By Linda Patterson
Smaller governmental entities have a unique set of needs and requirements in their investment portfolios. Unlike larger entities with investment staffs, advanced technology and a core portfolio of longer term funds, small entities face a number of difficulties. Internally, the smaller entity often does not have staff who can spend extended time working solely on the investment portfolio. Traditionally, the smaller entity's governing board is extremely conservative and risk adverse and the portfolio is closely tied to the banking contract. Additionally, the securities market (the "street") prefers large dollar trades which leave smaller entities with less attractive price levels. These barriers can be discouraging for a smaller entity which wants to be just as "state-of-the-market" and needs the incremental income of a producing portfolio as much as any size government.
It often seems that large entities conduct a completely different kind of investment program from smaller entities and work in a completely different market. The larger entities often do have access to longer maturities because of bond funds or reserves. However, underlying fundamentals and investment processes used by the largest portfolios are also available to the smallest of portfolios. We simply have to learn the rules, evaluate what alternatives are appropriate, and build on those fundamentals to form practical strategies.
What Makes a Small Entity's Investments Unique?
The smaller entity's unique needs and limitations are primarily a function of cash flow needs and market access. A small entity normally does not have substantial excess funds which can be extended out the yield curve and thereby earn the extra yield afforded those who can take that risk of extension. If budgets and fund balances are normally spent within a single fiscal year, the smaller entity must assure that dwindling funds are available for cash flow needs. Liquidity becomes foremost in importance and vies, with safety, for first priority in your investment objectives. These two factors should normally limit the smaller entity to investment options within a one year or eighteen month investment horizon.
The need for liquidity must be the over-riding consideration of small entities. No entity can afford to lose its ability to pay creditors. As a result, cash flow analysis becomes the first step in building a portfolio. A cash flow analysis will determine the amount of funds necessary in the general time frame. The cash flow may also identify "core" funds which will not be needed within the normal one year time frame and thus can be extended (in a normal yield curve environment) for additional yield.
There are other factors which make a smaller entity unique for investment purposes. Staff resources are often limited by inadequate training or use of a small staff for a multitude of other responsibilities. In addition, the pace of the bond market and the variety of influences on it, make access to market information and investment technology crucial. No portfolio can be expected to take full advantage of market potential unless the investor has access to the necessary data and time to make appropriate and accurate decisions on that information.
With the downsizing in many large brokerage firms, a small entity does not always receive the attention given to larger accounts. Small regional brokerage firms usually do not trade in large block size and do not purchase securities on a regular basis so coverage may be limited. This can be a detriment, but, need not be. Small entities can receive the same level of quality coverage from primary and regional brokers if they take the time to learn about the products they are allowed to buy and build a relationship with several brokers who cover small accounts. Therefore, it is imperative that smaller entities use at least three reputable broker/dealers in insure that they receive balanced and accurate market bids (sale price) and offers (purchase price). Smaller entities, like any entity, should set compliance requirements for brokers, check references with your peers, take three bids/offers, and always get full information.
Fundamental investing guidelines and techniques fit large and small entities. Although larger entities have more dollars to invest and, sometimes, more security options available to them, the fundamentals guiding those investments are same for any size portfolio. We have to learn those fundamentals and modify them to meet a smaller entity's needs and limitations.
Most of the fundamentals of investing apply to both large and small entities and represent common sense and common practice. It is important to remember not to get caught up in the technical aspects of trading or portfolio structuring and forget these fundamentals. One example of this is the old axiom "If it sounds too good to be true, it is!" No investor can afford to forget this or the other fundamentals that keep safety and liquidity our most important objectives.
Nothing is free!
When it comes to investments or banking it is critical to remember that every firm must make its reasonable profit. Banking services are never "free". The rates you receive on other services or interest rates on CDs will reflect the cost. By same instance, a money manager who offers to manage your funds without charge makes his money on the mark-up. Brokers who offer to safekeep your securities or provide "soft-dollar" services free receive their mark-up on the trade also. Remember the only way to pay for anything with public funds is by competitive bid.
Diversification in all things!
Requirements for diversification inculcate all aspects of investing. This goes back to the old saying that you should not put all your eggs in one basket. Diversification in the types of securities you own will protect your entity from credit risk or major changes in one type of security. Diversification by maturity is important to assure that you have liabilities covered in preparation for a change in market direction. Diversification in brokers is also critical. You should never depend exclusively on a single broker. Regardless of how good that broker is, he is dependent on one economist and one trading desk. Using several brokers will assure that you see value from several different sources. Always get three bids or offers.
An Investment Policy is Paramount in Importance!
Before you do any investing you should have an investment policy approved by your governing body. Your policy establishes the objectives and limitations of your investing activities and protects you the investor. The policy will guide your all activities.
Create a cash flow foundation!
It is impossible to determine what investments need to be made without a solid cash flow analysis. Cash flow analyses need not be complicated or time consuming. Your general ledger and bank statements will provide all the details and data you need to put a history of revenue and expenditure cash flows together. The time you spend will reward you by allowing you to stretch out slightly further on the yield curve. You may even identify a "core" portfolio of money that can be extended beyond your one year horizon.
Pricing Your Portfolio is a Must!
Since many portfolios holding derivatives lost significant market value in 1994 as rates increased, market value has become a more visible concern to governing bodies. An investor must know the portfolio's worth even if securities were bought with the intent to hold to maturity. Marking-to-market a portfolio simply means assigning a market price to each security based on independent and accurate prices. One easy way method is to stay with securities that can be priced from the Wall Street Journal. If you use brokerage firms be sure to receive two prices and, on difficult to price securities, never use the firm that sold you the security as the sole source for the price quote.
Delivery versus Payment (DVP)!
Perhaps one of the most important safety requirements is DVP. You must always have access and control over all of your assets or your cash. You must clear every trade DVP which assures that your independent clearing agent has control at all times for you.
Safekeeping by a contracted, independent third party will assure that you know where your securities are and that they are clearly marked as to your ownership. Never allow brokers to safekeep for you. The ownership of the securities becomes blurred on a bankruptcy or interruption of service. Pay a bank or trust company. It is well worth the cost.
Don't Buy Bonds that will Mature after You Do!
It is a good rule to always buy bonds and other securities as if you can hold them to maturity. Although sometimes it looks like a 'sure thing' that you can sell a security at a future date, if you can not sell it without a dollar loss you must be able to hold that security without creating a liquidity crisis.
Banking and Investing are Two Separate Processes!
For many years, public entities relied on bank contracts to form the basis of their investment strategy. The markets have become much more sophisticated and alternatives much too attractive to do so now. Do not tie your investing options to your banking contract by setting a rate on CDs, etc. Let your bank know that you will include them in competitive bids as you look for relative value.
When in Doubt - Don't!
The market moves quickly and is very inventive. New products and terms are constantly popping up. It is safest to stay with what you know and slowly work on learning more.
Investment Alternatives for the Small Entity
As a smaller entity you may think that you do not have many investment alternatives. On the contrary, even with strict state laws and local policies, you have many options which offer value. Here we have chosen those investment alternatives that are most representative of what is available to small entities within strict safety and liquidity guidelines. The public investor has to look at each of these alternatives first to determine the advantages and disadvantages of each. Only by looking at all characteristics of an investment type can you be sure you are making valid comparisons on yield.
This article will not define each security or look at each of its technical aspects. That information is readily available and should be read and understood before you purchase any of the choices. Instead we will focus on some of the major factors that affect that alternative's value to a small portfolio.
There is a general fallacy that a U.S. government guarantee is a synonym for totally risk free investing. Market prices change with everything from market conditions and currency swings to wars and weather. In the fixed income market, rates and prices change inversely. (Prices up mean rates down.) Since Treasury Bills (Bills) by definition no longer than one year, fluctuating rates have only a limited effect. But a 50 basis point swing on a $1 million 1 year Bill results in a change in market value of approximately $4,500 and may affect your ability to sell it at breakeven or better. The government guarantee holds only if the Bill is held to maturity. Despite this reality in market changes, the Bill remains the staple of short term investing for small investors. They are guaranteed, they may rise in value to allow profit taking, and they are the most liquid market in the world.
Many larger investors actually use Bills as a cash equivalent because of this liquidity. This type trading causes what we call an active "secondary market" for the Bills where you can always find a buyer. (Just remember it may not be at your price.)
The short end of a normally shaped treasury yield curve is steeply upward sloping. Since Bills constitute the short end of the treasury yield curve they have the natural effect of "rolling down the curve" which is very beneficial to the small investor. (See next section on investment strategies.)
The ability to buy directly from the Treasury is often touted as a benefit of Bills. Although you can buy from the Treasury the auction process is cumbersome. Because of the size and efficiency of this market, it is just as effective - and easier - to buy from a broker after three offers are received.
Agency Discount Notes
Agency discount notes ('discos") are nearly as liquid as Bills. In addition, discount notes can be bought with differing maturity dates. The agency will "post" discount notes for a range of dates not only specific dates like the Bills. The yield advantage to agency discount notes is based primarily on a credit quality issue. An agency has the backing of the U.S. Government. (An instrumentality is a government sponsored corporation.) Theoretically, the credit quality does not equal that of a Bill or Treasury Note which creates credit risk. Since risk is reflected in increased yield, the agency should pay the investor for increased risk. The difference between the Bill yield and the agency is called "spread". The credit risk is always there so we would expect a spread over the comparable Bill.
Spreads will vary considerably given market conditions but a general rule of thumb is that there should be a spread over the comparable Bill. Watch for legitimate spread claims. In an inverted curve (short maturities are the highest yields) a salesman will often say "these offer a great spread of 22+ to the Bill". What he doesn't say is that the shorter bills or cash are even a better buy. You have to check where all the relative value is on the curve not just your maturity range!
Short Treasury and Agency Notes
Notes, by definition, change from one year to ten years in maturity and carry a semi-annual fixed coupon. Older notes then fall into the maturity range appropriate for smaller portfolios. They carry the same credit quality and often provide good value. However, in evaluating notes remember that, unlike Bills and 'discos' the coupon notes can be priced at either a discount or premium. The premium will have to be amortized to reflect its true book value.
Certificates of Deposit
CDs were a staple of small investors for many years. In most states these are collateralized by government notes and bonds. The primary advantage of CDs is their flexibility on maturity dates and size. However, the primary disadvantage is their illiquidity. If you need the funds before maturity there is no secondary market. You will have to pay a normal 25% penalty rate to get your money.
'Repo' is the mainstay of the large investor's short term investing. It is a multi-trillion dollar daily market that provides liquidity and funding to "the street". Repo is a very safe alternative that allows you to invest odd amounts of money overnight. It can be easily done with a primary dealer or a bank. It is not recommended that repo be done with any other type counterparty. And, always, when doing repo make sure the (PSA) Master Repurchase Agreement is in place that defines the agreement and transaction completely.
If your funds are "swept" overnight by your bank they are probably using repo or a money fund as the investment vehicle. Moving large pieces of collateral makes the transaction more cost efficient for larger investors. The collateral transfer costs may be cost prohibitive for small entities. The smaller investor has access to the repo market however through two new innovations. Many primary broker/dealer firms offer tri-party repo. In this arrangement the collateral is held by a large money center, independent, third-party bank. It has the same guarantee as regular repo but avoids the collateral transfer costs. In addition, some firms have small user repo programs using a modified tri-party agreement. The small entity calls in on a PC and invests small amounts of money for one day or several days at a set rate. The firm combines all these small amounts and enters the repo market as a large player but assigns collateral individually.
There are no real disadvantages to repo in supplementing your marketable securities, but, you must be careful to have an Master Agreement in place and have your collateral priced.
Investment Pools and Mutual Funds
Pools and funds offer great liquidity and flexibility to the small investor. It is critical however to know everything about the pool or fund you use because their investments should parallel what you have in your own policy. Local pools probably assure you of better control and stability because of their local board of participants and better familiarity with what local entities want and need.
A crucial point with pools and funds is to understand the two types of funds available and how to use them for investments. The first type, the constant dollar funds, are designed for liquidity. In this type the net asset value (NAV) is kept at a constant $1 value. Unrecognized gains and losses are not calculated into the NAV. As a result, the value is quoted as yield and the interest accumulates. These are normally stable and have great liquidity because they are relatively short in weighted average maturity (WAM). These types are perfect for liquid funds. They will not fluctuate greatly and most now have protection in place which will assure that action is taken by the manager if the NAV market value drops below a certain level.
The second type pool or fund has a fluctuating NAV. In this type the net asset value fluctuates as unrecognized gains and losses are calculated into the value of the shares. As market values change daily the value of your shares can swing greatly. The portfolios are typically longer and therefore more volatile. They are not kept liquid because their goal is yield. This means if you buy shares at $10/share you can quickly own shares worth, for example, either $15+ or $5. Obviously, these types of pools or funds are not intended for liquid money. Smaller entities who use fluctuating NAV pools or funds must realize that these should be bought and sold like securities. If you have a specific liability to fund, about six months before that liability date you should start watching the NAV and withdraw at a comfortable level. Otherwise you may incur a loss when the funds are needed.
Commercial paper (CP) is an alternative available to some smaller investors. It is highly liquid and normally offers a spread above the comparable treasuries because of the credit risk involved. That credit risk can be minimized by only buying short CP (it can only extend to 270 days maximum) and by requiring the highest rating. A rating of A-1/P-1 will rarely change in such a short period. Just remember to diversify your holdings and not limit the portfolio to only one issuer.
After preparing your cash flow, reviewing the fundamentals and choosing the appropriate and acceptable investments for your portfolio, you are ready to create your portfolio. Most small entities should construct their portfolio so that the investments, at least one year out match their liabilities.
An easy tool for daily use with your investing is a simple calendar. Mark the calendar with every payroll, debt service and other major liabilities on the date due in red. Your cash flow analysis will then tell you what general amounts in payables you will need on a weekly basis to supplement the larger scheduled liabilities. As securities are purchased, mark the maturity amount in black on the maturity date. At a quick glance you can see each liability being loosely matched to an investment.
- Laddering a Portfolio
The process of buying securities spaced out equally across time is called laddering. It is a very passive and defensive method. As securities mature they are reinvested on the longest maturities of the range thereby receiving the highest yields. This will not necessarily match your cash flow. (This should not be used in an inverted curve environment where short rates are higher than long ones.)
We refine this process by matching a series of liabilities for a liability ladder. The liability ladder accurately addresses funding issues and provides a better safety net for funding. In addition, the investments are chosen not because they are equally spaced (like using every Bill) but because they represent value in that time period. The calendar does not have to be filled in in maturity order. Once funds are matched or available (from a pool for instance) for the next six months, if there is value in the six month maturity and you need funds there, buy it. If there is value in eight months next, buy that.
In this strategy, we do not fund to the exact date of the liability. If a payroll is payable on July 10th, the security you buy to fund it can mature several days or a week before that date. We have discussed several liquid options, like repo, pools and money funds, which then can be used until the date of the liability.
Where is the value if you need funds in eight or 10 months in this example?
2 mo. 4 mo. 6 mo. 8 mo. 10 mo. 12 mo. 5.0 5.2 5.4 5.8 5.9 6.0
The value is in the eight month area because of the jump from 5.4 to 5.8 not 5.8 to 6.0.
The laddered portfolio is much safer than another portfolio strategy called the barbell. Smaller entities should rarely use the barbell method because it can seriously impair liquidity during rate changes and it demands much more active investing. A barbell concentrates the securities in two points: the long and short ends of the maturity range available, i.e. placing half in cash and half in the one year Bill. This structure is designed to gain from liquidity and the higher, longer yields. It usually produces higher yields. However, if the rates rise you may not be able to liquidate your longer maturities for funding purposes.
- Finding Relative Value - Shopping the Yield Curve
The process of finding relative value is straightforward but requires effort by the investor. Every time an investment is made the investor looks for relative value. First, if we do not have a specific maturity need, we must identify where value is on the curve. Second, if a specific liability must be funded, we must look for value in that maturity range.
As a first step, a small entity (with a one year portfolio horizon) should always be aware of the Bill yields. Check the Wall Street Journal to determine at least the "current" 3, 6 and 12 month yields. This is the standard against which you will judge value. If other securities do not offer a spread over these yields they do not represent value. (An investor with greater access to market information would then look at the historical spreads against the bills to determine historic value.) You will see value at this time point only, which is sufficient.
3 mo. 6 mo. 12 mo. Curve #1 5.68 5.62 5.54 Value is 3 month Curve #2 5.68 5.80 5.75 Value is 6 month
Once the value points are identified, you examine your own portfolio and cash flow to see when funds are needed. If, in curve #2, you need funds around the six month area, you know the rate to beat is 5.80%. Now, you can look at other options and comparison shop. If we have the following in the six month area you buy the six month Bill because the spread is not sufficient for the risk on CP.
Discount Notes yielding 5.82% CP yielding 5.85% Money Fund yielding 5.80% Pool yielding 5.85%
Now you must take a general position on the direction of rates in six months. If you believe rates will rise significantly during that time you would probably go to the pool and ride the rates up. If rates are expected to drop you would want to lock in the Bill or discount note.
This process of researching what is available, comparing it against the Bills and making a general rate call will be repeated every time you make an investment decision.
- Riding the Yield Curve
The idea of "riding the curve" on a positively sloped curve is to increase returns. You buy a security out on the shoulder of the curve and hold it until it can be sold at a gain because it's current maturity and yield has decreased (prices increased). This strategy is not fool safe because it assumes that short rates won't rise. It also assumes that you are able to sell positions for a profit.
Shopping Tips for Shopping the Yield Curve
There are certain tips that help you identify value and take advantage of "blue light specials" in the marketplace.
Good Days and Bad Days
Because they are date dependent, securities sometimes mature on a weekend or holiday. You will not have the funds to invest so you should be compensated (roughly equal to the interest lost for those days) with addition yield for the days lost. Check your calendar beforehand!
Holding Current Coupons
"Current coupons" are the most recently auctioned treasuries. These have the most value to portfolios because they are the most actively traded. Chose the "current" when it is value. These will also earn higher spread in securities lending programs.
Capturing Liquidity Premiums
Short term investors often can not extend at all so they look for value within their time horizon. This creates a liquidity premium. If you extend slightly with "core" funds longer than your normal maturity horizon, you can buy slightly longer (a 2 year) and hold the security until its value increases (at 1 year) because of its value to liquidity investors at that time. This is an active strategy and requires active investing with longer bonds. For smaller entities however, Bills also sometimes gain a liquidity premium effect within three months so a one year may become more expensive at 3 months and allow a sale at a profit.
All treasuries trade in a "when issued (WI) period". This is the period between their auction announcement and settlement. A more active strategy involves buying and selling in the WI before settlement without paying for the trade. Be prepared to pay if you can not sell it!
Round Lots and Odd Lots
Securities are normally sold in round lots (Bills $1mm) for trading purposes. If you plan to sell the bonds it is best to stay with a round number. Since the market likes round lots, an occasional "odd lot" will be offered with additional value if you plan to hold it.
When Spreads Do Not Represent Value
Very often, "specials" in discount notes or bills or term repo will occur which represent an aberration on the curve and outstanding value. These must be measured against the Bills. However, if you have an inverted curve a 20+ spread on a below value Bill still does not represent value! Check carefully.
A swap results from selling a security you own and buying another with higher yield or better cash flow. It uses the value accumulating in your portfolio. This is a more active strategy than most small entities will use because it requires that you know the book and market value of your securities and requires a solid analysis. Both the yield and the financial impact of a swap must be analyzed. A short example is shown below.
Sell T-Note 5.5% 4/30/96 for 5.56%
@ 99.30 (book is 99.30)
Buy T-Note 7.375% 5/15/96 for 5.56%
This looks like a good swap moving out at breakeven and into a higher coupon but..
- Proceeds will not allow you to buy as much face of the 7.375%.
- At maturity, you receive less money on the buy side. Here it is a 2 bp "give-up".
Swapping can increase your returns but like all strategies and investment you must have full information and if you can't explain it - don't do it.
As a small investor, you still have options available to you to increase the earnings on your portfolio. The underlying fundamentals and investment processes used by all portfolios are available to the smallest of portfolios. We simply have to learn the rules, evaluate what alternatives are appropriate, and build on those fundamentals to form practical strategies.
This article is reprinted with the permission of:
Patterson and Associates
301 Congress Avenue, Suite 570
Austin, Texas 78701
(512) 320-5042 or 1-800-817-2442