9.5.2 Investment Considerations
Bond funds, similar to surplus operating funds and reserve funds, are primarily invested according to a prudent investor standard for safety, liquidity, and yield. This means minimizing credit risk (the risk that the obligor under an investment defaults), market risk (the risk that an investment will decrease in value or become unmarketable), and opportunity risk (the risk that an investment precludes the ability to make a later, higher yielding investment).135 The GFOA Best Practice – Investment and Management of Bond Proceeds recommends that issuers consider the following:
Establishing guidelines for permitted investments to reduce credit risk, developing good cash flow estimates and periodically updating those estimates to reduce market risk, and integrating knowledge of prevailing and expected future market conditions with cash flow requirements to reduce opportunity risk. As with investment decisions made with other public funds, the balance generally is weighted heavily towards the preservation of capital (avoiding risk), maintaining liquidity second, and yield last.
In practice, intelligent use of the various investment vehicles can result in a strategy that maximizes earnings within appropriate safety, liquidity, and federal tax law constraints yet provides investment earnings that may minimize an issuer’s overall net borrowing costs.136
INVESTING PROJECT FUNDS – Project schedules usually range from 1 to 3 years and are relatively unpredictable. Because the 0–5 year portion of the yield curve can be relatively steep at times, substantial yield is sacrificed if investments are overly liquid. Investments that mature before monies are actually needed must be reinvested for relatively short periods of time and, generally that translates into a lower investment yield. It is important, therefore, to understand how reliable a projected draw schedule is and whether deviations are likely to cause delays in or speed up expenditures. With this information in hand, the appropriate investment vehicles can be evaluated for yield and liquidity. Investment agreements can be tailored to eliminate liquidity and reinvestment risk in a project fund, but safety and yield also must be evaluated. Investment decisions are circumstance specific but investing in a portfolio of fixed rate securities maturing on dates and in amounts corresponding to expected expenditures purchased with the vast majority of proceeds, supplemented by a money market fund to address liquidity concerns, is usually worth consideration.
INVESTING CAPITALIZED INTEREST FUNDS – If the local agency obligations bear interest at fixed rate, investing capitalized interest funds is a function of how much money will be needed and when. Investments should be selected to mature on or just before an interest payment date on the bonds and in an amount that, together with interest earnings thereon, will be sufficient to pay the interest on the public agency’s obligations.
INVESTING DEBT SERVICE RESERVE FUNDS – While analysis must be circumstance specific, DSRF investments can be of longer duration than other bond proceeds investments. However, because securities with long maturities may be subject to significant changes in market value, bond documents often limit the term of such investments. See Section 2.4.7, Investments. This longer duration usually translates into greater yield. Because project and other fund investments tend to have short average lives and commensurately lower yields, they tend to produce so called negative arbitrage. In other words, their investment yield is lower than the borrowing cost of the funds. DSRF investments frequently present an opportunity to earn positive arbitrage; that is, the investment yield is greater than the borrowing cost on the monies deposited into the fund. Federal tax law generally prohibits tax exempt issuers from retaining arbitrage earnings, but because positive and negative arbitrage offset each other from fund to fund and over time (for the life of the bond issue), DSRF investments often present a valuable opportunity to fully offset negative arbitrage in other funds.
INVESTING DEBT SERVICE FUNDS – The predictability of when monies will be needed to make debt service payments suggests that issuers can purchase or instruct their trustee to purchase securities with DSF deposits that mature on or shortly before the debt service requirement date. However, because the average life of any investment must be less than 6 months in order to meet the debt service schedule, the yield on these investments is likely low. Public agencies may consider using tailored investment agreements (GICs), forward purchase agreements, and certain pooled investment funds (other than money market funds) to provide additional yield. See Section 9.4.2, Investments Specific to Bond Funds.
INVESTING REFUNDING ESCROWED FUNDS – Refunding escrows are almost always structured by professional investment advisors and then verified for tax law compliance and cash flow sufficiency by an independent certified public accounting firm. SLGS are commonly used for refunding escrows. See Section 9.4.2, Investments Specific to Bond Funds.