North Carolina Local Government
Investment Association
Winter Meeting – 2013
Investments 101
Presented by :
Lee Carter
Gary Porter
Capital Management of the Carolinas, LLC
General Requirements (G.S. 159-30)
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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
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Safety
Liquidity
Yield
Governments should evaluate:
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Eligibility under G.S. 159-30(c)
Appropriateness
Request prospectus or other information
before investing
Depository Accounts
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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
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Authorized in G.S. 159-30(b1)
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CDARs, Finistar, etc.
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Deposits in institutions up to insurance limits
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Don’t use depository that a government utilizes directly
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Out-of-state institutions – reciprocal flows
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Financial soundness of depositories
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LGC 203 reporting
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Deposit broker must keep accurate records
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“Funds in transit”
U. S. Treasuries & U. S. Government
Guaranteed
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U.S. Treasuries
U.S. Government Guaranteed
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GNMA
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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
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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
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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
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A1 / P1 / F1 only
No split ratings
“+” ratings for S&P
Term vs. overnight commercial paper
Bankers Acceptances
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No specific rating on security
Issuer must be either of the following:
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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
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SEC-registered funds (both cash and term
portfolios)
AAA-rated (cash portfolio)
Investments limited to G.S. 159-30
Certified by LGC
Other Investments
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Stripped securities
Repurchase agreements
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Other mutual funds
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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)
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
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STIF
Interlocal pools
Other Investments (Not Under
G.S. 159-30(c))
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OPEB Trust Fund
LEO Separation Allowance Trust Fund
Special investment legislation
Not Authorized
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Corporate notes
Brokered CDs
Foreign securities – only domestic
subsidiaries are allowed
Bonds and notes from other states
Euro dollar CDs
“Retail” repos
Investment Instruments
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Select the Proper Investment Instruments –
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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
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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
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Agencies –
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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.
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Types of call options:
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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
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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
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Commercial Paper – Promissory notes issued by
corporations and maturing in 270 days
or less (no split ratings)
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Stand Alone – Backed solely by the credit worthiness of the
issuer
Letter-of-Credit – Security for purchaser is provided by a letterof-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
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Safekeeping/Custody
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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
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Investment types – what is allowed by law
Collateralization – which method (pooling or dedicated)
Repurchase Agreements – must comply with all provisions of state law
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Safekeeping –
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Signed Agreement
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Transaction Deadline – usually between 10:00am and 12:00pm
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Online access to account information
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Services –
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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
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Investment Parameters
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Diversification –
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By issuer
By credit quality
By maturity –should have a stated maximum
Reporting
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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
Broker
/Dealer
Executes Trades
Purchases or Sales
Local Unit
Issues Trade Confirms
Issues S/K Receipt
Local Unit
S/K Agent
Settles Transaction
DTC
Dealer’s
S/K Agent
Issues S/K Receipt
Local FED
NY FED
Cash Flow Forecasting
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Prepare a Cash Forecast – “The Holy Grail”
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Cash Flow Projection - inflows and outflows of cash,
use known amounts and estimates
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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
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Always have a liquidity pool for unforeseen expenditures.
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Ex. – Commissioners buy land at their Tuesday night meeting,
and by-the-way the closing is Friday.
GFOA recommends:
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“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
of Risk
Risk Free
Prime Commercial Paper A1/P1
Collateralized Bank CD’s
Bankers’ Acceptances
U.S. Treasury Repos (DVP)
U.S. Government Agencies
U.S. Government Guaranteed (GNMA)
U.S. Treasury (Bills, Notes, Bonds)
Investment Instruments
Liquidity Scale (Highest-to-Lowest)
Most Liquid Overnight Repos
NCCMT
T-Bills
Other short-term Treasuries
Government Agencies
Bankers’ Acceptances
Commercial Paper
Long-term government bonds
Long-term U.S. Agency Bonds
Illiquid
Certificates of Deposit
The Investment Process
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Identify unit’s objectives and constraints
Develop an investment policy
Develop administrative systems and internal controls
Prepare a cash forecast
Determine investment horizon
Establish an investment outlook and strategy
Analyze the yield curve
Select optimizing investments
Monitor markets and investment results
Report results
Adjust and rebalance the portfolio accordingly
From Investing Public Funds, 2nd Edition, Girard Miller, GFOA
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Establish an Investment/Economic Outlook
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Most public investors are not trained economists
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Most have an unwritten or implicit investment outlook
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A formalized investment outlook may help improve
communications and accountability
The outlook may include long-term, macroeconomic,
cyclical and short-term expectations
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Analyze the Yield Curve
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Yield Curve – graphical representation of interest rate levels
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What type of yield curve environment are you in?
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Normal
Flat
Inverted
How do you think the yield curve will change in the
future?
Yield Curve Structures
3
2.5
2
Yield
Normal
Flat
1.5
Inverted
1
0.5
0
1 Mo
3 Mo
6 Mo
1 Yr
2 Yr
Term
3 Yr
5 Yr
10 Yr
20 Yr
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.
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Where are we on the business cycle?
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Probably late trough phase
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Looking for interest rates to increase in future
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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 bond
Cost = 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
Interest rate moves to 2.0%
New Price = 96.585% New Market Value = $ 965.85 FVA
($14.81)
($34.15)
10 year maturity, - 1.50% coupon bond
Interest rate moves to 2.0%
New Price = 95.489% New Market Value = $954.89 FVA
Interest rate moves to 3.0%
New Price = 87.123% New Market Value = $871.23 FVA
($45.11)
($128.77)