Investing Public Funds

1. Investing Public Funds Practical Issues in Today’s Public Investment Programs Linda T. Patterson Patterson & Associates linda@patterson.net

2. A Public Investor • Special fiduciary duties for public funds: • market and internal entity knowledge • to understand risk • to be conservative • to be pro-active and curious • effective communication skills

3. What is public investing? • Managing and balancing risks • Putting all the money to work. • Investing all funds cash, short and long term • Creating a performing asset • Building a portfolio to serve the entity • Utilizing markets and products for entity benefit • Adding yield but not risk to the portfolio • Assuring cash efficiency and security

4. What is PFIA supposed to do? • Provide guidelines for safety • Apply to all entities • Allow entities to set their own parameters • WAM and maturities and authorized investments • Define guidelines on investments • Provide for flexibility (maturity) • Provide for control on extension risk (WAM)

5. Standard of Care • Prudent Person Rule • Investment shall be made with judgment and care, under prevailing conditions, that a person of prudence, discretion, and intelligence would exercise in the management of the person’s own affairs, not for speculation but for investment considering the probable safety and probable income to be derived. • Essentially I am more concerned with the return of my money than the return on my money • A key point is “circumstances then prevailing” because conditions change • internally and in the market

6. PFIA Specific Requirements(Call it “Audit Risk”) • Write a Policy which:(2256.005) • Emphasizes safety and liquidity • Addresses diversification, yield, maturity & capability • Lists authorized investments • Includes procedure to monitor credit rating changes • Set a maximum maturity and WAM • Tell how market prices are monitored • Require delivery versus payment (DVP) • Review and adopt policy annually

7. PFIA Specific Requirements • Entity must write a strategy (2256.005) • Council must review and adopt the strategy annually • Council must designate investment officer(s) (2256.005) • Designate by resolution • Effective until rescinded or terminated from employment • Council must provide for the training of officers • Council has the option to chose officers (no necessary set position) • Officers must disclosepersonal/business relationships • Refers to personal business relationships • 2nd degree of affinity or consanguinity (blood or marriage) • Specific income limits are set but full disclosure is safer/easier • Disclosure to TX Ethics Commission and governing body

8. Investment Officers • Must be designated by resolution • Officers or employees of entity • Contracted investing entity can be officers • Effective until rescinded or terminated • Regional Planning Commission officer can only serve RPC

9. Training Specifics • Training sources must be approved by governing board (or investment committee) • Treasurer and CFO (if Treasurer not CFO) and investment officers need training • Investment Officers must be trained within 12 months of appointment • training every two years beginning with 1st day of fiscal year

10. PFIA Specific Requirements • Provide policy for written certification (2256.005) • To all firms wishing to sell a transaction must provide certificate • Includes pools, banks, investment advisors as well as broker/dealers • Provides for the review – it is not a guarantee • Counter-parties(2256.005 and 2256.025) • All counterparties must certify to the Policy • A list of broker/dealers must be approved annually by Council • Or a Council designated Investment Committee • Audits (2256.005 and 2256.023) • Annually obtain or complete an annual management audit • Assuring compliance with the Policy and the PFIA • Audit by independent auditor may be required • if invested in more than CDs and pools

11. PFIA Specific Requirements • Reporting(2256.022) • Must be prepared jointly by investment officers • Must be signed by each Investment officer • Must be submitted to Board quarterly • On a timely basis • Must contain detail and summary information • Must conform to PFIA report requirements • Must state compliance with Policy and PFIA

12. PFIA Specific Items • 2256.005 CDs may be bought orally • 2256.006 Prudence is based on the whole portfolio • 2256.021 Prudence to liquidate at loss of rating • Does not constitute an authorized security with lower rating • Policy must include procedure for monitoring credit rating and possible liquidation • 2256.017 No need to liquidate if authorized at purchase • Discuss and decide the reasonable action to take • 2256.024 Chapter is sub-cumulative to other law • Some Water District variations have been created

13. Basic Public Objectives • Safety of principal • Preservation of capital • Liquidity • Assuring that funds are available • Covering known and unexpected expenses • Diversification • Avoiding risk of over-concentration • Yield • Making all the funds work • How do we achieve the objectives?

14. Change • Market conditions change constantly • Know the “circumstances then prevailing” • The best weapon is information • Do not single-source information • Have a reasonable process for downgrades • Ongoing disclosure to governing boards will help • Internal situations change • Changes in tenured individuals • Board proclivities for risk change • New or different types of funds may change (bond $$) • Weather events may influence need for liquidity • Legislation changes

15. Use the Act and Your Policy to Address Change • Fundamentals • Your objectives • Economic realities • Firm Foundation • Controls and plans • Flexibility • Policy guidelines which allow change • Securities not usually used (state and municipal debt and CU) • New liquidity alternatives • Extension alternatives (step-ups)

16. Adapting to Change • Competitive process will keep you on top of the market • Periodic review of policies and procedures will keep policy dynamic • Trainingwill keep you up-to-date • Expecting change allows you to adapt

17. A Major Change Factor • Interest rates control you and your strategies • Know what you can control • Know the rates generally Public entities operate primarily in this area of the curve.

18. PFIA Changes Mirror Markets • 1980’s Banking and investments were split apart • 1990’s Markets accommodative and investors taking risks • 1994 Major crash in Orange County • 1995 Major adjustments to law/controls • 2000’s Banks go for service not investment and mineral rights gain strength

19. 2013 Legislative ChangeSB 581 • Public Funds Collateral Act Amendment • Releases custodian from having to send trust receipts to public entity • Custodian has choice of recipient • Trust receipts to public entity or to bank with directions to forward • Public entity can request current collateral list • YOU need to tell your bank/custodian that you want reports monthly from the custodian

20. Investment Process/Cycle • The process is cycle to verify circumstances then prevailing have not changed • The process exists for all types of investing • The process requires ongoing systematic review

21. Step 1: Cash Flow • Identifies when you need money to pay bills • Protects your liquidity • Improves investment returns • Establishes parameters for policy guidelines • Maximum maturity • Maximum weighted average maturity • Risk benchmark • Promotes safe maturity extensions • Defines your portfolio

22. Cash Flow AnalysisWhat? • Study of how cash moves through an entity • Capture revenues & expenditures for analysis over time • Study of how and when money flows • Problem periods • Opportunities • Basis for cash projections

23. Cash Flow AnalysisWhy? • Protects your liquidity • Improves investment returns • Establishes parameters for policy guidelines • Maximum maturity • Maximum weighted average maturity • Risk benchmark • Promotes safe maturity extensions • Cash is the gas that makes an entity go • Cash flow analysis makes the portfolio go Defines your portfolio

24. Cash Flow Sets Time Horizons • Knowing cash flows/horizons allows you to act pro-actively • Provides comfort that necessary funds are available • Allows some extension by recognizing future flows • Yield is not the end-game but an added benefit • Defines the portions of your portfolio • And from that the strategy for each

25. Debt Service Time Horizons • A $2mm debt payment is scheduled out 6 months • $400,000 is paid in each month to meet debt service • Staying liquid over the 6 months earns $14,000 • Investing each successive month at rates shown earns $16,333

26. Two Approaches • Both approaches have same goal • Present viable information for decision-making • Develop parameters for portfolio structure • Limiting liquidity risk • Traditional approach details • Define all variables • Build on extensive historical data • Extensive analytics for forecasting • Expense Orientation approach simplifies • Limit the elements being analyzed • Designed to get going faster

27. Traditional Cash Flow • Capture more detailed information • Continue use of 80-20% rule or • add categories • Capture historical data before analysis • Total revenues minus total expenses • Multiple years will highlight and smooth aberrations • End result is same cash balance data

28. Major Category History

29. Multi-year History Smoothes • Layering each year’s history allows an average • Building off history allows you to compute monthly % • Historical % used on new budget creates a forecast • Tie the summary sheet to detail sheets per year • Layering sheets allows for research on aberrations

30. The 80-20 Rule • Regardless of approach • Capturing every detail can be overwhelming in detail • Can be difficult to maintain • 80% of expenses come from 20% of expense categories • Payroll and fringes probably account for 80% • 80% of revenues come from 20% of revenue sources • Taxes, state payments or fees probably account for 80% • Capture the key elements • Summarize remaining “other” amounts and focus

31. Let’s Flow • A key to cash flow analysis is to START • Eliminating the need for years of data • Data farming too often an excuse not to act • You can create the basic cash flow now – a base line • How much is your payroll each month? • How much is your accounts payable each month? • When are your debt service payments? How much? • Add a ‘liquidity buffer’ for the unexpected

32. A Debt Service Example This entity has two debt service payments: February and August. Funds for debt service flow in from tax payments first 6 months. Balances build in these front months. Keeping funds liquid leaves them at the lowest possible rate. We need to make these funds work.

33. Using the Information An overview of the cash flow needs allows the investor to look ahead. The flow in Jan. alone covers the February payment. The net balances of each other month can be invested 11, 9, 8 and 6 months.

34. A General Fund Sample We use the excess balances not needed for the next month and extend. Three excess balances result in 3-month investments. The cash flow knowledge allows Sept. to be extended to 8-month investment.

35. Either route gets you to… Core • A view to the balances of cash throughout the year • The net cash shows the peaks and valleys on balances • Normally there is a minimum balance across the year • On this graph the entity has historically never gone less than $2,000,000. - this is our ‘core’ • Cores can be invested longer knowing that there is little chance of using that cash

36. Maturity and WAM • The Investment Policy and its controls are often based on cash flow • The maximum maturity (flexibility) • allows the entity to extend and reflects a core and longer time horizon • The weighted average maturity (control) • controls for over-extension

37. Information for Maximum Maturity A. B. core core ? • Entity A has no core – starting and ending the cycle at zero • They can not invest longer than one year = maximum maturity 1 yr • Entity B has a core so they can invest longer • Possibly B could create a maximum maturity of 2 years • You must understand what the core is made up and if might change

38. Cash Flowing Capital Projects • A recurring problem: obtaining information • A large nonrecurring expenditure • A unique cash flows for some entities • Work with departments for expenditure plans before $$ arrives • Bond document may have draft plan • Get regular updates from departments and engineers to modify plans • Some projects are repetitive and history of old funds shows pattern • Explaining the importance of cash flow helps generate support • Impact of additional earnings • Verify arbitrage impacts

39. CIP Trends Streets - 2007 Use multiple historical issues of the same type fund streets water mains land acquisition Trend often appear over the time frame of the total project Use for projections on the same type projects in the future Streets - 2009 Street Composite – New Funds Streets Projection 2005

40. Cash Flow Investing • We focus on a monthly expenditure need • Eliminate the need to invest to each liability • Meet the monthly need with one early investment • Place the maturity before the first known liability • Use liquid options or short investments to target each liability in month • Reduces cost of safekeeping but still increases portfolio effectiveness

41. Translating the Information into Action Entity needs $3 million a month for A/P and payroll costs. Investment matures on 2nd and is available for rest of month. Payables $250,000 Payables $250,000 Payables $250,000 Payables $250,000 Payroll $1mm Payroll $1mm

42. Cash Flow Structure Creates the Portfolio

43. Summary • Cash flow analysis should be straightforward • Undue maintenance needs will render it cumbersome and un-usable • Cash flow must be done to set policy controls • Cash flow should result in information not statistics • Cash flow will pay for itself in good investing decisions • Maintenance is minimal • Perhaps one-half hour every quarter

44. Cash Flow Questions • A continuing money balance is a ______ . • Cash flow sets my ________ and ______ . • What level of analysis is most productive? • The key action is to _____ . • Multi-year averaging eliminates _____________ . • Let’s _______.

45. Step 2: Identify Risks • Risks occur in every investment • Risks occur within the custody area • Risks occur with counter-parties • Identify your risk tolerance level

46. Risk • Exists in all securities and all markets • You can not avoid risk • You can manage risk • Risk can be used to your advantage • Measured risk will increase yield • Use credit ratings and limitations for control

47. The Oink Factor • The animals in any marketplace • The bull, the bear and the pig • Beware the pig in you • A pig keeps his head in the earnings trough and ignores the circumstances prevailing • The pig goes only for yield • Primary pig controls • Maximum maturity limitations • Weighted average maturity limits • Controlled leverage

48. “Market” Risks • Who is this “market” anyway? • You are the market • Encompasses all investors • Their actions and expectations control actions • Built on investors expectations

49. General ‘Market’ Risk • Market risk is based on the market price • Diversifying reduces your exposure • Money will flow from one sector to another for safety or yield • High credit quality reduces exposure • High quality retains its value (i.e. UD $ as reserve currency) • In fixed income markets • When prices go up – rates go down • So, a bull market has rates dropping

50. Credit Risk • Credit risk is the risk of issuer failure • Inability to pay interest or principal • Authorized investments normally face little credit risk • Most statutes require AAA ratings or equivalents • Limit the maturity to further manage risk • Recognize the media loves a scare – don’t react without cause • Do your homework on why prices are moving • Talk to several sources and reason it through • Measure and control the inherent risk in securities • Create diversification limits • Use CP but restrict to dual ratings and stay under 90 days • Understand issuers restraints and strengths • For example: FHLMC and FNMA conservatorship raises credit • Measure and monitor bank credit • Monitor bank credit on ongoing basis • Use independent bank ratings agencies (Veribanc, Prudent Man) • Monitor collateral market value