Making Money in a Zero-Yield Market
Find the silver lining in 2011's low-rate world.
As if a stagnant economy, sloggy tax revenues and roller-coaster stock markets were not enough, low interest rates are driving public managers, budget officers and treasurers crazy. What once was a major source of state and local budgetary revenue — investment income — has now been shrunk to insignificant levels by the near-zero rates public investors get for short-term cash. Pension funds can no longer count on government bonds to secure 5 percent long-term yields, and individual investors have watched their money market funds pay so little that some don't even get a 1099 form to file for dividend income.
While I can't spin gold from lead, this column can help you make some lemonade amid this grove of lemons. Here are nine very specific suggestions for getting the most for your taxpayers and employees' money:
- Fine-tune your cash forecast
- Harvest profits on short-term Treasurys
- Think about Benefits Bonds (pensions and OPEB funding)
- Review fees: Less is more
- Revisit stable-value funds in deferred compensation plans
- Explore FDIC-insured bank CDs and CDARS
- Think twice about "callables"
- Manage higher-yield paper professionally
- Refinance existing debt at lower rates
Fine-tune your cash forecast. Public treasurers and cash managers need better information than most of them receive from other department heads, on when budgeted money will be spent. Without that vital information, they are often compelled to keep money too liquid, in the lowest-yielding investments. Excess liquidity in today's low-yield markets is one of the more costly investment problems facing some municipalities today. By explaining the extra income that can be gleaned from still-safe but longer-maturity investments, public investors can help their colleagues squeeze extra revenue from the working capital. It sure beats layoffs and pay freezes.
Harvest your profits on short-term Treasury notes. Many public investors "buy and hold" their investment portfolios. For financial professionals with myriad responsibilities, that is a sensible general strategy, and a "laddered portfolio" has many virtues. But in today's market, those unmatured Treasury notes you bought a year or two ago have already earned almost all they ever will. You can trade them in now at a price near par, and reinvest the proceeds elsewhere for a higher yield. If you live in a state with a well run investment pool, or participate in a local government investment pool, you may be able to find better yields on equally liquid investments. And if your cash forecast (above) shows you can invest longer, the returns available for investments beyond two years are definitely higher than what you'll earn by holding on to the short stuff. Don't duplicate liquidity: it costs you dearly. The "bid yield" is what you give up in order to trade your holdings for something better.
Start thinking about "Benefits Bonds." As the economic recovery struggles to maintain upward momentum, it's probably still premature to begin issuing taxable municipal bonds to pay off pension and retiree medical obligations, but that time may yet come in the next 12 months. Low interest rates have made the borrowing side of the strategy workable for many employers. The question now is whether the stock market is ripe enough. I've written on this subject before, so you can simply reference the prior column. As you'll see if you study my earlier research, the time to issue bonds to make long-term investments for retirement benefits plans is usually during a recession, and we're not there. There's perhaps a 50-50 chance that a double-dip is coming, in which case this strategy will be obvious to those with the statutory power and the fortitude to sell cheap debt and buy cheap stocks. But timing is everything, as my research clearly shows. The window last closed in late 2009 and issuers have remained on the sidelines with good reason. As I noted in 2010, a double-dip recession (or scare) would be a preferable time to issue. I'll say more about this in the future if the timing seems right. For now, however, savvy finance officers can begin discussing this idea with their advisors and elected officials as a potential strategy to save major bucks in the long run.
Another, lower-risk, variation on this theme is the award-winning strategy used by the city of Beverly Hills, Calif., which sold taxable notes at a low rate to buy out employees' vested retiree medical benefits on a voluntary basis, giving workers a combination of retiree health savings accounts, deferred compensation and a partial cash option. Nearly 60 percent of employees took the deal. The city saved millions, gave employees a benefit plan they preferred, and reduced taxpayers' exposure to long-term investment risks.
One caveat that has emerged since my earlier writings: In some states, the legal obligations of public employers to pay for previously promised retiree medical benefits has been eroded in court. Before you turn a "soft debt" into a "hard debt" you will want to verify that you have already cut or at least trimmed the size of your obligations as much as possible. That can be done through revisions in plan design, collective bargaining, or litigation. Then if borrowing is used to finance the plan more cheaply, you'll get a better deal in the financial markets as investors will see that you've done your homework — unlike Uncle Sam who just keeps borrowing more without addressing the underlying costs of our national retirement plans.
Fees count: Less is more. Many individuals have learned the hard way that commercial money market mutual funds are paying near zero because their advisors' fees have eaten up the meager portfolio income. Frugal public treasurers typically use institutional money market funds which usually charge lower fees. In bank trustee accounts (e.g., bond proceeds and debt reserves), it is not uncommon for some banks to employ a higher-fee money market fund that pays the bank a richer compensation level than a lower-fee institutional fund. In deferred compensation plans, a similar tendency by some third-party administrators to use higher-fee retail mutual funds has led to negative investment returns, and it is time to replace them with lower-fee institutional money market funds. It pays to shop around for lower-fee products, especially when the investment income on the underlying investments is so low. The decision by the Bank of New York Mellon to charge large institutions a 13 basis point (0.13 percent) fee for just keeping money in the bank account — to defray FDIC fees — should be a wake-up call to everybody that cash yields can actually go negative after fees.
In deferred compensation (457 and 403b) plans, now would be a great time to revisit the administrative fees charged by your plan administrators and record-keepers. Competitive pricing continues to trend lower, and you may be able to save your employees some significant money if you put the plan out to bid or at least perform a "price check" on fee levels. A consultant can sometimes help you drive fees lower — enough to pay for the costs of a guided re-procurement. The larger your plan size (total assets) and average participant account balances, the lower your fees should be.
Stable-value funds. In today's low-yield money markets and roller-coaster stock markets, public employees may find the "stable value" funds in their 457 deferred compensation plans a good place to park timid money. These funds may offer significantly higher yields than a money market mutual fund, yields similar to intermediate-term bond funds, and they are designed (not guaranteed) to avoid price fluctuations like a bond fund. Most have pretty good credit quality. So when the day eventually comes when interest rates increase, the product is expected to be less subject to price erosion. Some of today's stable-value funds have a market value in their underlying portfolio that exceeds the current par price of the fund, because assets were purchased previously that trade today at a profit. This surplus provides some additional cushion against future price risks. Investors must ask about several concerns:
- What are the underlying fund fees? How do they compare with the competition?
- What credit ratings do the issuer, underwriter or "wrapper" (guarantor of stable prices) have?
- If the issuer is an insurance company on its own account, is there state-level insurance for retirement investors or is the account uninsured?
- Are there penalties for early withdrawal, multiple withdrawals, or limitations on subsequent transfers to other investments?
Think twice about 'callables.' Many public treasurers who invest on their own are "pitched" callable government securities by their broker/dealers. These instruments typically carry a higher yield than conventional coupon securities, but they can be called away from the owner at the issuer's option. When rates decline, or even as the securities mature and lower yields are available on shorter maturities, the issuer will usually call them. Thus, the investor foregoes the higher coupon income that could have been locked in. It is noteworthy that professional investors who trade actively will typically buy callables far less frequently than many part-time buy-and-hold investors who do not understand the fair market value of the embedded option. Often they know or see something the naïve buyers don't. In a low-rate environment, callables can sometimes be a mirage. If the economy double-dips into a secondary recession, this would be one of the risks of these securities. Also, if you wonder why brokers like to sell these securities, remember that they get either an issuer's commission or a secondary markup every time you re-invest called paper in another callable. The more calls, the more they make.
Revisit FDIC bank CDs. Banks in some, but only some, states have become more aggressive in seeking public funds to fund their loan portfolios. There are also CDARS and other platforms to acquire "bundled" FDIC insured bank deposits. Just be sure you understand your legal authority, the insurance guarantees, and the liquidity and marketability of your investments.
Manage higher-yield paper professionally. With "risk-free" paper paying zero, public treasurers are looking for ways to earn higher returns. That typically requires taking one of two kinds of risks: maturity (price) risk or credit risk. For the next two years, the federal reserve has essentially removed maturity risk for paper within that range, but higher yields are only available on longer maturities that stretch further out the yield curve. Maturities beyond two years clearly have price risk to manage if rates later rebound. On the credit side, commercial paper or corporate notes can be purchased by public investors in some states, but this often requires prudent professional credit analysis that is often beyond the skill sets and research capacity of municipal officials. Fortunately, that skill can be rented from money management firms that perform independent credit evaluations as they manage public portfolios. It may be worth spending 5 to 10 basis points (depending on portfolio size) to hire full-time professionals who can manage both market and credit risk in the pursuit of higher yields. If they don't quickly earn their fee, you can dump them on short notice.
Refinance debt at lower rates. Finally, nobody should overlook the obvious opportunity to advance refund or call-refund outstanding bonds and notes by issuing replacement paper at lower yields. It's similar to refinancing your home mortgage at a lower rate. Most states and municipalities have already pulled this trigger (you only get one shot) but some issuers have refundable paper outstanding. A muni-bond financial advisor can help you sort through the potential savings which requires a present value analysis of the costs of re-issuance vs the future interest reductions. Interestingly, some smaller deals are getting done with direct bank loans, as they look harder for uses of their nearly-zero-interest deposits.
Disclaimer: Girard Miller's comments, suggestions and views herein are his own general opinions and do not constitute specific investment advice nor an offer to buy or sell securities. His independent views do not necessarily reflect those of any organization with which he was or is presently affiliated, including his employer PFM Asset Management LLC.
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