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North Carolina Local Government Investment Association
Winter Meeting – 2013
Investments 101
Presented by :
Lee CarterGary Porter
Capital Management of the Carolinas, LLC
General Requirements (G.S. 159-30)
Moneys may be deposited or invested Finance Officer manages investments Subject to governing board restrictions These are usually in investment policies
Types of securities allowed Approvals for trades Maturity limitations Allowable concentrations
Managed so that cash is available when needed - liquidity
Basic Guidelines
Safety Liquidity Yield Governments should evaluate:
Eligibility under G.S. 159-30(c) Appropriateness
Request prospectus or other information before investing
Depository Accounts
Board must designate official depositories Insured or collateralized as required through G.S. 159-31(b) Financial soundness of institution is the best safety mechanism Deposit placement systems
Authorized in G.S. 159-30(b1) CDARs, Finistar, etc. Deposits in institutions up to insurance limits Don’t use depository that a government utilizes directly Out-of-state institutions – reciprocal flows Financial soundness of depositories LGC 203 reporting Deposit broker must keep accurate records “Funds in transit”
U. S. Treasuries & U. S. Government Guaranteed
U.S. Treasuries U.S. Government Guaranteed
GNMA Prepayment risk
REFCORP (from S&L bailout) FDIC-guaranteed corporate notes Other securities possible Must be specifically guaranteed as to principal
and interest
Government Agencies and Instrumentalities
Agency must be specifically listed in G.S. 159-30 “Direct” obligations only – not agency-guaranteed Fannie Mae & Freddie Mac under U.S.
conservatorship – form may change in 2013 or later
Best known issuers are Federal Home Loan Bank (FHLB), Federal Home Loan Mortgage Corp. (Freddie Mac), Fannie Mae
State and Local Obligations
State of North Carolina and NC local governments and public authorities only
Bonds and notes only – not COPs Notes being rolled into bonds eligible,
not notes being rolled into COPs
Commercial Paper
A1 / P1 / F1 only No split ratings “+” ratings for S&P Term vs. overnight commercial paper
Bankers Acceptances
No specific rating on security Issuer must be either of the following:
Long-term rating is “AAA” Bank or holding company headquartered
in NC No U.S. bank currently qualifies – only
a few international banks are AAA-rated
NCCMT
SEC-registered funds (both cash and term portfolios)
AAA-rated (cash portfolio) Investments limited to G.S. 159-30 Certified by LGC
Other Investments
Stripped securities Repurchase agreements
Third-party safekeeping Collateral must be Treasuries or U.S. government guaranteed Counterparty must be a primary dealer or bank Marked to market daily (at least 100% of value)
Other mutual funds Bond proceeds only – subject to arbitrage provisions Fundamental investment limitations limited to G.S. 159-30 Ratings, arbitrage tracking – check with bond attorney
Other pools STIF Interlocal pools
Other Investments (Not Under G.S. 159-30(c))
OPEB Trust Fund LEO Separation Allowance Trust Fund Special investment legislation
Not Authorized
Corporate notes Brokered CDs Foreign securities – only domestic
subsidiaries are allowed Bonds and notes from other states Euro dollar CDs “Retail” repos
Investment Instruments
Select the Proper Investment Instruments –
Cash - Money in the bank, s/b an interest bearing account
NCCMT – Basis of your liquidity, AAA rated, state certified, money market fund, same day liquidity; Term Portfolio offers longer option w/ next-day liquidity
U.S. Treasuries – default risk free; Bills, issued at a discount, Notes and Bonds issued with coupons; does have interest rate risk
U.S. Agency Securities – discount notes (like T-bills), bullet coupon issues, callables, step-ups, floaters. Best known issuers are Federal Home Loan Bank (FHLB), Federal Home Loan Mortgage Corp. (FHLMC), Federal National Mortgage Assoc. (FNMA) and Government National
Mortgage Assoc. (GNMA)
Investment Instruments
Certificates of Deposit and Other Deposits – Collateralized through pooling method, dedicated method or covered under FDIC insurance
Commercial Paper – unsecured promissory note of issuing corporation. Types are: Stand Alone, Letter of Credit, Asset Backed
Bankers’ Acceptances – used to finance foreign trade or working capital
Repurchase Agreements – need to use a tri-party repurchase agreement with an independent custodian
Flex Repo – repurchase agreements but flexible drawdown schedules
Investment Instruments
Agencies – Discount Notes – Priced at a discount, resemble T-bills
($10,000 bond - $9,950 cost = $50 discount/interest)
Bullets – Issued with coupons, like notes and bonds, trade on a 30/360 day basis (bad days & good days)
Callables – Coupon issues with call options built-in. Option allows issuer to call issue at some point in the future.
Types of call options:
American Call – anytime after a specified lockout period (CC) Bermuda Call – callable on interest payment dates (IPD)
by predetermined schedule European Call – callable one-time after a specified lockout
(one-time call)
Investment Instruments
Step-Ups – Coupons step-up at preset times to higher levels, issues are
usually callable on step-up dates.
Ex. – Coupon starts at 1% and steps-up every 6 months to 1.25%, 1.50%, 1.75% respectively, final maturity is 2 years
Investment Instruments
Commercial Paper – Promissory notes issued by corporations and
maturing in 270 days or less (no split ratings)
Stand Alone – Backed solely by the credit worthiness of the issuer
Letter-of-Credit – Security for purchaser is provided by a letter- of-credit provided by issuer’s bank that allows issuer to draw down funds to pay off maturities
Asset Backed (ABCP) – Security interest in some type of asset backing up the issue is the purchaser’s protection. Assets could be credit card receivables, trade receivables, etc…
Foundations of a Solid Investment Program
Safekeeping/Custody Authorized Dealers & Financial Institutions – maintain a list Internal Controls – need to have in place Delivery vs. Payment (DVP) – to a 3rd party custodian in the
unit’s name Custodian - responsible for accurate record keeping and
accounting of assets, timely delivery of securities, safekeeping of the assets and reporting to the client
Suitable and Authorized Investments Investment types – what is allowed by law Collateralization – which method (pooling or dedicated) Repurchase Agreements – must comply with all provisions of
state law
Safekeeping –
Signed Agreement
Transaction Deadline – usually between 10:00am and 12:00pm
Online access to account information Services –
Safekeeping of assets Receipt of income (interest) Market value reporting
Compensation – usually included in banking services contract, may be a charge based on market value held
Foundations of a Solid Investment Program
Investment Parameters
Diversification – By issuer By credit quality By maturity –should have a stated maximum
Reporting Methods – how often and what reported (individual
securities, cost, market value, realized and unrealized gains and losses, weighted average maturity (WAM)
Performance Standards – appropriate benchmarks s/b established
Marking-to-Market – How often will market value or “fair value” be calculated GASB #31, at least annually at 6/30
Foundations of a Solid Investment Program
The Investment Process
Local Unit
Local Unit S/K Agent
Local FED
Dealer’sS/K Agent
NY FED
DTC
Broker/Dealer
Issues S/K Receipt
Issues Trade Confirms
Executes TradesPurchases or Sales
Issues S/K ReceiptSettles Transaction
Cash Flow Forecasting
Prepare a Cash Forecast – “The Holy Grail”
Cash Flow Projection - inflows and outflows of cash, use known amounts and estimates
Payroll, debt service, scheduled agency payments
Capital project estimates, departmental spending estimates
Maturities, tax receipts, state funds
Projection of Investable Balances - shows how the timing of cash flows and maturities affect investable balances
Cash Flow Forecasting
Always have a liquidity pool for unforeseen expenditures.
Ex. – Commissioners buy land at their Tuesday night meeting, and by-the-way the closing is Friday.
GFOA recommends:
“continuously investing a portion of the portfolio in readily available funds, such as local government investment pools (LGIPs), money market funds, or overnight repurchase agreements to ensure that appropriate liquidity is maintained to meet ongoing operations.”
- GFOA Recommended Practices
Investment Instruments
Default Risk Scale (Highest-to-Lowest)
Higher Degree Prime Commercial Paper A1/P1of Risk Collateralized Bank CD’s
Bankers’ Acceptances U.S. Treasury Repos (DVP)
U.S. Government AgenciesU.S. Government Guaranteed
(GNMA)Risk Free U.S. Treasury (Bills, Notes,
Bonds)
Investment Instruments
Liquidity Scale (Highest-to-Lowest)
Most Liquid Overnight ReposNCCMTT-BillsOther short-term
TreasuriesGovernment AgenciesBankers’ AcceptancesCommercial Paper
Long-term government bonds Long-term U.S. Agency BondsIlliquid Certificates of Deposit
The Investment Process
1. Identify unit’s objectives and constraints2. Develop an investment policy3. Develop administrative systems and internal controls4. Prepare a cash forecast5. Determine investment horizon6. Establish an investment outlook and strategy7. Analyze the yield curve8. Select optimizing investments9. Monitor markets and investment results10. Report results11. Adjust and rebalance the portfolio accordingly
From Investing Public Funds, 2nd Edition, Girard Miller, GFOA
Establish an Investment/Economic Outlook Most public investors are not trained economists
Most have an unwritten or implicit investment outlook
A formalized investment outlook may help improve communications and accountability
The outlook may include long-term, macroeconomic, cyclical and short-term expectations
Analyze the Yield Curve Yield Curve – graphical representation of interest rate
levels What type of yield curve environment are you in?
Normal Flat Inverted
How do you think the yield curve will change in the future?
0
0.5
1
1.5
2
2.5
3
1 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 10 Yr 20 Yr
Yie
ld
Term
Yield Curve Structures
Normal
Flat
Inverted
Bond Math is Not Complicated
Interest Rates and Bond Prices
Bond Pricing
Bond prices move inversely to interest rates
Interest Rates go Bond Prices go
Interest Rates go Bond Prices go
Need To Know This!
You will have a Fair Value Adjustment at Year-end
5.50% decline
5.50% decline
5.00+% decline
Where Are We Now?
Source: Investing Public Funds, 2nd Ed.
Standard Business Cycle and Interest Rate Tendencies (USA: 1940 – 1996)
Source: Investing Public Funds, 2nd Ed.
Where are we on the business cycle?
Probably late trough phase
Looking for interest rates to increase in future
Rates are at historic lows so you won’t be “going out on a limb” with this prediction
Bond Pricing
Bond purchased at par (price = 100%)2 year maturity, - .25% coupon bondCost = Principal Amt. x Price ($1,000 x 100% = $1,000)
Interest rate moves to 1.0% New Price = 98.519% New Market Value = $985.19 FVA($14.81)Interest rate moves to 2.0%New Price = 96.585% New Market Value = $ 965.85 FVA($34.15)
10 year maturity, - 1.50% coupon bondInterest rate moves to 2.0% New Price = 95.489% New Market Value = $954.89 FVA($45.11)Interest rate moves to 3.0%New Price = 87.123% New Market Value = $871.23 FVA($128.77)