X. INVESTMENT STRATEGIES AND DEBT ADMINISTRATION
A locality often is able to meet current obligations and, at the same time, have uncommitted cash left over to invest in interest-yielding securities.
Funds to meet debt service requirements may come from several sources, including short-term investments, and must be brought together on a timely basis to avoid temporary defaults.
Cash flow projections that reflect economic conditions should enable the fiscal manager to predict how much money will be available to invest and for how long.
Public Investment Criteria
Safety is the highest priority for most public officials, followed by liquidity and yield.
Liquidity involves managing investments so that cash will be available when needed.
Yield--the ultimate measure of success in a market economy--is conditioned by interest rates, minimum investment requirements, and the maturity dates of investments.
Marketability varies among money market instruments, depending on the price stability of the instrument, and on the extent of the available secondary trading market available.
Risk characteristics of securities must be understood before decisions are made about which specific instruments to purchase (see Exhibit 1).
Price stability of investments is a concern of public officials that reflects their desire to avoid financial loss in the event of an unexpected cash shortage.
Maturities of the various securities and how these would affect the portfolio mix must be understood before a fiscal manager decides to invest in them.
Many state legislatures restrict the investments of local governments to securities that are collateralized or backed by the United States government.
Investments constitute cash reserves in addition to serving as income-producing assets.
In general, securities with little risk, high liquidity, and short maturities also have low yields.
For an investment to provide a high yield, one or more of the other relevant criteria must be compromised.
Exhibit 1. Money Market Instruments Used by Local Governments
| Invetsment Instrument | Obligation Issuer | Denominations | Maturities | Marketability | Yield Basis | Comments/ Restrictions |
| United States Treasury Bills | U.S. Government obligations | $10,000 to $1 million | 3, 6, 9 & 12 months | Execellent secondary market | Discounted on 385-day basis. Also offered as tax anticipation bills through special actions | Popular investment; can be purchased in secondary market for varying maturities |
| U. S. Agency Securities | Various Federal Agencies | $1,000 to $25,000 | 30 days; 270 days; one year | Good secondary market | Discounted on a 360-day basis | Not legal obligtation of or guaranteed by the Federal Government |
| Negotiable CDs | Commercial Banks | $500,000 to $1 million | Unlimited; 30-day minimum | Active secondary market | Interest maturity on 360-day basis | Backed by credit of issuing bank |
| Non-Negotiable CDs | Commercial Banks/ Savings & Loan Associations | $1,000 minimum (usually $100.000) | 30-day minimum | Limited secondary market | Interest maturity on 365-day basis | Lower interest rates for amounts under $100,000; 90-day interest penalty for early withdrawal |
| Repurchase Agreements | Commercial Banks | $100,000 minimum | Overnight minimum; 1 to 21 days common | No secondary market | Established as part of purchase Yield generally close to prevailing federal rates | Open: can be liquidated at any time. Fixed: maturity set for specific period |
| Banker's Acceptances | Commercial Banks | $25,000 to $1 million | Up to six months | Good secondary market | Discounted on a 360-day basis | Backed by credit of issuing bank with specific collateral |
| Commercial Paper | Promissory Notes of Finance Companies | $100,000 to $5 million | 5 to 270 days | No secondary market | Either discounted or interest-bearing on a 360-day basis | Dealers will often negotiate "buy-back" agreements at a lower rate prior to maturity |
Types of Securities
U.S. Treasury bills (T-bills)--the most important money market instrument available for local government investments--represent an obligation of the federal government to pay a fixed sum of money after a specified period of time from date of issue.
o The minimum denomination is $10,000, with additional increments of $5,000.
o T-bills can be sold quickly for relatively predictable prices in the secondary market.
Zero Coupon Treasury securities represent ownership of interest or principal payments on United States notes or bonds purchased at a discount of 20% to 90% off the $1,000 face value.
o These securities are available in a wide range of maturities spanning one to thirty years.
o Popularity types of Zero Coupon Treasury securities include Certificates of Accural on Treasury Securities (CATS), Separate Trading of Registered Interest and Principal Securities (STRIPS) and Treasury Investment Growth Receipts (TIGRS)
Certificates of deposit (CD) are a receipt for funds that have been deposited in a commercial bank for an agreed upon period of time.
o The owner of the CD receives both principal and interest on the maturity date.
o CDs are sold according to specified maturity periods, ranging from 14 to 180 days.
Two types of CDs: (1) negotiable, which the original investor can sell to another party on the secondary market; and (2) non-negotiable, which must be retained by the original investor until maturity.
Federal agency securities are issued by government-sponsored, privately-owned agencies that established to implement federal policies and include Federal Farm Credit bonds, Federal Home Loan Bank bonds and discount notes, and Federal National Mortgage Association bonds.
o The risk factor is very low, but agency securities have less liquidity because the market for agency paper is smaller than for T-bills.
o Agency securities trade at a yield premium over T-bills, but the earnings from some agency securities are subject to state and local taxes.
Repurchase agreement are contracts between two parties whereby one party sells an instrument (such as a T-bill) to the other and agrees to buy it back at a later date (often the next day) at a specified higher price.
o Two types of repurchase agreements: (1) fixed--a specific interest rate and maturity period are established at the outset and a penalty might be levied if liquidated prior to maturity; and (2) open--agreement may be liquidated at any time, with the interest rate dependent on the duration of the transaction.
o Repurchase agreements are most often entered into for very short periods of time, usually from one to twenty-one days.
Banker's acceptances, usually created in conjunction with foreign trade transactions, are time drafts negotiated by commercial banks to finance the shipment or storage of goods.
o The bank guarantees to honor the draft on the due date and sells the draft at a discount to an importer.
o On the due date (typically ninety days after issue), the bank honors the draft for the full face value and debits the account of the issuing company.
Commercial paper includes promissory notes of finance corporations or industrial firms which offer higher yields than T-bills.
o Liquidity is low, as secondary trading market does not exists for commercial paper.
o As a result of the higher default risks, many states have restrictions against investment by local governments in commercial paper.
Money market funds pool investments to earn higher interest rates and often serve as a combination savings and checking account.
The direct purchase of stocks is generally not recommended for short-term investments of public funds. A mutual fund or index fund with a proven track record may offer an alternative investment strategy.
Derivative securities derive their value from some form of investment, such as Treasury bonds, corporate stocks and bonds, foreign currencies, or commodities contracts.
o Derivatives are designed to help corporations guard against sudden shifts in global financial markets
o An "interest rate swap" allows a company to exchange a fixed interest rate for a floating rate payment.
o Derivatives offer higher yields which makes them attractive at times when short-term interest rates are low.
o Like many rapidly rising investment schemes, the fall can be even more rapid, and for unsuspecting municipal governments, the consequences can be devastating.
Arbitrage
Arbitrage occurs when a government issues bonds at one rate of interest and invests the proceeds at a higher rate of interest; the resulting gain is referred to as arbitrage earnings.
o Advantages: Governments can make money by investing bond proceeds at higher interest rates than the interest rate on the bonds; however, the arbitrage earnings on tax-exempt bonds are constrained by federal tax laws.
o Disadvantages: Arbitrage earnings that exceed limits imposed by federal regulations must be rebated to the federal government. Failure to adhere to federal arbitrage provisions can, in certain circumstances, cause the municipal bonds to lose their tax-exempt status.
During the 1980s, the federal government became concerned that municipal governments were abusing their power to issue bonds by issuing bonds unnecessarily in order to try to earn arbitrage.
o The 1986 Tax Reform Act put into place a variety of restrictions and regulations designed to prevent abuse.
o Federal arbitrage rules state that the yield on the investments can only be 1/8 of 1% higher than the interest rate on the bond issue, or arbitrage restrictions apply.
Any earnings in excess of the bond yield must be returned to the U.S. Treasury in a process called "rebating."
Another federal regulation limits advance refundings to once for each original bond issue.
Constraints on Public Investments
Local government investments are regulated by state statutes that are presumed to reflect public policy.
Local jurisdictions impose additional limitations on their investments to mitigate risk, to diversify investment holdings, and to avoid weak financial institutions.
Banks are required to pledge securities as collateral to secure public investments, the costs of which usually are passed on to the public entity in the form of reduced rates of return.
State-managed investment pools resemble money market mutual funds in their portfolio composition and provide professional management, diversification, and money market rates of return on liquid assets which minimizes the risk to smaller jurisdictions.
Summary and Conclusions
The primary benefits of an investment strategy must be measured in terms of the increased interest earned through the investment of temporarily idle cash.
o Yield, or return on investment, is the paramount criterion for measuring the success or failure of an investment strategy.
o Liquidity can be built into an investment strategy through careful planning and structuring of the portfolio mix.
State laws protect public funds by: (1) limiting banks with which local governments can do business, (2) determining, in most instances, the amounts that can be left on deposit in each bank, and (3) requiring collateral for uninsured funds.
Local governments confront (1) the need to expand revenues if public demands are to be met, (2) already heavily burdened taxpayers, and (3) narrow restrictions on their ability to borrow to finance public expenditures.
The investment portfolio is a source of additional revenue that does not involve increased taxation or additional debt.
The development of more diverse bond offerings has resulted in increased complexity and responsibility for the administration of public debt.
Capital Project Funds
Capital project funds account for the resources required to build or buy capital facilities; these resources come from the issuance of bonds or other long-term obligations, from intergovernmental grants, or as transfers from other funds.
When the project is completed, the capital project fund is terminated and the accounting results are transferred to the debt service fund which tracks payment of interest and principal on each capital project.
Semi-annual interest payments are made from the date of issue and not from date of purchase.
When bonds are sold, the buyer must pay the seller the equivalent of interest for the period from the issue date to the date of purchase.
Accrued interest received on the sale of the bonds is transferred to the debt service fund to partially offset to the amount needed from the general fund for the first interest payment.
When bonds are sold at a premium (higher than face value), the difference is usually transferred to the debt service fund and used with other resources to pay off the bonds.
When a discount is allowed, the full face value of the bonds is still required for the project, and the difference may have to be made up from the general fund or the debt service fund.
Some states do not permit bonds to be issued at a discount which may force the issuing authority to pay a higher interest rate on the bonds to ensure their sale.
Proceeds from bond sales and transfers from other sources (e.g., state or federal grants) should be invested and the investment revenue transferred to the debt service fund for payment of the principal or interest.
Debt Service Funds
Debt service funds are account for: (1) the accumulation of resources to pay the principal and interest on long-term debt and (2) the investment and expenditure of those resources.
o Several bond issues should be accounted for in a single fund--the fewer the number of funds, the less complicated the accounting for long-term debt.
o The money required for the repayment of debt often is collected in the general fund and then transferred to the debt service fund.
o Bond indentures often require that the money needed for servicing bonds has first claim on the general revenue of the governmental unit.
The principal and interest on serial bonds are serviced annually; therefore, no resources are accumulated on which interest can be earned.
Resources to service the principal on term bonds are not needed until the debt matures and, therefore, can be invested.
o A sinking fund accumulates the assets and fund balance annually to eventually be used for payment of the debt.
o The annual payment to the sinking fund is determined by: (1) the dollar value of the bonds to be retired, (2) the number of payments to be made into the account, and (3) the anticipated rate of earnings on the invested funds.
Long-Term Debt Control
Accurate debt records are vital to short-term and long-term fiscal operations.
The general fixed assets account group records at cost all fixed assets purchased, constructed, or obtained by contract.
Assets that are sold, destroyed, or otherwise rendered valueless are removed from the account group by debiting the general fixed assets account for the original amount recorded and crediting the particular fixed asset.
The long-term debt account group records long-term liabilities, such as serial bonds, long-term notes, and long-term commitments arising from lease or purchase agreements.
Financial Reporting
Annual financial reports should list all outstanding debt by type of issue (general obligation, special assessment, or revenue bonds).
o Annual schedule of debt service should present information for each broad class of debt, including interest, amortization requirements, and total debt service requirements.
o The portion of the debt of the school district, county, township, or special districts payable from taxes levied by the reporting jurisdiction should be included.
o A computation should be made of the jurisdiction's legal borrowing status.
o A sinking fund balance sheet should record the relation of sinking funds to actuarial requirements and provide a listing of current holdings.
o Unfunded debt--short-term borrowing that constitutes an obligation payable out of current revenues--should also be identified.
o Debt arising from the issuance of revenue bonds in proprietary funds must also be shown, including complete information on the facilities that support such debt.
Accurate and complete reporting on public debt develops confidence on the part of investors and the general public as to the fiscal management of a jurisdiction or public organization.
Distribution of Revenues and Issuance of Additional Bonds
A reserve fund receives the income derived from the operation of a self-supporting project.
o Moneys in the reserve fund are then distributed monthly in the order established by the bond resolution or trust indenture (see Exhibit 3).
o Moneys remaining in the reserve fund after the required distributions have been made may be placed in a surplus fund.
Sufficient leeway should be provided in the bond indenture or resolution to permit the issuance of additional bonds.
Exhibit 3. Distribution of Revenues from Self-Supporting Projects
(1) Operations and maintenance have first claim on the reserve fund. Without proper O&M funds, a facility may experience severe loss of income. Revenue bonds are commonly payable from net revenues--that is, gross receipts less operating and maintenance costs.
(2) The bond service account should receive monthly payments sufficient to cover the next semiannual interest payment, as well as the next principal payment on serial bonds.
(3) A sinking fund is sometimes required in the case of term bonds, in lieu of principal payments on serial bonds.
(4) The debt service reserve fund is gradually built up to equal a full year's maximum principal and interest in the case of serial bonds, or two year's interest in the case of term bonds.
(5) A renewal and replacement fund (sometimes called a replacement reserve) is established to replace equipment and provide necessary repairs beyond normal maintenance. Funds are paid into this account in amounts recommended by the consulting engineer and may be cumulative.
(6) A reserve maintenance fund may be established to meet unusual or extraordinary maintenance charges that have not been budgeted. Some jurisdictions combine the reserve maintenance fund with the renewal and replacement fund.
(7) The working capital fund, to cover unforeseen contingencies, should be equivalent to about one-tenth of the annual gross revenues.
Debt Service and Retirement
Prompt payment of all principal and interest requirement is the most direct evidence of sound debt administration.
A payment calendar should be developed from the bond and interest register and the ledgers for bonded debt and interest.
Funds for principal and interest payments must be are deposited with the paying agent in advance of the due dates, and the coupons and matured bonds should be paid as they are submitted.
Sinking Funds
The management of a sinking fund requires proper safeguards to protect the fund's integrity.
Local governments in most states are restricted as to the types of investments that can be made.
o Investments should be limited to high-grade issues and should exclude projects with unproved earning power.
o In some cases, a municipality may invest its sinking funds in its own securities.
o Sinking fund investments must have liquidity--maturities must be timed so that funds will be readily available to retire the term bonds when they come due.
o Sinking funds should be consolidated to simplify transactions, to save time in putting the funds to work, and to secure a better investment position.
An independent audit of the sinking fund should be made annually in addition to regular auditing by the controller of all sinking fund transactions.
Recording and Canceling Coupons and Bonds
Recording and canceling of coupons and bonds that have been paid is the final step in servicing a municipal debt.
Many commercial banks and trust companies include recording and cancellation as part of their services as paying agents for municipal bonds.
Refunding and Conversions
Refunding is the process of issuing new bonds to retire bonds already outstanding.
o Advantages: Refunding bonds can result in savings if the interest rate on the new bonds is lower than the interest rate on the existing bonds. Refunding bonds can be used to remove restrictive bond covenants that apply to existing bonds. Governments can use refunding bonds to restructure debt service payments.
o Disadvantages: Refunding bonds have the same types of issuance costs as a new issue, thus the government in essence repeats these costs during the life of the debt. Advance refundings can be done only once during the life of a bond, so the issuer must identify the most advantageous time to refund. Advance refundings are not allowed for private activity bonds.
A call provision in the original bond issue is exercised to initiate the refunding.
Current refunding bonds are issued within 90 days of the call date of the outstanding bonds
Advance refunding bonds are issued more than 90 days in advance of the call date. Federal restrictions are applied to arbitrage earnings on such bonds.
Refunding bonds may be exchanged with the holders of the outstanding bonds or may be sold and the outstanding bonds redeemed in cash.
The refunding analysis should include a determination of:
(1) Probable interest rate on the refunding bonds if offered in the prevailing market;
(2) Gross amount of interest to be saved in terms of: (a) current dollars payable in the years in which the savings will occur; and (b) present worth of dollars to be saved at future dates; and
(3) Cost of refunding--any call premiums payable and costs incident to the issuance of refunding bonds.
Refunding of the outstanding debt may be appropriate to eliminate/modify restrictive covenants.
Refunding issues do not have to go through the same legislative and/or constitutional approval process as the original bonds since the original bond issue was already approved.
Refunding issues are typically sold through a negotiated sale because of their complexity.
Refunding mature or maturing bonds should be avoided if possible, and if necessary, should be undertaken with great discretion.
A municipality may find it necessary to refund outstanding debts to avoid default or serious disruption of fiscal operations.
Forced refunding occurs when a municipality must refund outstanding debts to avoid default or serious disruption of fiscal operations.
Such emergencies should be anticipated and the necessary steps taken with sufficient lead time to resolve the problem in an orderly and businesslike manner.
Defaults
Defaults are likely to result in a sharp decline in the municpality's credit standing, skepticism among lenders, and difficulties in negotiating favorable interest rates on future bond issues.
Approximately $5.5 billion, or 30% of the average net municipal debt outstanding, was in default during the Depression.
The Federal Municipal Bankruptcy Act was enacted to prevent defaults of this magnitude.
Types of Defaults
Minor or temporary defaults involve failure to meet the maturity payment of a single security or temporary postponement of interest payments as a result of unanticipated declines in revenue collections, the shutting off of normal lines of bank credit, and/or a temporary inability to market refunded bonds.
Municipalities that have encountered such fiscal problems as peak debt service in period of low-paying capacity, serious breakdowns in the local economic base, and/or abnormally high tax delinquency face a more serious class of defaults
Jurisdictions confronted by abnormally high debt, severely curtailed revenues, and significant accumulation of operating deficits, with little or no prospect for correction except through a comprehensive refunding plan, face a third class of defaults
Scaling of debt involves a reduction in the jurisdiction's overall commitments because the total obligation is beyond the local government's capacity to pay.
Extensive postponements often are preferred by investors, with the expectation that subsequent growth and development will eventually bring protection to their investment.
Steps in Readjustment
A municipality should take the initiative in planning and implementing the refunding plan to demonstrates good faith and competence and gain the necessary cooperation from investors.
An official statement should be issued to the municipality's creditors, giving notice of its inability to meet its obligations, identify the causes and probably duration, and outline the steps contemplated to correct the situation.
o Municipal records should be opened to bondholders, and a summary analysis should be distributed outlining the municipality's financial status and capacity to pay.
o A complete investigation of all relevant factors--financial, administrative, and economic--is a prerequisite to the planning of corrective action.
The refunding plan must provide: (1) mechanisms to release current accounts from all accumulated deficiencies; and (2) financing procedures that will maintain balanced operations.
Most states have adopted legislative measures to circumvent the financial catastrophe faced by many governments in the thirties.
The ultimate responsibility, however, still rests with local officials to adopt administrative procedures that will protect their community from "mortgaging its future."