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Today’s Investment Environment

E-Quarterly Newsletter - December 2022 Quarterly Newsletter

By Ryan Miles, Senior Investment Adviser | Managing Director
and Tami Olszewski, Senior Investment Adviser

It’s a Good New, Bad News Story

Investing available cash resources is a core finance function for any governmental entity. And while the investing needs of these entities can vary greatly, all units of government should seek to accomplish two primary objectives once adequately sized working cash balances are established:

  1. Protect the value and purchasing power of your organization’s accumulated funds by earning a reasonable rate of return when giving safety of principal the highest regard; and,
  2. Produce reliable investment income as a revenue source for your budget through various interest rate cycles.  In this context “reliable” infers the ability to confidently forecast this source of income over one or more fiscal periods with reasonable accuracy.

Seems simple, right? Unfortunately, these goals have been difficult to achieve over the last decade.

Historically low investment yields and now the persistence of elevated inflation are the archenemies of municipal investment portfolios, or any portfolio comprised largely of fixed-income investments for that matter.  Not only is it difficult to produce income, but the future value of that income is eroded by the plague of inflation.

While the current interest rate environment is far more hospitable to producing substantially higher investment income for longer periods of time, those higher rates come with other, undesirable consequences.  In this case, the good far outweighs the bad.

The Bad News

The difficult municipal investment environment of the last few years has been further complicated by the rapid rise in interest rates throughout 2022. If you have available cash to invest in today’s market, great!  You’ll have the opportunity to earn returns that haven’t been available for short maturities in a very long time.

However, this upward rate trend erodes the reported value of many of the existing holdings in your portfolio. As governmental investors produce audited financial statements over the next few months, declines in the market values of investment holdings will almost undoubtedly impact important balance sheet items.

Some investments, like bank certificates of deposit, are carried and reported at face value under accounting rules established by the Governmental Accounting Standards Board (GASB). Other investments, such as U.S. Treasury securities and municipal bonds, must be “marked-to-market” under those same GASB standards.

The reported value of investments that are marked-to-market will be reflective of observable prices as of the end of the last fiscal period – June 1 or Dec. 31, 2022, depending on the type of jurisdiction. The main concept here is that when interest rates go up, the market value of many fixed-income investments goes down.  Generally, longer-termed investments experience larger fluctuations in value for a given change in interest rates.

Nearly all bonds held in your investment portfolio that were purchased early in calendar year 2022 and not very near to maturity will have fallen in value due to the mark-to-market requirements under GASB rules. The value of your investments will be reflected as a part of the balance sheet item “fund balance.”  Therefore, declines in the value of your investments will typically negatively impact fund balance.

Similarly, when you’re reviewing investment reporting as of yearend, your statements will likely show “unrealized losses,” which represent the decline in market value of certain investments in your portfolio because of the rise in interest rates since the beginning of the year. And that decline could be dramatic. The table below shows the yields of U.S. Treasuries for benchmark maturities at the beginning of 2022, June of 2022, and the end of 2022 (approximate).

Yields of U.S. Treasuries
Term to Maturity Beginning of 2022 (Mid) June 2022 Recent (End of 2022)
6 mos. 0.22% 2.30% 4.71%
1 year 0.40% 2.94% 4.66%
2 years 0.80% 3.27% 4.25%
5 years 1.40% 3.45% 3.67%
10 years 1.53% 3.36% 3.51%

Higher investment rates are resoundingly welcomed by all fixed-income investors.  But, the magnitude of change over the course of the last half of the year will produce “negative” total returns (change in market value plus net income), which will likely garner more attention from elected officials and the public than the additional interest income earned this fiscal period.

Based on the escalation in rates, it won’t be uncommon for local governments to see total unrealized losses for 2022 in the mid-to-high single digits (4% – 7%). Broad bond market indices will likely show double digit negative total return for 2022, even with a slight rally in prices.

The Good News

It’s not all bad, though. First, unrealized losses are just that. You would have to sell bonds from your portfolio for those “paper losses” to manifest as “realized losses,” which is unlikely. Regardless of when you purchase a fixed-income investment, you will still collect all cash flows as long as the issuer doesn’t default and you don’t sell it before the stated maturity date.

Second, rising interest rates mean that any investments you purchase now will have materially higher returns than just one year ago. That means more interest income as revenue for your budget.

As you review your community’s year-end investment results, as well as any reporting for the last quarter of 2022, be mindful of these dynamics and how you communicate with your constituents. Unlike stocks, whose future value at the time of sale is unknown, bonds will return their principal amount and all coupon income by a stated date if held to maturity.

At the time of bond purchase, you know the sale price, sale date, and the return you will have achieved at maturity. Stocks, on the other hand, require both a purchase and sale decision to realize a desired rate of return, if that can be achieved at all.

While mark-to-market losses mean deterioration in the value of your fixed-income portfolio, those “losses” also mean higher future cash income for your various funds, which is something we haven’t seen for a very long time.


Required Disclosures: Please Read

Ehlers is the joint marketing name of the following affiliated businesses (collectively, the “Affiliates”): Ehlers & Associates, Inc. (“EA”), a municipal advisor registered with the Municipal Securities Rulemaking Board (“MSRB”) and the Securities and Exchange Commission (“SEC”); Ehlers Investment Partners, LLC (“EIP”), an investment adviser registered with the SEC; and Bond Trust Services Corporation (“BTS”), holder of a limited banking charter issued by the State of Minnesota.

This communication does not constitute an offer or solicitation for the purchase or sale of any investment (including without limitation, any municipal financial product, municipal security, or other security) or agreement with respect to any investment strategy or program. This communication is offered without charge to clients, friends, and prospective clients of the Affiliates as a source of general information about the services Ehlers provides. This communication is neither advice nor a recommendation by any Affiliate to any person with respect to any municipal financial product, municipal security, or other security, as such terms are defined pursuant to Section 15B of the Exchange Act of 1934 and rules of the MSRB. This communication does not constitute investment advice by any Affiliate that purports to meet the objectives or needs of any person pursuant to the Investment Advisers Act of 1940 or applicable state law. In providing this information, The Affiliates are not acting as an advisor to you and do not owe you a fiduciary duty pursuant to Section 15B of the Securities Exchange Act of 1934. You should discuss the information contained herein with any and all internal or external advisors and experts you deem appropriate before acting on the information.

Read More From This Newsletter

E-Quarterly Newsletter - December 2022 Quarterly Newsletter VIEW
Happy Holidays From Ehlers!

We are excited to share our new quarterly newsletter! We listened to the feedback so many of you offered in our Client Engagement Survey earlier this year – the need for stories directly relating to the work you do, more case studies, and the ability to self-select the articles you’d like to read – and hope you find this new format valuable.

 

Don’t Let Increasing Property Values Increase Taxpayer Angst

It’s that time of year…and I’m not talking about the holidays! It’s the time when school district revenue calculations are complete and property tax levies are nearly finalized; it’s also the time when counties begin mailing tax information to property owners. The annual confluence of these two activities usually results in some level of taxpayer confusion and questioning.

Getting the Job Done

In a rising interest rate environment, your ability to drive capital projections toward completion may prove more challenging! The political appetite for taking on more debt to fund municipal projects may have dwindled and the narrative may have shifted more toward reducing debt burden. This scenario presents an opportunity consider alternative strategies.

Arbitrage is Back!

Rising interest rates on investments are most certainly welcome for communities investing bond proceeds.  However, as is the case with most good things, a new set of challenges are introduced.  For issuers of tax-exempt bonds, these challenges can largely be summed up in a single word: arbitrage.

2022 Market Commentary: The Year In Review

To say a lot has changed in the bond market this year would be a major understatement…changes that can largely be attributed to the actions taken by the Federal Reserve to combat persistent inflation.

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