By Scott McIntyre, CFA
It has now been over five years since the press initially reported on the extreme abuses in the Orange County California public funds investment pool. In 1994, it was reported that Treasurer Robert Citron, a long time custodian of public trust, leveraged the county portfolio multiple times over and invested heavily in derivative securities in an effort to maximize returns. Sadly his mistake was not malicious or self-serving, but rather due to a lack of investment product knowledge. As the extent of the damage was brought to light, other public entities throughout the nation began to look closely at their own investment practices in an effort to uncover possible problems of their own. The unpleasant result was that Orange County was not alone in their reckless pursuit of higher returns. A huge number of public entities had indeed gambled with derivative securities that possessed far greater risk than their investment officers had been led to believe, and the worst bond market year in history had reduced esoteric security prices to a fraction of the original value.
Most public entities wisely responded to the growing crisis by slamming the door on purchases of additional risky bonds. In stopgap measure, investment choices were limited in many cases to the most basic of securities. Public investors that had cut their teeth on CDs and Treasury bills long before moving on to dreaded derivatives, found themselves back on old familiar ground. When the Texas Public Funds Investment Act was amended the following year to restrict purchase of high-risk securities, the public breathed a collect sigh of relief and adopted a much more conservative approach to investing funds.
New legislation also required that designated investment officers receive training in hopes of better understanding the investment choices available to them under the law. By becoming familiar with these permitted securities, public entities are able to safely maximize public tax dollars through prudent investment management.
The possibility of losing money through reckless investing has now been greatly diminished, but ironically the chances of losing money through overly conservative practices have become common. Those entities that regressed back to CDs and Treasury bills years ago and are reluctant expand their investment choices may be incurring large opportunity costs. These "invisible losses" can be significant. To illustrate, a City with a $10 million dollar investment portfolio that primarily invests in 91 day T-bills, could expect a yield in the current investment environment of about 5.80%. By simply substituting U.S. government agency discount notes, a high quality security with identical characteristics to Treasury bills, yields can be increased by as much as 40-50 basis points. The additional income in this example would be as high as $50,000 annually.
A prudent investment strategy for a smaller entity with significant cash flow needs should focus on liquidity and high credit quality. The U.S. Treasury market is indeed the most liquid of any market, but certificates of deposit are very illiquid having no secondary market and subject to penalties for early withdrawal. Agency debentures and agency discount notes are not quite as liquid as Treasuries, but have a large and actively traded secondary market. As is the case with Treasury debt, credit quality should not be an issue with Federal agency debt. Although agencies do not carry the explicit guarantee of the United States Government, they are guaranteed by the agencies themselves and carry the highest credit ratings available.
The typical discount note is issued by a handful of familiar Federal agencies including the Federal National Mortgage Association (FNMA or "Fannie Mae"), the Federal Home Loan Mortgage Association, FHLMC or "Freddie Mac"), the Federal Home Loan Bank (FHLB), the Federal Farm Credit Bank (FFCB) the Student Loan Marketing Association (SLMA or "Sallie Mae"), Tennesee Valley Authority (TVA) and the World Bank.
The discount notes issued by all of these agencies earn income in the same manner as the familiar Treasury bill. They are sold at a discount, do not pay a coupon and mature at par. The income earned is simply the difference between the amount initially paid and the maturing par. Available maturities range from a single day to 365 days, and denominations as small $5,000 can be purchased allowing for tremendous investment flexibility. Federal agencies also issue a variety of short fixed coupon bonds that pay interest on a semi-annual basis.
By utilizing a 60-day AAA-rated public funds investment pool in addition to short agency securities, an entity can diversify the overall portfolio and effectively hedge against the possibility of rising interest rates. A pool offers full daily liquidity to its users, pays interest monthly, and seeks to maintain a $1 net asset value, which means that participants can always withdraw the principal amount in full, even if market prices on the securities held in the pool have changed.
Larger entities that are able to develop reliable cash flow models may find that they can add even greater incremental returns by extending a portion of their portfolio out along the yield curve.
The imprudent practices of Orange County California left a lasting impression on public funds law throughout the Country. In Texas, the reaction of many entities in 1994 was to move to an extremely conservative investment strategy subjecting them to significant unseen losses in the form of below market earnings. The revised Texas Public Funds Investment Act did intend to restrict the purchase of improper derivative securities, but never intended to discourage the use of familiar and safe investment securities. By expanding permitted investments to include a couple of basic security types, performance can often be enhanced significantly, while simultaneously achieving the diversification requirements of the Act.
It has been over five years since the crisis in Orange County, and it's time for the lingering ghost to fade away.
This article is reprinted with the permission of: First Southwest Asset Management 700 Pacific Avenue, Suite 500 Dallas Texas 75201 (214) 953-4031