GFOA's Best Practices recommends that governments develop a fixed income diversification strategy as one way to manage the risks associated with the objectives related to their investment portfolios. This resource provides governments with some considerations that should be addressed as they consider risk and diversification matters in their investment policy and actual investment portfolios.
Government investors have a fiduciary responsibility to protect public funds and to prudently manage their investments in order to achieve the investment objectives of 1. Safety, 2. Liquidity, and 3. Return.
Generally, a less diverse portfolio will increase the risk of achieving these objectives because of its greater exposure to unforeseen changes in market conditions and/or the portfolio may not be able to produce the predictive cash flows by the organization. Therefore, governments should develop a diversification strategy that takes into account their specific tolerances for interest rate risk, credit risk, liquidity risk, and market risk.
Developing a Diversification Strategy:
Governments need to establish risk parameters that consider its investment objectives and constraints, tolerances for volatility, liquidity requirements and the current risk/reward characteristics of the market. The profile should be updated if there is a change in risk tolerance. Such a profile provides a framework for making individual investment decisions but could also help structure the investment portfolio.
Diversification of investments within a portfolio is an effective tool in managing acceptable risk.
The greater variation in the characteristics of the portfolio investments, the greater diversification is achieved in a portfolio. Diversification is achieved by investing in a variety of securities with dissimilar characteristics that respond differently to market changes. A basic level of diversification can be achieved by, at a minimum, holding investments of varying:
- maturity dates
- security types
- issuer allocation
- industry (business) sector
Considerations when developing and implementing the strategy could include:
- carefully and clearly defining what the objectives safety, liquidity and return mean to the government entity
- preparing a cash flow forecast to determine liquidity needs and the level and distribution of risk that is appropriate for the portfolio
- considering political climate, stakeholders' view toward risk, and risk tolerances
In addition, the following strategies can be used to reduce risk in a portfolio:
- ensuring liquidity to meet ongoing obligations by investing a portion of the portfolio in readily available funds, such as Local Government Investment Pools (LGIPs), money market funds, or overnight repurchase agreements
- establishing limits on positions in specific securities to protect against default risk
- establishing limits on specific business sectors
- developing strategies and guidelines for investments in single class of securities (such as commercial paper or bankers acceptances)
- limiting investments in securities that have higher credit and/or market risks (such as derivatives)
- limiting particular structures (i.e. optionality, amortizing components, coupon types, issue sizes)
- defining parameters for maturity/duration ranges
- GASB Statement No. 79
- GFOA Best Practice, Using Cash Forecasts for Treasury and Operations Liquidity
Developed by the Committee on Treasury and Investment Management, January 2020.