North Carolina Local Government Investment Association

Winter Meeting – 2013

Investments 101Presented 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

Yiel

d

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)