Putting a Price on Portfolio Safety

Is your attitude toward risk penny-wise and pound foolish?
September 17, 2009 AT 3:00 AM
Girard Miller
By Girard Miller  |  columnist
Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

No other maxim in governmental finance is as widely repeated -- and yet as often ignored -- as "SLY," the public cash-management mantra of "Safety first, then Liquidity, then Yield."

Ask any treasurer or public cash manager how their portfolio has performed, and the most common response you'll get is the yield they earned. Public finance professionals can't brag much about how they avoided losses and preserved principal. They seldom talk about how they maintain sufficient liquidity to pay bills even if the financial markets melt down. That's because they want to show the income (yield) they received in order to compare it to the cost of running their office or the annual budget for investment earnings.

Newspapers only care about safety and liquidity when it's absent. Elected officials often share the same short-sightedness. Some ambitious professionals likewise want to make a name for themselves by beating their benchmarks and their budgets. After all, in today's recessionary malaise, the extra dollar earned on investments might be the one that avoids laying-off a police officer or a teacher.

Which brings me to the dilemma now facing public officials responsible for cash management portfolios. At the bottom of a recessionary cycle, yields on money-market securities and government notes typically held for short-term investments are always near their lowest levels. Yet, the risks facing portfolio managers at this point in the cycle are the highest, not the lowest. That's because (1) any major increase in interest rates in the future will result in lower bond prices; (2) credit risk haunts the markets (More companies and banks could fail -- or suffer credit downgrades and price losses -- in the first year of a sluggish economic recovery plagued by mounting home foreclosures and lingering corporate over-leverage); and (3) buy-and-hold investors who buy longer maturities to gain yields will probably suffer a loss of purchasing power whenever inflation returns.

The great economist John Maynard Keynes called this point in a Great Recession the "liquidity trap." Short-term interest rates on risk-free securities are nearly zero, but any investment of longer maturity or greater credit risk is unattractive because of inflation or deflation risks. So investors are trapped. To get more yield, they are forced to give up some safety.

Which brings me to the point of this column: What's the price you would ascribe to safety? Is it worth 5 basis points (0.05 percent) of yield? 10 basis points? A hundred basis points (1 percent)? When the financial markets were imploding in 2008 and early 2009, most investors were converts to the Will Rogers attitude: They cared only about the "return of their principal not the return on their principal." But as the economy turns a corner (hopefully) from recession to a slow recovery, I now hear stories about investment committees and treasurers who are no longer focused on the lessons they learned in the Great Recession. My, how quickly we forget -- especially in light of the risks of a 1937-type double dip, or even a 1981-type double dip.

So here's my question: What reduction in yield should you accept in order to achieve safety? And what reduction in yield will you accept in order to enhance safety? Is peace of mind worth 10 or 20 basis points? Is freedom from default risk worth only a quarter-percent of yield? Are portfolio managers-the ones who invested in securities that were later downgraded -- worth hiring, even if their fees are lower? Are professional credit departments worth the fees you pay to gain access to them? Do you even have a qualified professional credit team -- either internally or through your paid advisor?

When I wrote the original 1986 version of "Investing Public Funds," the reference source for language used in many of the investment policies used throughout the country, I suggested the possibility that "occasional measured losses" from a highly diversified portfolio (less than 1 percent per security) could be acceptable if the total portfolio return could still exceed its target. That was back when interest rates were approaching 8 percent and credit risks were lower. It was a period of economic expansion. In today's world, with 0.25 percent overnight interest rates, the game has changed, at least for 2009-10. Portfolios today can seldom generate enough income to offset a capital loss. Yet we still have some money mangers and broker-dealers pushing the "occasional measured losses" idea as if it were the Eleventh Commandment. Well, as the guy who wrote it in the first place 20 years ago, I'm here with Bob Dylan ringing in my mind to announce: "The times, they have a-changed."

To be specific, the exact language in the second edition of "Investing Public Funds," co-authored in 1998 with Corrine Larsen (then of the Government Finance Officers Association), said this: "Investments shall be undertaken in a manner that seeks to ensure the preservation of capital in the overall portfolio. To attain this objective, diversification is required in order that potential losses in the value of individual securities do not exceed the income generated from the remainder of the portfolio."

Think about it. If today's short-term interest rates are one-half of 1 percent, then the total portfolio exposure through risky securities must be less than one-half of 1 percent. That essentially rules out a lot of strategies for smaller portfolios and especially for those that do not monitor credit risk daily. And it surely tells us that taking risks with longer maturities that can lose principal in a rising-rate environment are the highest when short-term interest rates are near zero.

In future columns, I will provide some risk-management techniques and principles to guide those who must navigate these treacherous waters. For today, I'll suggest two very simple and important ones: Don't buy maturities longer than you can afford to hold, and make sure you have broad and granular diversification if you dabble in non-guaranteed securities. With the cost of getting experienced professional help and credit research now less than 10 basis points for many larger public portfolios, it may be prudent to out-source the portfolio risk management function instead of going it alone.