Feeling confused and not knowing who or what to believe? In the world of public funds investing, you’re not alone.
As of the date of this article, the Federal Open Market Committee has increased the upper bound of the Federal Funds Target Rate from 0.25% to 4.5% since March of 2022. The Fed aggressively hiked interest rates at seven consecutive meetings, including an unprecedented four consecutive 75 basis point moves. To put this into historical perspective, the last time that the Fed raised rates by 3% or more in a single year was in 1981.
There’s no shortage of opinions as to what the Fed will or will not do in 2023. There’s a strong argument for treasurers and finance directors to preemptively label any projections or forecasts they’re unfortunate enough to be subjected to by a more accurate term: “speculation.” That said, from where we sit today, the undeniable fact is that this recent and historical tightening of monetary policy has transformed cash into a compelling asset class.
Stable $1.00 Net Asset Value Investment Pools
Joint Powers Authority (JPA) investment pools like California CLASS are not merely a place to hide from volatility, nor just a temporary location from which to allocate funds into longer-dated securities. Lagging interest rates for bank deposit products also bolster the argument for evaluating the merits of ‘AAAm’ rated JPA pools that offer daily liquidity and transact at a stable $1.00 Net Asset Value (NAV).
Investing in a stable $1.00 NAV investment pool is a foundational consideration of a well-balanced liquidity strategy. One very important characteristic of a ‘AAAm’ rated pool is that it will have a weighted average maturity (WAM) of less than 60 days.
WAM is an average of the effective maturities of all securities held in the portfolio, weighted by each security’s percentage of net assets. The higher the WAM, the longer it takes for all the securities to mature and repay their principal. The shorter the WAM, the sooner the securities mature; for example, California CLASS Prime’s WAM is less than 40 days as of January 12, 2023. Comparing the WAM of various investment options will provide insight as to why one pool is offering a higher net yield to participants in either a rising or declining interest rate environment.
In a rising rate environment, the pool with the shorter WAM will reinvest maturing securities at higher rates sooner than will a pool with a longer WAM. In other words, the yield of a pool with a shorter WAM will manifest the impact of any Fed policy decision faster.
Enhanced Cash, Variable NAV Investment Pools
The other component of a balanced liquidity strategy is a thoughtful allocation to an enhanced cash-style pool. Before we get into that, let’s frame the situation with the Fed right now.
The Fed has demonstrated its willingness to aggressively bring inflation in line with its price stability mandate. But at some point, the Fed will stop tightening. When it does, it will consider cutting interest rates to invigorate an economy whose growth was necessarily nudged into a “sustained period of below-trend growth”1 by the current tightening regime.
Enhanced cash pools are generally managed to a WAM of greater than 60 days. By investing farther out the yield curve,2 they often generate higher interest income than stable NAV pools, but this enhanced performance is accompanied by higher interest rate risk. Pools like California CLASS Enhanced Cash absorb and transmit that risk by operating as variable NAV pools. This means that the transactional share price can fluctuate as the values of the securities within the portfolio increase or decrease inversely to changes in yields.
When interest rates are decreasing, a pool with a longer WAM can generate a higher rate of return than one with a shorter WAM. This is because the shorter WAM pool is forced to invest maturing securities’ proceeds at lower prevailing rates, while a longer WAM pool is “locked in” to higher rates for longer.
Investors in a variable NAV pool can see the NAV increase as yields fall. This offers investors the opportunity for their liquidity strategy to generate price appreciation in addition to interest income. This price appreciation comes from a change in the NAV that corresponds with a decrease in rates. The opposite holds true as well: when rates increase, the NAV can decline.
Tying Things Together
- When rates are rising, allocating funds to stable $1.00 NAV investment pools with a short WAM may facilitate the capture of rising interest rates.
- When rates are plateauing or falling, investing in a variable NAV-enhanced cash pool can generate higher interest income than its stable $1.00 NAV counterpart.
- A well-balanced liquidity strategy does not entail or involve trying to time the allocation of funds between stable and variable NAV pools but rather uses both pools in a complementary and disciplined manner. This diversified approach can optimize the performance of an agency’s liquidity management strategy when compared to an approach that attempts to time the market or avoid developing a strategy altogether.
It is impossible to time the markets. Consider the Fed’s dot plot from this time last year to what we’ve experienced. The Fed was projected to hike rates one time in 2022. They ended up raising the target rate range seven times.
What will managers of public funds experience between the date of this article’s publication and January of 2024 that will seem equally improbable to the divide between 2022’s projections and today’s reality? No one knows. Year after year, the Fed and well-compensated economists attempt to forecast interest rates, and they very rarely get it right... and these are the guys with all the data!
The best that any manager of public funds can do is construct a well-balanced portfolio that is prudently positioned to weather the only thing we can all be certain about, and that is interest rate uncertainty.
The disciplined development and execution of your agency’s liquidity strategy is firmly within your control. Steward that process and your agency, and its taxpayers, will benefit from your thoughtful expertise.
Key Takeaways
- For the first time in a very long time, there are meaningful returns to be earned in the cash asset class.
- The Fed is tightening now but that could quickly change - nobody knows.
- Diversification is the primary safeguard in positioning your portfolio against the certainty of uncertainty.
- The concept of weighted average maturity is critical to a well-balanced liquidity strategy.
- California CLASS Prime and Enhanced Cash are complementary investment pools for agencies seeking to optimally invest and manage their liquidity.
Written by:
By Brent Turner, CTP,
Regional Director of Strategy, California CLASS