Investing Public Cash in a 0% Market
Searching for incremental yields?
The events of 2008 reminded every public cash manager that investing short-term funds is all about safety, liquidity and yield, in that order. Those who got too cute in the last market cycle were burned severely by bankruptcies and frozen funds. What worked for decades suddenly unraveled. For example, securities lending became a dirty word as assets out on loan were frozen for various reasons in 2008. Unsecured and uncollateralized investments that once provided attractive extra yields now cause more worry than they are worth for many public officials.
Now that the Fed has cut the target rate for overnight funds to near-zero, the challenge facing cash managers is how to produce any kind of positive return on taxpayer funds. They find themselves falling short of revenue estimates in budgets that were adopted a year ago when interest rates were higher. So there is intense pressure to pick up additional yield somewhere, in a world where that seems to imply greater risk at every turn.
Here are a few thoughts to guide the search for incremental yields in 2009:
1. Look for market inefficiencies and market segmentation. As my column on TLGP guaranteed corporate obligations last month explained , the new world order in the debt markets has introduced new instruments that enjoy full government guarantees but have not cleared the legal approvals needed in some states because of obsolete or over-specific investment statutes. This offers an opportunity to investors who have done their homework and obtained sufficient legal clearances.
2. Extend maturities with ultra-caution. In 2009, there will be a strong temptation to extend maturities into 2011 and beyond in order to climb up the yield curve and obtain slightly higher rates. That worked in 2008 as interest rates were still trending downward, but this coming year could bring a different scenario after the economy enters a recovery mode. My historical research for my book Investing Public Funds found that rates in the intermediate maturities typically don't begin to move upward too rapidly until the economy is already six months into its recovery, but that won't help you if you are locked in to 5-year paper when interest rates hit rock-bottom. Don't try to "ride the yield curve" once the wind is against you, which becomes increasingly probable once the malaise ends.
Even a two-year Treasury note can lose more in principal price if interest rates go up even a fraction of its current yield advantage, so it's essential that you conduct a break-even analysis to determine how much higher rates must go up before you will be defending your job.
Those who buy longer maturities in the U.S. Treasury sector are really just borrowing from next year's yields to earn higher returns now. Only extend maturities when you are clearly being paid to give up your liquidity and to assume greater market risk, even if you can afford to hold to maturity.
Some savvy public-sector and institutional money managers are running portfolio durations below their normal target, reflecting a concern that they have more to lose from extending durations than they have to gain.
3. Bank CD platforms can work for you. With the increase in FDIC insurance from $100,000 to $250,000, it is now feasible for bank CD services to assemble and quote you competitive "packages" or "mini-portfolios" of fully insured bank certificates. Rather than bidding these out yourself to a limited list of banks, you can work with one or more public-sector investment providers who screen the banks for credit, shop the market and deliver to you a portfolio package of FDIC obligations with maturities of your choice. As with any other "brokerage" business (such as GIC brokers and mortgage brokers of yore), it's prudent to avoid the tiny fly-by-night shops that can fold their tent overnight at the first sign of a lawsuit. Stick with institutional players with deeper roots in the community.
4. Use professional managers for corporate paper. With interest rates so low, some public officials are reluctant to pay fees to private-sector investment managers in order to earn the lowest returns of their lifetime. At the same time, however, this past year's flight to quality has driven many public officials in eligible states to abandon the unsecured commercial paper and medium-term corporate note markets. This is prudent at their personal level, as very few public cash managers and treasurers have research skills or staffs deep enough to perform professional credit analysis. As a result, the buy-side's high risk aversion has created a place in 2009's market for experienced money managers with superior credit research facilities to assemble broadly diversified portfolios of highest-grade corporate paper that will earn several times their fees, while allowing their clients to sleep at night.
5. Ask tough questions of money managers. Last year separated the "wannabes" from the prudent treasury/cash management firms with deep, skilled research teams. It is now important and reasonable to ask both incumbent and potential investment managers to disclose and document specifically their experiences with defaulted, bankrupt, insolvent, impaired and other zombie credits in the past two years. If they held Lehman paper after the collapse of Bear Stearns, for example, you really need to ask yourself why you would entrust your taxpayers' money to their credit team.