Bad News, Good Views: Municipal Investments in a Rising Rate Environment

By Brian Reilly and Ryan Miles

Investing available cash resources is a core finance function for any city. And while the investing needs of municipalities vary greatly, all local governments should seek to accomplish two primary objectives:

1. Protect the value and purchasing power of your city’s accumulated funds.
2. Produce reliable investment income as a revenue source for your budget.

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

Historically low investment yields and the current spike in inflation are enemies of municipal portfolios, or any portfolio comprised largely of fixed-income investments. While that’s bad news, we can confidently say that market dynamics so far in 2022 provide a positive outlook.

The bad news

The difficult municipal investment environment has only been compounded by the rapid rise in interest rates through the last quarter of 2021 and the first quarter of this year. If you have available cash to invest in today’s market, great!

However, the upward rate trend will erode the reported value of many of the existing holdings in your portfolio. Most cities will publish their 2021 audited financial statements over the next few months, which will include changes in the value of investment holdings.

Some investments, like bank certificates of deposit, are always carried and reported at face value under Governmental Accounting Standards Board standards. Others, such as U.S. Treasury securities and municipal bonds, must be “marked-to-market” under those same standards.

The reported value of investments that are marked-to-market will be reflective of current prices as of the end of the last fiscal period, or Dec. 31, 2021. The main concept here is that when interest rates go up, the market value of many fixed-income investments goes down.

Nearly all bonds held in your investment portfolio that were purchased earlier in 2021 and not very near to maturity will have fallen in value due to the mark-to-market requirement. Therefore, they will negatively impact the accounting measure “fund balance.”

Similarly, if you’re reviewing investment reporting as of yearend or the end of this quarter, your statements will show “unrealized losses,” which represent the decline in value of certain investments in your portfolio because of the recent rise in interest rates. And that decline could be dramatic. The table below shows the yields of U.S. Treasuries for benchmark maturities at the beginning of 2021, end of 2021, and end of first quarter 2022 (approximate).

Yields of U.S. Treasuries

You might look at current yields compared to those at the end of 2021 and think those are still pretty low rates. And from a historical perspective, you’d be right. But it’s the magnitude of change that matters.

Based on the escalation in rates, it won’t be uncommon for local governments to see total unrealized losses for 2021 in the mid-single digits (4% – 6%). Broad bond market indices for first quarter 2022 may have one of the worst performances on record.

Good views

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 — or even three months 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 first quarter of 2022, be mindful of these dynamics. Unlike stocks, whose future value is unknown, bonds will return their principal amount by a stated date.

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.

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.

Brian Reilly, CFA, is a managing director with Ehlers and Associates, Inc., and president of Ehlers Investment Partners, LLC. Ryan Miles, CPFIM, is a managing director with Ehlers Investment Partners, LLC (www.ehlers-inc.com). Ehlers is a member of the League’s Business Leadership Council (www.lmc.org/sponsors).