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Public Debt and the Art of the Float

Governments need to balance expected returns on their invested cash with the costs of their bonds and other obligations. Shifting a portion of their long-term debt from fixed to floating rate is a way to hedge interest rate risk.

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It’s a cliché we hear from so many political candidates: “Government should be run like a business.” Ironically, the collapse of Silicon Valley Bank and other recent bank debacles confirm that governments do indeed have much to learn from businesses. But in this case, the lessons are what not to do.

The most obvious message to be drawn from these meltdowns is that organizations, whether businesses, not-for-profits or governments, cannot ignore the credit risk of depositing large amounts of uncollateralized cash in seemingly rock-solid banks. The more subtle, yet no less important, lesson is that governments need to carefully and consciously manage their interest rate and related liquidity risks. More specifically, they must appropriately balance expected returns on invested assets with their required payments on bonds and other debts.

For sure, this is a principle that government treasurers and other public finance officers of a certain age need not be taught. They are likely to recall the 1994 bankruptcy of Orange County, Calif. The county, one of the nation’s wealthiest, borrowed short and invested long, which ultimately produced the same financial consequences as those that struck Silicon Valley Bank.

However, there is an interest rate risk-management strategy that is as straightforward as it is effective. It involves nothing more complex than hedging short-term investments with long-term floating rate debt — debt whose interest rate is not fixed but adjusts periodically due to changing market conditions.

Governments acquire investable cash for a variety of reasons, most of which relate to anticipated timing differences between the dates of inflow and required outflow. The sums can be substantial, as they can include, for example, proceeds of bonds issued to fund construction projects or tax revenue received at the start of a year to cover expenditures throughout the year. Rather than simply parking the cash in bank accounts, they typically invest it in short-term securities so as to earn a somewhat greater return than they could with a bank deposit.

However, as with any investment, there is risk: As interest rates rise, short-term investment returns increase; as they fall, those returns decrease. Insofar as the investments are short term and can be expected to be held to maturity, declines in earned interest will not be offset by corresponding increases in market value. To the extent that the investments are substantial, declines in investment returns can put big holes in government budgets.

If governments had offsetting short-term floating rate obligations on which they incurred interest costs, then their interest rate risk would be hedged; any declines in interest revenues would be offset by declines in interest expenses. However, few governments have significant short-term floating rate liabilities. The overwhelming amount of interest costs they incur are tied to long-term, fixed-rate bonds. Thus, owing to the imbalance between short-term assets and liabilities, they may be incurring substantial interest rate risk.

To mitigate this risk, governments could — and indeed should — shift a portion of their long-term debt from fixed to floating. The amount should be approximately equal to the sum they have in short-term investments. In that way, any increases or decreases in interest returns on those investments would be matched by comparable changes in their interest payments on their floating rate debt.

Certainly in the current environment, with high interest rates and an inverted yield curve, governments are seemingly better off with an unhedged balance sheet. They are earning high returns on their short-term assets while paying low-interest, locked-in rates on their long-term bonds. Still, the laws of gravity are inviolable: What goes up must come down. Besides, governments should not be speculators, and most well-managed governments would be willing to accept smaller returns in periods of rising interest rates in exchange for decreases in their net earnings volatility.

In fact, if as many analysts believe short-term interest rates may soon approach their peak, now might be an especially propitious time for governments to add floating rate debt to their bond portfolios. Moreover, an economic recession, which some analysts are also predicting, is typically associated with declining short-term interest rates. In such an environment, when government resources are likely to be especially constrained, a hedged balance sheet becomes even more beneficial to public-sector entities as their investment-return declines are offset by reduced interest costs on their debt.

Using floating rate debt to hedge short-term assets is not some academic, but impractical, strategy. The commonwealth of Massachusetts estimated that its unmatched asset-liability portfolio cost it over $1 billion between 2004 and 2014. To address this loss, it planned to sell $3.6 billion in floating rate debt for capital projects between 2015 and 2018.

Public finance officials have not been giving the risk of declining short-term interest rates the attention that it deserves. Perhaps that is because they see the magnitude of losses as small compared to other risks. However, as the late U.S. Sen. Everett Dirksen might have put it, “A few basis points here, a few basis points there, and pretty soon you’re talking real money.” Or maybe it is because they are unaware of the opportunities to mitigate that risk presented by adopting a floating rate approach. If so, then by calling attention to interest rate risk Silicon Valley Bank’s misfortune may, for state and local governments, be an unintended but constructive consequence.

Martin J. Luby is an associate professor in the Lyndon B. Johnson School of Public Affairs at the University of Texas, Austin. Michael H. Granof is an emeritus professor of accounting in the university's McCombs School of Business.

Governing’s opinion columns reflect the views of their authors and not necessarily those of Governing’s editors or management.
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