December 2017

Allowable Investments Under The Texas Public Funds Investment Act

Benjamin M. ClarkSVP – Portfolio StrategiesHouston, TX

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Objectives of this Session

Understand the General Requirements of PFIA Investment Policies Training

Identify and Define PFIA Authorized Investments Identify Investments Not Authorized under PFIA Discussion: Investing in Uncertain Times

Disclaimer is on the last page of this presentation.

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General Requirements of PFIA:Investment Policy (Sec. 2256.005)

STANDARD OF CARE. (a) Investments shall be made with judgment and care, under prevailing circumstances, that a person of prudence, discretion, and intelligence would exercise in the management of the person's own affairs, not for speculation, but for investment, considering the probable safety of capital and the probable income to be derived. Investment of funds shall be governed by the following investment objectives, in order of priority:

1. preservation and safety of principal;2. liquidity; and3. yield.

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General Requirements of PFIA:Investment Policy (Sec. 2256.005)

Written policy required Prioritize

Safety of Principal Liquidity Yield

Must address the following Authorized investments Maturity/WAM/Average Life Limits Methods for monitoring market valuations Requirement of DVP settlement

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General Requirements of PFIA:Investment Strategies (Sec. 2256.005 (d))

Separate written investment strategy may be adopted Must be reviewed at least annually Investment officer(s) can be designated – various

restrictions placed on such person(s) Priority of Objectives

Suitability of investments Preservation and safety of principal Liquidity Marketability of the investment Diversification of the portfolio Yield

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General Requirements of PFIA:Compliance Audit & Investment Training

Compliance audit of management controls Once every two years Internal or private auditor Ensure compliance to established investment policies

Investment Training – Local Governments Required if investing public funds in anything other than CDs Treasurer, CFO (if Treasurer is not CFO) & Investment Officer Investment training must be from an independent and approved

source

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Unauthorized Investments – OverviewSec. 2256.009 (b)(1)-(4)

1. Interest-only mortgage-backed collateral securities (IOs)

2. Principal-only mortgage-backed collateral securities (POs)

3. Collateralized Mortgage Obligations (CMOs) with a stated final maturity date greater than 10 years

4. “Inverse Floater CMOs” Those in which the CMO’s coupon floats to an index that

adjusts opposite to the changes in a market index

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Authorized Investments – OverviewSec. 2256.009 (a)(1)-(6)

1. Obligations, including letters of credit, of the United States or its agencies and instrumentalities

2. Direct obligations of this state of its agencies and instrumentalities3. Collateralized mortgage obligations (CMOs) directly issued by a

federal agency or instrumentality of the U.S.4. Other obligations where by the principal and interest payments are

backed by the full faith & credit of this state or the U.S. government or their respective agencies and instrumentalities, including obligations fully guaranteed by the FDIC

5. Obligations of other state, agencies, counties, cities and other political subdivisions rated “A” or better by a nationally recognized rating firm

6. Bonds issued, assumed, or guaranteed by the State of Israel

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Authorized Investments: OverviewObligations of the U.S. Govt. or its Agencies & Instrumentalities

“Obligations”: U.S. Treasury Securities “Agencies”: Official U.S. federal government agencies

Securities issued or guaranteed are backed by the full faith and credit of the U.S. government

Explicit and unconditional commitment GNMA, SBA, Ex-Im Bank, FHA & others

“Instrumentalities”: Govt.-sponsored enterprises (GSEs) Not backed by a FF&C guarantee Securities carry credit risk Farmer Mac, Farm Credit, FHLB, Freddie Mac, Fannie Mae,

TVA

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Non-Amortizing vs. Amortizing Bonds

Non-Amortizing (Example: Agency Debentures) No periodic return of principal dollars Principal returned at maturity or call date Typically pays semiannual interest

Amortizing (Example: Mortgage Backed Securities) Principal & interest returned according to a

designated periodic payment schedule Principal balance falls over time

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Authorized Investments:U.S. Treasury Securities

Non-amortizing Issued by the U.S. Department of the Treasury Direct obligations of the U.S. Government Maturities ranging from 4 weeks to 30 years

T-Bills: 4-52 weeks T-Notes: 2-10 years T-Bonds: 30 years

T-Bills trade at discounts to par – investor receives full face value at maturity

T-Notes & T-Bonds pay semi-annual interest, principal returned at maturity

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Authorized Investments:U.S. Treasury Curve: November 2016 vs. 2017

1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 15Y 20Y 30YTreasury Curve (Nov 2017) 1.04% 1.21% 1.37% 1.54% 1.68% 1.81% 2.08% 2.28% 2.41% 2.53% 2.64% 2.87%Treasury Curve (Nov 2016) 0.29% 0.48% 0.61% 0.76% 0.99% 1.27% 1.66% 2.01% 2.22% 2.41% 2.59% 2.96%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

Treasury Curve (Nov 2017)

Treasury Curve (Nov 2016)

*some observations are interpolated Source: Bloomberg as of 11/13/2017

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Authorized Investments:Agency Bonds

Non-amortizing – generally pay interest semi-annually GSE Issuers (Established)

Federal Home Loan Banks (1932) Fannie Mae (1938/68) Freddie Mac (1970/88) Farm Credit (1916) Farmer Mac (1987)

Structures Discount Notes Fixed Maturity - Bullets Callable Step-Up

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Authorized Investments:Agency Bonds

Farmer Mac(FAMCA)

Provide secondary market for agricultural,rural housing, and rural utilities

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Authorized Investments:Agency Bonds

Source: FTN Financial and US Agencies

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Authorized Investments:Agency Bonds

Source: FTN Financial and US Agencies

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Authorized Investments:Agency Bonds

Source: FTN Financial and US Agencies

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Authorized Investments:Agencies vs. Treasuries

2Y Bullet

3Y Bullet

5Y Bullet

7Y Bullet2Y NC 6M

3Y NC 6M 5Y NC 6M

7Y NC 6M

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

1 3 6 12 24 36 60 84 120 180 240 360

Yiel

d

Months

Treasury Curve (Nov 2017) Agency Bullet Callable Agency

Source: Bloomberg and FTN Financial

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Authorized Investments:Mortgage Backed Securities - Basics

Amortizing Often referred to as “pass-through” securities A MBS is an undivided ownership interest in the

P&I cash flows generated by a pool of mortgage loans (pro-rata distribution)

Monthly P&I collected by mortgage originators and “passed-through” to investors less servicing and guarantee fees

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Authorized Investments:Mortgage Backed Securities – Pass-Through Explained

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Authorized Investments:Mortgage Backed Securities - Advantages

High yielding asset (significant pick up versus Agency Bullets and Treasuries)

Excellent credit quality (explicit government guarantee for GNMA)

Built-in cash flow ladder (amortization forces principal return)

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Authorized Investments:Mortgage Backed Securities - Issuers

GNMA (Ginnie Mae) – Government owned and operated agency created to promote homeownership among low to middle income families (unconditional govt. guarantee)

FNMA & FHLMC (Fannie Mae & Freddie Mac) –Government sponsored agencies developed to promote a secondary market for conventional mortgage loans (referred to as Conventionals)

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Authorized Investments:Mortgage Backed Securities – Investment Risks

Primary risk is that the investment prepays differently than anticipated Borrowers have right to prepay principal in full or in part at any

time without penalty Similar to a callable bond, the right to prepay is an option held

by the homeowner

Therefore, an assumption regarding a range of prepayment rates is necessary to evaluate MBS opportunities (Bloomberg consensus, prepayment models helpful)

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Authorized Investments:Mortgage Backed Securities – Drivers of Prepayments

Rate incentive (can borrowers get a lower mortgage rate?) Refi rate incentive: How far in or out of the money a borrower is. A pool

with a 5% WAC (WAC: weighted avg coupon or mortgage rate) in an environment with 4% rates has 100 bps of incentive.

Loan size: small loans prepay slower (smaller economic benefit for paying fixed costs and enduring headaches)

Current LTV/FICO: difficult for high LTV and low FICO borrowers to refi (but very low FICO borrowers default more)

Loan age: new loans and very old loans exhibit slow prepayments

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Authorized Investments:MBS vs. Treasuries

10Y 2.5s, 2.17%

15Y 2.5s, 2.40% 20Y 3.0s, 2.67%

30Y 3.0s, 2.98%30Y 3.5s, 2.98%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

0 50 100 150 200 250 300 350 400

Yiel

d

Months

Treasury Curve (Nov 2017) Fixed Rate MBS

Source: Bloomberg and FTN Financial

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Authorized Investments:CMOs

CMOs are securities that are created from a pool of mortgage pass-through securities Principal & interest are distributed to different classes

(called tranches) of bonds. Each bond (tranche) usually has a different principal

amount, coupon rate, maturity, and prepayment risk.

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Authorized Investments:CMOs - Advantages

Only bonds with stated maturity of <10 years are authorized under PFIA

Cannot be IO, PO or inverse floating structures Investors are able to find better matches for their needs

Average life Average life variability Cash flow ladder/payment window Price point

Diversify collateral exposure Benefit from difference collateral while maintaining structure

Protection against market uncertainties

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Authorized Investments:Obligations of the State of Texas or Other States

Municipal Bonds Issued by political subdivisions Maturities typically out to 30 years Generally provide long call protection without a large

“cost” Tax-free & taxable issues available Taxable munis currently in favor with public funds due

to higher nominal yields

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Authorized Investments:Taxable Municipal Bonds vs. Treasuries

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

0 50 100 150 200 250 300 350 400

Yiel

d

Months

Treasury Curve (Nov 2017) US Taxable GO AAA Muni Curve

Source: Bloomberg

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Authorized Investments:Certificates of Deposit - Basics

FDIC insured up to $250,000 per institution Range of maturities Bank CDs

Typically offer attractive rates Early redemption fees can apply

Brokered CDs Negotiated instruments Assigned CUSIPs No early redemption fees Can be traded – subject to market pricing

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Authorized Investments:Certificates of Deposit - Requirements

Issuing institution has main office or a branch office in this state and is Guaranteed or insured by FDIC or NCUSIF or successors Collateralized by PFIA authorized investments Secured in any other manner and amount provided by law

Funds may also be invested in CDs through CD brokerage services like CDARS provided that the broker has its main office or a branch in this state and is selected from a list adopted by the investing entity Full amount of the principal and accrued interest of each CD

must be insured by the U.S. or an instrumentality of the U.S.

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Other Authorized Investments:Repurchase Agreements – Basics & Requirements

“Repos” Short-term borrowing arrangements for broker/dealer and other

entities that hold positions in government securities Must be fully collateralized by a combination of cash and PFIA

authorized investments Must have a defined termination date Positions must be pledged to the entity (county), held in the entity’s

name and deposited at the time the investment is made Requires 3rd party safekeeping arrangement Counterparty must be a primary dealer or financial institution doing

business in this state Other restrictions defined in 2256.011

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Other Authorized Investments:Securities Lending Program: Basics & Requirements

The act of loaning a security to another investor or dealer Authorized under 2256.0115(a) Value of securities loaned under the program must be not less than

100% collateralized, including accrued income Must allow for termination of the loan at any time Must be secured by pledged securities authorized under PFIA,

pledged irrevocable letters of credit issued by a bank – with restrictions or cash

Loan must be placed through a primary government securities dealer or a financial institution doing business in this state

Must have a term of one year or less

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Other Authorized Investments:Banker’s Acceptances – Basics & Requirements

Short-term debt instruments issued by a company that is guaranteed by a commercial bank

Similar to T-Bills – trade at a discount to par Must have a stated maturity of 270 days or fewer from

date of issuance Liquidated in full at maturity Eligible for collateral for borrowing from Federal Reserve

Bank Accepted by a bank that is rated not less than A-1 or P-1

or an equivalent rating

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Other Authorized Investments:Commercial Paper

Unsecured, short-term debt instrument issued by a corporation typically for the financing of short term liabilities (accounts receivable, inventory, etc.)

Must have a stated final maturity of 270 days or fewer

Issuer must be rated not less than A-1 or P-1 or an equivalent rating by at least:

A. Two nationally recognized rating agenciesB. One nationally recognized credit rating agency and

it fully secured by an irrevocable letter of credit

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Other Authorized Investments:Mutual Funds – Basics & Requirements

Investment made up of a pool of money invested in a basket of securities

Shares are redeemed at a “Net Asset Value” (NAV) Offer diversification and professional management – for

a fee SEC registered no-load money market mutual funds

Must provide a prospectus and other information required by federal law

Must have a dollar-weighted average stated maturity of 90 days or fewer

Must seek the objective of maintaining a stable NAV of $1/share Investing entity (county) must not own more than 10% of the fund’s total

assets

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Other Authorized Investments:Mutual Funds – Basics & Requirements (cont.)

SEC registered no-load mutual fund WAM less than 2 years Must be invested exclusively in obligations that are PFIA

approved Must be continuously rated no less than AAA or equivalent by a

nationally recognized ratings agency Must conform to requirements in section 2256.016(b)

Not Authorized Entity must not invest in the aggregate more than 15% of its

monthly average fund balance, excluding bond proceeds, reserves and other funds held for debt services

Must not own more than 10% of the mutual fund’s total assets

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Other Authorized Investments:Guaranteed Investment Contracts – Basics & Requirements

Insurance contracts that guarantee repayment of principal and a stated return May be fixed or floating

Must have a defined termination date Secured by obligations authorized under PFIA 3rd party safekeeping Bond proceeds, other than reserved and funds

maintained for debt service, may not be invested with a term longer than 5 years

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Other Authorized Investments:Guaranteed Investment Contracts – Basics & Requirements (cont.)

To be eligible: Entity (county) must specifically authorize GIC as an

eligible investment Must receive bids from at least 3 separate providers Must purchase the highest yielding GIC bid received Price must take into account expected drawdown

schedule Must have reasonable administration fees

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Other Authorized Investments:Local Govt. Investment Pools – Basics & Requirements

State or local pool offered to public entities Texas Class, Tex Pool, Tex Star, Logic, etc.

Government pools vs. “Prime” pools Pool manager must furnish the following:

Types of investments in pool Maximum dollar-weighted maturity allowed Maximum state maturity allowed Objectives of the pool Size of the pool Names of the members on the advisory board Custodian bank & independent auditor Existence of insurance or guarantees held as a source of secondary

payment

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Breakdown of securities held WAM of assets % of pool’s portfolio invested in

assets with maturities longer than 1 year

Book value vs. market value Size of pool and number of

participants

Custodian bank that is safekeeping the assets

Listing of daily transaction activity

Yield & expense ratios Names of PMs Any changes to addendum to

the offering circular

Other Authorized Investments:Local Govt. Investment Pools – Basics & Requirements (cont.)

Requirements for the deposit and withdrawal of funds Historical performance of the pool Yields WAM Expense ratios

To maintain eligibility pool must furnish: Transaction confirms Monthly report that contains:

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Other Authorized Investments:Investment Pools – Basics & Requirements (cont.)

Entity (county) may contract to delegate authority to hold legal title as custodian of investments

Yield shall be calculated in accordance with regulations under federal law

Pools created to function as a money market mutual fund must mark its portfolio to market daily and seek to maintain a $1 NAV.

If ratio of the market value divided by book value of the portfolio is less than 0.995 or greater than 1.005, holdings shall be sold as necessary to maintain ratio between that range

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Other Authorized Investments:Investment Pools – Basics & Requirements (cont.)

Advisory Board must be composed:1. Equally of participants in the pool and other person who do not have a

business relationship with the pool and are qualified to advise the pool for a public funds investment pool created under Chapter 791 and managed by a state agency; or,

2. of participants in the pool and other persons who do not have a business relationship with the pool and are qualified to advise the pool, for other investment pools

Must be rated no lower than AAA, AAAm or equivalent by at least one nationally recognized rating agency

If pool offers breakpoints, they must provide information on all levels of return based on breakpoints or state the lowest possible level of return based on breakpoints in advertising investment rates

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Other Authorized Investments:Miscellaneous

Institutions of Higher Education Mineral Rights Municipal Utility Ports/Navigation Districts Independent School Districts Decommissioning Trust

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