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Prudent Investor Update, October 10, 2018

Why invest in bonds in a low interest rate environment?

Municipal investing can have a variety of objectives – from generating regular income to funding future projects. Investment decisions are made based on the nature of these goals as defined by the asset management plan. This plan is key because it gives you details on timing and costs to invest appropriately.

The more thought you can put into your plan, the easier it will be to decide how to invest, especially if you can clearly identify the amounts you need and when. Identifying key uncertainties is also a help.

Your risk tolerance is also an important consideration and will be affected by your investment’s time horizon and your ability to withstand losses.  This is impacted by a number of issues, including your ability to access other funding or, change the timing of your spending date.

Some portions of the asset management plan will require smaller payments from your investments frequently over time, such as for the upkeep and maintenance of various capital assets, or perhaps for regular replacement of stock, like computers and vehicles. For those projects, income-oriented investments that include certain stocks and managed bond funds work well. You manage the risk of these investments by having a well-diversified portfolio, with a variety of asset classes and times to maturity.

You need a different approach for those projects that require a payout at a specific time – say if you know you will need to build a new facility or replace a bridge in five years.

Bonds can work best for these larger projects with a fixed time horizon, particularly if you use a strategy called cash flow matching.  In this strategy, you work backwards from when the expense will occur, and purchase one or more bonds that will mature at the time the payout it is needed. So, if you need $10 million in five years, you buy and hold a bond that will generate a fixed return that you know in advance and that will pay back the capital at exactly the five-year point.  This is a very precise way of helping to fund the asset management plan.  

Because of its precision, cash flow matching will not work for all elements of municipal investing. After all, asset management planning is not an exact science. While we can reasonably predict maintenance and capital asset replacement schedules, other factors can intervene. Whether it’s a dramatic weather event that does unexpected damage to infrastructure, or a change in Council with new priorities, some flexibility is needed.

As well, for projects with a very long time horizon, say 10 to 20 years, it may be advantageous to invest in stocks that are normally expected to deliver higher returns over the longer term. The strategy would then be to transition to bonds using cash flow matching once the time horizon has narrowed to five years or less. Every portfolio needs to be reviewed over time to manage upcoming expenditures and adjusted based on portfolio performance and market conditions.

The overall portfolio should be diverse enough to both manage market risk and to accommodate the dynamics of the municipal environment. Cash flow matching is just one bond management strategy.

ONE Investment has offered turnkey investment solutions for municipal governments for 25 years. ONE is developing a range of new products and services aimed at helping municipal governments navigate new opportunities presented by the prudent investor standard.

Stay tuned for more information on our progress in the next newsletter.