Recessions are nasty creatures. They deprive states and local governments of vital revenues just when the demands for social services increase. For those who typically receive a hefty income from investment interest on their cash, recessions are even nastier: The available cash dwindles as reserves are spent to avoid layoffs. Meanwhile, interest rates plummet, as they always do in a recession.
As the national economy crawls back from the Great Recession, state and local government treasurers and cash managers are scrambling to earn every penny possible on their operating cash balances. Every dollar they earn helps keep a budget in balance--a budget that may have been adopted when interest rates were higher and expectations on earnings greater. This creates a huge dilemma, because in many cases, the only way to bring in a higher yield may be to take unwanted risks in the investment markets. Like Odysseus, they must navigate the equally dangerous hazards of Scylla and Charybdis--or their financial equivalents.
Here's why: Almost all state and local governments can invest their cash in federal government and agency debt securities, usually without limitation as to maturity. In today's ultra-low interest-rate environment, the "yield curve" is very steep--which means that longer-term investments pay a lot more than short-term, liquid securities such as U.S. Treasury bills or money market funds.
To get the higher yields, some treasurers are making investments in government securities that must be held for as long as five or more years. The problem here is twofold: If they hold the investments to maturity, there is a good chance that interest rates at that point will be higher than today's. In that case, the portfolio's actual returns will then be less than the short-term market is offering. If inflation returns, it will be even worse because the purchasing power of the long-term investments will erode. To swap them for other securities, treasurers may have to lose principal.
A second risk lies in the availability of corporate commercial paper and medium-term corporate notes (short-term bonds maturing in two to five years) and uncollateralized bank deposits. Although most states require these investments to be the highest-rated in the market, there are too many cases of defaulted or near-defaulted corporate paper in the past year to allow policy makers to sleep at night. Municipalities in several states held debt from Lehman Brothers, Washington Mutual or other highly regarded but now-defunct issuers. As the economy recovers, we would hope to see fewer of these problems. But the risk of a "W" shaped recession, one with a double-dip, still remains, and some companies will undoubtedly be downgraded, which means that their paper may have to be sold at a loss.
Elected officials should be monitoring all these investment activities in the coming year. Although the worst of the recession is behind us, big risks still menace the investment program. Interest-rate risk affects almost everybody, and default or downgrade risk is a worry during any period of high economic uncertainty. Increasingly, local governments are hiring professional money managers with experience in these market situations. That buys extra peace of mind. But those who hold elective office still need to look over their shoulders to see how the downside risks are being handled in today's market.
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