The US Treasury finances federal deficits by issuing debt instruments called Treasury bills, notes, and bonds. The credit standing of each is the same, and the sole difference is the length of maturity. Treasury bills are issued for periods of one year or less, notes are issued to mature from more than one year but less than 10 years, and bonds are issued to mature from more than 10 years up to 30 years. Because of the credit quality of US Treasury securities, investors from all over the world with all forms of investment needs are attracted to these instruments. As a result, the market for these securities enjoys a depth that provides for substantial liquidity.
Various agencies of the US government and government-sponsored enterprises (GSEs) issue debt securities to finance various types of public operations. The agencies that issue the most popular securities, and probably issue the largest volume of government agency securities, are the Government National Mortgage Association (GNMA, commonly referred to as Ginnie Mae), Federal National Mortgage Association (FNMA, commonly known as Fannie Mae), Federal Home Loan Mortgage Corporation (FHLMC, commonly known as Freddie Mac), and Federal Farm Credit Banks (FFCB).
With the exception of the Farm Credit Banks, debt instruments issued by the agencies are often in the form of certificates of participation in the ownership of pools of mortgage loans. While the certificates of participation themselves are not obligations of the US government, the underlying mortgages owned by the pools usually are guaranteed by an agency of the government, such as the Federal Housing Administration (FHA) or the Veterans Administration (VA) in the case of Ginnie Mae.
Both FNMA and FFCB are privately owned organizations that perform specific functions in the public interest. There is only implied federal interest in the financial health of the institutions and protection of investors in the debt instruments issued by these institutions.
When an investor is considering a certificate of participation or a debt obligation of a federal agency, the investor should make a diligent investigation into the adequacy of the instrument for its purposes. In some cases, the cash flow emanating from certificates of participation is very good; the certificates provide current income and repayment of principal to the investor. At the same time, however, accounting considerations are complicated because of the combination of both principal and interest in the cash stream. Moreover, before making the investment, the investor in certificates of participation should understand the nature and long maturity of the mortgages or other debt contained in the investment pool.
For example, a GNMA pool of FHA mortgages may have an average maturity of 17 years, but in a period of declining interest rates, many of these loans in the pool may be prepaid by their respective homeowners/obligors as they refinance their home mortgages at lower interest rates. As a result, the investor in the GNMA pool will realize a more rapid return of capital and a smaller total income figure than had been anticipated. This situation may not fit into the investor's plans for providing cash flow over a budgeted period, or the heavier than anticipated stream of cash flow may cause the investor problems in reinvesting the excess funds.
Municipal securities are instruments issued by various nonfederal government political entities, such as states, counties, water districts, and so on. They provide, in most cases, tax-exempt income to investors who pay taxes. However, increasingly, they are appropriate for investors who have no tax liability. Municipal securities come in a variety of types and maturities, often providing a yield advantage over government securities or corporate instruments of similar credit ratings.
Bank obligations are evidenced in the form of either deposits in the bank or instruments that have been guaranteed or endorsed by a bank and offered in the secondary (resale) markets, such as banker's acceptances.
There are two basic forms of interest-bearing bank deposits: (1) negotiable time certificates of deposit (CDs) and (2) fixed-time deposits.
CERTIFICATES OF DEPOSIT CDs maturing in a year or less are payable to the bearer and therefore, if properly held by a New York custodian, are liquid in the hands of the holder if the CD is issued for at least $1 million. Many banks and investment dealers establish markets in CDs of the leading banks of the world and offer to buy and sell CDs for their own accounts. This is known as the secondary market. An investor can purchase a CD from one of these banks or dealers in the secondary market. Alternatively, an investor may initiate the bank deposit directly, in which case the CD is known as a primary certificate of deposit. If the investor chooses to sell the primary CD prior to maturity to recoup its cash funds early, it may sell it in the secondary market to another bank or a dealer. A bank is not permitted to repurchase its own CDs; this would be tantamount to early redemption of the deposit and subject to penalties. It is critical to note that a secondary market exists only for CDs issued by better-known banks and savings and loan institutions. Also, the instrument itself must be in correct negotiable form and available for prompt delivery in New York. A CD issued by a bank located offshore – usually London, Cayman Islands, Nassau – is called a Eurodollar CD.
FIXED-TIME DEPOSITS Fixed-time deposits are similar to negotiable CDs except that a bearer certificate is not issued. Fixed-time deposits often are issued domestically for amounts a bank wishes to accept. However, amounts of $1 million and more are usually required in London branches of major banks located in London, Nassau, the Bahamas, and the Cayman Islands. These are called Eurodollar time deposits since they are placed in offshore branches. Because these deposits are not represented by negotiable certificates, they are not liquid. Therefore, they often carry a higher yield to the investor than CDs.
BANKERS' ACCEPTANCES A banker's acceptance (BA) is a draft drawn by a bank customer against the bank; the instrument is then “accepted” by the bank for the purpose of extending financing to the customer. The bank's acceptance of the draft means that the bank plans to sell the instrument in the secondary market, and it also indicates the bank's unconditional willingness to pay the instrument at maturity. A BA often originates as the result of a merchandise transaction (often in international trade) when an importer requires financing.
As an investment instrument, a BA of a particular bank carries higher credit quality than the same bank's CD, because it is not only a direct obligation of the bank, like a CD, but also an obligation of an importer and usually collateralized by the merchandise itself. However, BAs are not deposits and do not carry the $250,000 insurance coverage of the Federal Deposit Insurance Corporation. Often BAs can be purchased at a few basis points' higher yield than a CD from the same issuing bank, because many investors are not as familiar with BAs as they are with CDs.
Asset-backed securities are securities where some type of collateral, or pool of assets, serves as the basis for the creditworthiness of the security. Earlier in this appendix, debt instruments from government agencies such as GNMA were referenced whose underlying collateral was a pool of mortgages. Also, many other nongovernmental securities are issued with collateral such as auto loans or credit-card loan receivables.
Commercial paper traditionally has been an unsecured promissory note issued by a corporation. The issuer may be an industrial corporation, the holding company parent of a bank, or a finance company that is often a captive finance company owned by an industrial corporation. Commercial paper is issued to mature for periods ranging from 1 to 270 days. Corporate obligations issued for longer than 270 days must be registered with the Securities and Exchange Commission; therefore, companies needing short-term financing typically restrict the maturities of this debt to 270 days or less. Commercial paper is available to the investor through many major banks that issue the bank's holding company commercial paper or act as an agent for other issuers, and through investment bankers and dealers who may underwrite the commercial paper for their clients. A growing percentage of the commercial paper issued today is now secured, or asset-backed, commercial paper.
A loan participation as an investment medium is attractive to an investor because it presents an opportunity to invest in a corporate obligation that is similar to commercial paper but normally carries a somewhat higher yield. Banks have invested in loan participations of other banks for decades as a means of diversifying loan portfolios. However, the use of loan participations as an investment medium for corporations was developed during the late 1980s.
The loan participation investment medium begins when a bank makes a loan to a corporation using standardized loan documentation. After the loan has been made, the bank seeks investors to buy “participations” in the loan. The investor in the loan participation has the obligation to investigate the credit of the obligor, since the bank selling the participation offers no guarantee or endorsement, implied or otherwise. Many companies that are obligors of these loans are rated by the commercial paper rating agencies, such as Standard & Poor's and Moody's Investors Service. In some cases, the entire short-term debt of the issuer is rated, while in other cases only the commercial paper of the company is rated. However, if the short-term debt or commercial paper is unrated and an investor must rely on his or her own credit analysis, the investor must use extreme caution due to the difficulty in ascertaining the credit soundness of the investment. Loan participations may have maturities ranging from one day to several months. Occasionally, the investor may be able to obtain a loan participation to suit his or her precise maturity requirements, particularly when large amounts (in excess of $1 million) are available for investment.
The investor should be aware that a loan participation is not a negotiable instrument and, therefore, is not a liquid investment. It does not constitute good collateral for the investor who needs to pledge part or all of his or her investment portfolio to secure certain obligations. A loan participation, however, may be a good investment from the standpoint of yield, subject to appropriate credit investigation by the investor.
Corporate debt instruments with maturities longer than 270 days are considered notes if they mature within 10 years from their original issue date. The instruments are considered bonds if they mature more than 10 years from the original issue date. Notes with maturities up to approximately three to five years can play an important role in portfolios where the objective is to increase yield over what is available from strictly short-term portfolios, and where nearly perfect liquidity is not necessarily required. Because they have a longer maturity than money market instruments, corporate notes are subject to greater market risk due to changes in interest rates. However, because the maturities may be only three to five years, the instruments are not subject to swings in market values as much as bonds are.
Corporate bonds are often included in investment portfolios in which the time horizon is much longer than liquidity portfolios. Bonds are seldom included in liquidity portfolios unless they will mature in one year or less (current maturity, not original maturity).
A repurchase agreement is an investment transaction between an investor and a bank or securities dealer in which the bank or dealer agrees to sell a particular instrument to the investor and simultaneously agrees to repurchase that instrument at a certain date in the future. The repurchase price is designed to give the investor a yield equivalent to a rate of interest that both parties negotiate at the time the transaction is initiated.
On its face, a repurchase agreement transaction, commonly referred to as a “repo,” appears to place full and complete ownership of the underlying securities in the hands of the investor. However, a number of incidents of default by dealers occurred during the 1980s, resulting in court rulings that brought the fundamental nature of repos into question. Those rulings implied very strongly that a repo was not, in fact, a purchase with a simultaneous agreement to repurchase the underlying securities, but rather a loan made by the investor to the dealer secured by the pledge of the underlying instruments as collateral to the loan. This viewpoint was bolstered by the fact that, in the repo business, the underlying instruments always have been called “collateral.” Investors who were previously authorized to invest in instruments subject to repurchase were now faced with making secured loans to banks and brokers.
Because repos traditionally have been a fundamental investment medium used by institutions to invest temporarily surplus funds overnight and for periods of approximately one week, the court rulings seriously undermined the viability of the repo for this important purpose. It was not until Congress adopted the Government Securities Act of 1986 (as supplemented by regulations issued by the Treasury Department early in 1988) that the investment community regained its confidence in the repo as an investment medium. That act, however, addressed only part of the issue. It laid out very clearly the rights, duties, and obligations of the dealer in a repurchase agreement as long as the dealer is not a bank. However, it left hanging in the wind the relationship of the dealer if the dealer is a bank. This void continues to exist.
In order to fill the void, the investor should enter into an underlying written agreement with the dealer or bank as the counterparty to the transaction. The agreement should spell out very clearly the rights, duties, and obligations of each of the parties, particularly in the event of the default of one of them. The agreement should also state clearly that the transaction is intended to be a purchase/repurchase transaction and explicitly is not a loan by the investor to the dealer or bank. The agreement should further provide that in the event of the default of the dealer, the investor has the right to take possession of the collateral, if the investor does not already have such possession, and to dispose of that collateral in order to recover the investment.
The Public Securities Association, an organization of securities dealers, prepared a model agreement that many banks and securities dealers have adopted and that they require their repo customers to execute. This model agreement appears to have been drafted in an even-handed manner and supports the interests of both counterparties in the repurchase transaction. Therefore, if the bank or securities dealer does not offer such an agreement, the investor should ask for the agreement from the bank or dealer.
Because of past history involving the collapse of some investment houses that were heavily involved in repos, an investor should be forewarned that the real risk in entering into a repo is the risk of failure of the counterparty (i.e., either a dealer or a bank) to perform under the agreement. The investor should not place great confidence in this type of investment due only to the collateral for safety of principal. The investor, however, should recognize that the success of the transaction actually depends on the viability and willingness of the dealer or bank to repurchase the securities at maturity of the transaction. Accordingly, the investor must be diligent to investigate the credit standing of the counterparty to the transaction.
As an additional protection, the investor should specify to the dealer or bank those securities that are acceptable as underlying collateral. Investing guidelines should specify that such underlying collateral may consist of only investment instruments permitted by the guidelines. Moreover, the guidelines should require that in a repo transaction, the value of the underlying collateral should exceed the amount of the investment transaction by some small increment, usually stated in terms of 102 percent of the amount of the transaction. This should be monitored by the investor on a regular basis to keep current on the market value of securities used as collateral. One final point to be considered is whether the collateral is set aside for the investor and does actually exist.
A money-market mutual fund is itself a portfolio of money market instruments. It provides a reasonable vehicle for investing modest sums where the amount may be too small to manage an effective investing program. For example, in managing amounts of less than $3 million, an investor is hard-pressed to meet the objectives of preservation of capital, maintenance of liquidity, and yield, because money market instruments normally trade in $1 million pieces. The portfolio loses some diversification because of the large size required. If diversification is necessary, it forces the size of any one investment to be less than $1 million, and the company will sacrifice liquidity.
One solution to this dilemma is to invest in a money-market mutual fund where the amounts invested may range from a minimum of perhaps $1,000 (in a retail-oriented money market fund) to many millions of dollars. Various kinds of money-market mutual funds exist. The more popular funds cater to consumers and businesses with modest amounts available, and others serve institutional investors with large amounts of investable funds. Generally, both categories of funds operate similarly, with the institutional funds requiring larger minimum investments and often taking smaller management fees.
The mutual fund affords the investor the opportunity to meet investment objectives of safety of principal, maintenance of liquidity, and yield provided that the investor carefully selects the particular fund. Fund selection should be based on a thorough review of the prospectus, with particular attention paid to the investment objectives of the fund, the experience and investment record of the fund's management, and the quality and liquidity of the investment instruments that the fund maintains in its portfolio.
The investor should inquire about redemption privileges and requirements of the fund and the fund's “pain threshold” for withdrawals. Most money-market mutual funds allow withdrawal virtually on demand either by check (which is actually a draft drawn against the fund) or by electronic funds transfer to the investor's bank account. Electronic funds transfer may be either a wire transfer for value the same day as the withdrawal or an automated clearinghouse transfer with settlement the following day. The pain threshold refers to the size of withdrawal that the fund can tolerate without incurring its own liquidity problems. For some of the very large money-market mutual funds, an immediate withdrawal of $50 million can be tolerated with little pain because of the fund's size. In contrast, a small fund of less than $500 million may have a problem meeting a withdrawal request for $5 million. The size factor should be seriously considered when selecting a money-market mutual fund.
The 2016 changes in the regulations related to money-market mutual funds has caused many institutional investors to reconsider “prime” money-market mutual funds and to either move to government-security-only money funds or move funds to bank deposits. Organizations with higher risk tolerances are also placing some of their short-term funds in separately managed accounts.1