federal Home Loan Bank. 

    Diversify

    A concept as simple as not putting all your eggs in one basket can help ensure the safety of your government's investment portfolio. Nonsystematic risk, the risk of individual securities or different categories can be reduced by appropriate diversification. Different asset classes, sub-assets, securities, different issuers, different maturities, different structures may react differently to changes in the market. Reducing this diversifiable risk is the goal of diversification. 

    Do not concentrate in one LGIP or one MMMF

    Related to the take-away on diversification, do not assume if you invest all your assets in a diversified LGIP or MMMF that you are diversified. You are not. You are concentrated. Make sure that your portfolio is diversified.

    Understand the return/risk nature of investing

    Investing entails risk. Determine the level of risk or volatility your government is comfortable with – or can tolerate – before you invest. Higher returns are accompanied by greater volatility. If an investment is “beating” its benchmark, ask, what is different? Why is this the case? Are there more risks involved?

    The basic tenet of fixed income is an inverse relationship of values or prices and interest rates

    When interest rates increase, the value of fixed-income securities falls. This price decline can be painful to portfolios for which safety is the most important objective. Total return metrics can help stay on top of portfolio price movement.

    Keep the government’s investment policy fresh

    Create and have your governing body approve a comprehensive investment policy that stands the test of time. It should serve to guide the entire investment program. Review it annually, but do not think it needs to be altered every time it is reviewed. Update the date it has been most recently reviewed.

    Communicate

    Take a proactive approach to communicating about your investment program – whether with your oversight committee, governing board, your citizens or other involved stakeholders. Embracing transparency goes a long way to building trust and goodwill that may prove useful in turbulent times.

    Be a good steward

    Understand the funds entrusted to you are not your own. Be aware of your fiduciary duty. Follow the parameters of your investment policy. Avoid conflicts. Good stewardship will make your job easier.

     

     

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