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Types of Investments
(Comptroller of Public Accounts, Treasury Operations)

Allowed Investments

Under the Public Funds Investment Act, school districts may invest in the items listed below.

Treasury Bills (T-Bills)

A Treasury Bill is a non-interest bearing obligation, issued at a discount, fully guaranteed by the U.S. government for 3 months, 6 months, or 12 months. All treasury bills are short-term securities of one year or less. Treasury bills are issued at a discount from their face value. The characteristics of Treasury Bills are listed below.

  • No coupon and trade at a discount, meaning that the investor is not paid interest in increments over the life of the investment, but instead the security is sold for an amount less than the face or par value of the security. When the security reaches maturity, the investor is paid face value.
  • Interest = par value minus cost
  • 3- and 6-month treasury bills are auctioned every Monday
  • one year treasury bills are auctioned every four weeks
  • Treasury Bills mature on Thursdays unless it’s a holiday, then they mature on the next business day
  • Treasury Bills are quoted and traded on a discount yield that is converted to a bond equivalent yield.

    Credit Risk: Low. Treasury bills are backed by the full faith and credit of the U.S. Treasury.

    Liquidity Risk: Low. Treasury bills are one of the most liquid securities in the market.

    Market Risk: Low. The short duration allows for less price volatility.

    Advantages: Treasury bills are very liquid; they have active primary and secondary markets and high availability.

    Disadvantages: Low relative yield.

    Web site: http://www.publicdebt.treas.gov/com/combills.htm

Treasury Notes and Bonds

A Treasury Note is a coupon security issued by the U.S. Treasury, fully guaranteed by the United States Government. Treasury Notes are intermediate securities with maturities of one to ten years.

A Treasury Bond is a coupon security issued by the U.S. Treasury, fully guaranteed by the United States Government. Treasury bonds are long-term debt instruments with maturities of 10 years to 30 years.

The characteristics of Treasury Notes and Treasury Bonds are listed below.

  • Treasury Notes have an original maturity of 10 years and under (2, 5 and 10 years).

  • Treasury Bonds have an original maturity greater than 10 years.

  • Treasury Notes and Treasury Bonds both mature on the 15th or the last day of the month.

  • Treasury Notes and Treasury Bonds have semi-annual fixed coupons.

  • Interest for Treasury Notes and Treasury Bonds is calculated on an actual (365 day) basis.

  • No coupon

  • Yield-to-maturity (YTM) is the most common measure of return for both Treasury Notes and Treasury Bonds. YTM is a financial ratio that measures the rate of return on a bond’s acquisition costs and its value at maturity. This ratio accounts for any interest income from the bond. It assumes that the bond is held and redeemed at maturity.

  • Treasury Notes and Treasury Bonds are purchased through auctions or secondary market.

    Credit Risk: Low. Treasury Notes and Treasury Bonds are backed by the full faith and credit of the U.S. Treasury.

    Liquidity Risk: Low on short-term maturities and moderate on long term maturities. This is the largest, most liquid market in the world.

    Market Risk: Low on short-term maturities and high on long term maturities due to the duration of the security.

    Advantages: Treasury Notes and Bonds have the advantages of liquidity, an active primary and secondary market and availability.

    Disadvantages: Market risk on longer securities, low yields relative to other securities.

    Web site: Treasury notes: http://www.publicdebt.treas.gov/com/comnotes.htm

    Web site: Treasury bonds: http://www.publicdebt.treas.gov/com/combonds.htm

Repurchase Agreement (Repo)

A repurchase agreement is an agreement between a seller and a buyer in which the seller agrees to repurchase the securities at an agreed upon rate. A holder of securities sells repurchase agreements to an investor with an agreement to repurchase them at a fixed price on a fixed date. The security buyer, in effect, lends the seller money for the period of the agreement. The terms of the agreement are structured to compensate the security buyer. Large amounts of money are needed for this type of investment. Types of repurchase agreements are listed below.

  • Overnight repurchase agreements, which mature the next day

  • Open repurchase agreements, which have undefined maturities. The rates are variable or set daily, they roll or terminate at the request of either party

  • Term repurchase agreements have a defined maturity date, a fixed rate, and are liquid

    Repurchase agreements can help brokers finance their inventories. The safety of repurchase agreements is based on: (a) the counterparty’s credit-worthiness, (b) a written and signed repurchase agreement, (c) a safekeeping location, and (d) delivery versus payment.

    Credit Risk: Low if covered by a Master Repurchase Agreement, which is a written contract that covers all repurchase transactions between two parties with respect to the repurchase agreements that have established each party’s rights in these transactions. A master repurchase agreement will often specify, among other things, the right of the buyer or lender to liquidate the underlying securities in the event of a default by the seller or borrower.

    Liquidity Risk: Not applicable if the repo is executed as an overnight trade. Liquidity risk is high if the repo is executed as a term trade (greater than one day). A repo is considered to be an investment agreement.

    Market Risk: Not applicable if the repo is executed as an overnight trade. Low, if the repo is executed as an open or term trade. Monitor collateral regularly

    Advantages: Repos allow for overnight investments to the penny. They also offer flexibility and market rates.

    Disadvantages: Rates are influenced by the fluctuating daily federal funds rate and the quality of available collateral, there is collateral risk if the collateral is not delivered DVP (delivery vs. payment).

Agency Securities

Agency securities are issued by government-sponsored corporations such as the Federal Home Loan Bank, Federal Farm Credit Bank, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Student Loan Marketing Association, and the Federal Land Bank. The characteristics of agency securities are listed below.

  • No explicit government guarantee, although government assistance is implied.
  • Most agencies securities are widely traded.
  • Some agency securities are exempt from state tax (FFCB, FHLB, FLB,
  • SLMA)
  • Interest is calculated on 30 day months
  • On 31st day settlement, the same amount of interest is accrued as the 30th
  • agency securities always have good day maturities but call date may be a bad
  • day of the week (falling on a weekend or holiday).

  • Agency securities are callable. The following are characteristics of a callable security:

    • The issuer has the right to repay the issue earlier than the maturity date
    • Popular for the issuer in a declining interest rate environment
    • Call protection — 3 year/1 year (three year maturity, but it can be called after one year), 5year/3 year (cannot be called for at least three years), etc.
    • Usually trades at an additional yield over and above what might be earned on a U.S. Treasury obligation with a comparable maturity
    • Priced yield-to-maturity or yield-to-call depending on premium, par or discount
    • Call date could be a bad day of the week
    • New issues are almost always at par.

    Credit Risk: Low. Backed by U.S. government-sponsored corporations, no explicit government guarantee, although there is implied assistance.

    Liquidity Risk: Moderate to High. Not as liquid as Treasury Notes but most are widely traded. Depending on the issue and size, the security can trade 10 basis points higher than Treasuries for short-term investments (one year) and 100 basis points higher for long-term investments(10years).

    Market Risk: Low on shorter maturities, high on longer maturities due to the volatility of prices.

    Advantages: Additional yield, which is based on implied but not guaranteed government support, active primary and secondary markets; usually traded at a higher rate than U.S. Treasury obligations with a similar maturity.

    Disadvantages: Market pricing difficulties and market risk on longer maturities.

    Web site: http://www.salliemae.com

    Web site: http://www.fca.gov/

    Web site: http://www.fanniemae.com

    Web site: http://www.freddiemac.com

Agency Discount Notes

Agency discount notes are discount notes issued by the Federal National Mortgage Association, Federal Farm Credit Bank, Federal Home Loan Mortgage Corporation, and Federal Home Loan Bank. The characteristics of agency discount notes are listed below.

  • Like treasury bills, agency discount notes have a maturity of one year or less.
  • No coupon
  • Discount to par
  • Actual/360
  • Can mature any day of the week, maturity varies

    Credit Risk: Low. Debt issuance of U.S. government agencies

    Liquidity Risk: Low. Actively traded money market instrument

    Market Risk: Low. Short-term maturities of less than one year

    Advantages: Liquidity, usually trades10 or more basis points above comparable Treasuries: Very active secondary markets, thus highly liquid.

    Disadvantages: No significant disadvantages

Commercial Paper

Commercial paper relates to short-term borrowing from business corporations. Often, a corporation will have a letter of credit to back up this type of borrowing. Commercial paper refers to short-term obligations with maturities ranging from overnight to 270 days issued by banks, corporations or other borrowers to investors. The corporation’s credit worthiness determines the rating of the commercial paper. These are the best-yielding (highest interest rate) securities.

The characteristics of commercial paper are listed below.

  • Unsecured debt
  • Bearer or depository trust company eligible. A depository trust company is a firm through which the members can use a computer to arrange for investment securities to be delivered to other members via computer, thus there is no physical delivery of the securities. A depository trust company uses computerized debit and credit entries. Depository trust companies are members of the Federal Reserve System.
  • Required minimum ratings: Standard and Poors: A-1, Moody’s: P-1.
  • Discount (most common). A discount is the difference between the purchase price of a security and its par (face) value. This discount represents the income to be earned on the security, and will be accreted over the life of the security.
  • Purchased direct or through dealers

    Credit Risk: Moderate to high. The ratings of the company issuing the commercial paper should be monitored; i.e., A-1/P-1.

    Liquidity Risk: Moderate. If a company has credit problems it may receive a negative credit watch, which will lead to a rating being downgraded. Commercial paper also may be somewhat difficult to sell.

    Market Risk: Moderate, due to the short-term nature of this security.

    Advantages: Higher yield, specific maturity dates chosen by the purchaser within a range of 270 days, and rated by credit agencies for evaluation purposes.

    Disadvantages: Reduced liquidity. The lack of active secondary market reduces the liquidity of commercial paper, there also may be other associated market pricing difficulties.

    Web site: http://www.ny.frb.org/pihome/fedpoint/fed29.html

Bankers Acceptance

A bankers acceptance is a money market instrument which is used to finance import or export transactions. Bankers acceptances are essentially checks. They represent a bank’s promise and ability to pay the face or principal amount on the bankers acceptance on the stipulated maturity date. The characteristics of bankers acceptances are listed below.

  • Trades at a discount
  • Prime bankers acceptances are shorter maturities
  • Required minimum ratings: Standard and Poors: A-1, Moody’s: P-1
  • Four tiers: (1) domestic, (2) Yankee — foreign banks in the US, (3) European or Asian-U.S. banks abroad, and (4) Foreign

    Credit Risk: Moderate to high. Ratings banks issuing the bankers acceptance should be monitored. The short term obligations of the bank must be rated not less than A1/P1.

    Liquidity Risk: Moderate. Monitor credit and stability of bank. A bankers acceptance may be somewhat difficult to sell.

    Market Risk: Low to moderate, due to the short-term nature of this security.

    Advantages: Higher yield, specific maturity dates are chosen by the purchaser within a range of 180 days.

    Disadvantages: Reduced liquidity. The lack of active secondary market reduces the liquidity of commercial paper, there also may be other associated market pricing difficulties.

    Web site: http://www.ny.frb.org/pihome/fedpoint/fed12.html

Certificates of Deposit (CDs)

A certificate of deposit is a time deposit issued by a bank that pays interest periodically or at a specific maturity date, as evidenced by a certificate. The bank, or other financial institution, issues a certificate which indicates a specific dollar amount has been deposited with that bank for a fixed period of time at a predetermined interest rate. The characteristics of CDs are listed below,

  • Interest calculations are mostly based upon a standard 360 days in a year called actual/360 but some are actual/365
  • Insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000

Because CDs are only insured by the FDIC for $100,000, and because the investment is dependent solely upon the credit worthiness of the bank deposits of amounts in excess of $100,000 should be secured in some way. Collateralization recommendations:

  • Obtain state collateralization law
  • Obtain Federal Reserve Bank’s operating circular on public depositors’ collateral
  • Ask the bank to pledge securities to secure deposits of public monies that are not otherwise insured by the FDIC
  • Identify depository risk exposure — how reliable is the bank
  • Establish a written depository collateralization agreement that includes: (1) funds to be collateralized; (2) eligible collateral; (3) market value; and collateralization ratios.
  • Establish effective safekeeping procedures
  • Prepare financial reporting disclosures

    Credit Risk: High. The investor should monitor the financial condition of the bank.

    Liquidity Risk: High. CDs cannot be liquidated without paying penalty.

    Market Risk: Moderate. Monitor collateral value and require adequate margins.

    Advantages: Flexible rate structures for small and large denominations, ease of investment transaction.

    Disadvantages: Not liquid. Dependent upon FDIC insurance under $100,000 and dependent solely upon the credit worthiness of the bank if not collateralized.

    Web site: http://www.gfoa.org/

Derivative Securities

A derivative security is an instrument whose value is based on and determined by another security or benchmark. The most common derivative securities are listed below.

  • Mortgage-backed securities These securities are issued by the Federal Home Loan Mortgage Corporation (FHLMC), Federal National Mortgage Association (FNMA), and other institutions, which are guaranteed by the Government National Mortgage Association (GNMA). Investors receive payments out of the interest and principal on the underlying mortgages. Sometimes banks issue certificates backed by conventional mortgages, selling them to large institutional investors. The growth of mortgage-backed certificates and the secondary mortgage market in which they are traded has helped keep mortgage money available for home financing. Certificates are held in trust by a third party custodial bank. Most are rated AAA because of high quality collateral. Payments can be monthly, quarterly or semi-annual.
  • Interest Only (IO) and Principal Only (PO) The cash flow elements are stripped from mortgage backed securities and traded separately. These have high volatility and market risk.
  • Inverse Floaters An inverse floater is a type of security with a coupon that periodically resets at a higher rate when market interest rates fall and resets at a lower rate when market interest rates rise. Inverse floaters have high price volatility.
  • Callable Bonds. The issuers have the option to redeem these bonds early if they can lower the finance costs. Most have a call protection period; there may be a discreet call, whereby the investor has sold the issuer the right to repurchase the bond back from the investor, but only on specified interest payment dates or other predetermined dates as per a formal call schedule, or a continuous call, where the issuer of the security maintains the right to repurchase it from the buyer at any time after the initial call date has passed.
  • Floating Rate Notes: The coupon rate periodically moves up or down in step with a specified market rate of interest. Floating rate notes are issued by instrumentalities, mortgage-backed securities, municipalities, and corporations. They have a reset period, an interest payment period and low price volatility.
  • Step up callable: A set coupon or interest rate is set for a stated period such as six months or a year. After that time if the coupon or interest rate does not increase to a specified level, the security will be called. There are many structures and many maturities. There can also be multi-step-ups, in which there is an initial coupon then several known coupon increases and call options.

    Credit Risk: Moderate, due to agency issuance.

    Liquidity Risk: High. Certain security types may have the maturity date extended and may significantly lose value.

    Market Risk: High security extension, and volatility risk is high, longer security means more market risk.

    Advantages: Higher yields.

    Disadvantages: Higher volatility

    Web site: http://www.fanniemae.com/markets/mbssecurities/

    Web site: http://www.freddiemac.com/debt/html/faq.html

Local Government Investment Pools

Local government investment pools are integrated investment instruments, formed as a money market fund equivalent, sometimes governed by a board of participants. Investment pools can include mandatory participation. Some pools have non-mandatory participation. Investment pools are calculated based on an actual/360 day basis. Investment pools are created under the Interlocal Cooperation Act. Backed by the securities in the fund, the investor owns a pro-rated share of the portfolio. There is always 1-day liquidity. The investment pool is quoted on a yield basis, accrues daily and pays monthly. Purchases can be made directly from the local government investment pool. No minimum size is required for investing in the pool.

Credit Risk: Low. There is no credit risk on securities, some credit risk exists on pool ratings.

Liquidity Risk: Moderate to high. There is nominal risk on the constant dollar pools. There is more risk on fluctuating net asset value pools..

Market Risk: High. Risk on fluctuating net asset value pools only.

Advantages: Total liquidity, professional management, convenience, and safety. Some investment pools are rated by a nationally recognized credit rating agency. They are "dollar in dollar out", which means that the dollar value of the original deposit is expected to be maintained through conservative management practices. They are able to maintain several accounts and produce separate reports.

Disadvantages: There is credit risk potential, possible loss if the net asset value falls below one dollar. Investors should require timely reporting of managed funds.

Money Market Funds

Money market funds are integrated investment instruments. They are constant dollar funds created and governed by a private entity. They are registered by the Security and Exchange Commission and sometimes rated by a nationally recognized rating agency. They are calculated on an actual/360 day basis. They are backed by the securities in the fund. The investor owns a prorated share of the portfolio, which is quoted on a yield basis, accrues daily and pays monthly. Purchases can be made directly from the fund or through a bank broker. The minimum size of the investment differs by fund, usually $100 is the minimum requirement.

Credit Risk: Low to moderate. No credit risk on securities; the risk is on the fund rating.

Liquidity Risk: Low; there is nominal risk because the dollar value of the original deposit is expected to be maintained through conservative management practices.

Market Risk: Low, limited due to short-term average maturity.

Advantages: Total liquidity, professionally managed, convenience, safety and flexibility. The dollar value of the original deposit is expected to be maintained through conservative management practices.

Disadvantages: Market risk and credit risk. Investors should read the money market fund prospectus and require timely reporting.

Web site: http://www.ibcdata.com/mfs/select_i.htm

Web site: http://www.gfoa.org/

Prohibited Investments

There are specific mortgage-backed securities — collateralized mortgage obligations (CMOs), sometimes referred to as derivatives, which are NOT authorized under state law and the district may "unauthorize" any security it desires. The unauthorized securities include:

  • Interest Only (IO) CMOs — whose payments represent only interest on the outstanding principal of the underlying mortgage-backed security.
  • Principal Only (PO) CMOs — whose payments represent only principal from the underlying mortgage-backed security.
  • Collateralized mortgage obligations with a stated final maturity date of greater than 10 years.
  • Inverse CMOs (Inverses) whose interest rate is determined by an index that adjusts opposite to changes in a market index.

In addition, other unauthorized investments include investments that do not meet the criteria listed in the Act and investments that fail to meet the specific criteria for authorized investments laid out in sections 2256.009 through 2256.16 of the Government Code. Finally, unauthorized investments include any investment that the board of trustees in its investment policy specifies as not suitable for the district .