A Recap of 2023 Investment Results
The sharp rise in rates over the year just ended resulted in strong returns for LGIPs and money funds. We estimate that the full year returns for LGIPS were in the range of 5.10% to 5.30%. (The lack of consistent reporting across the universe means we cannot calculate a precise figure.) Our model portfolio, invested in Treasuries (60%), investment grade corporate bonds (30%) and cash (a money fund) returned 4.68%.
The bond market rally over the past several months was a boost to the 1-3 year portfolio. Until November it lagged cash. But monthly returns for November and December were in the double digits (1.15% in November and 1.13% in December), annualizing to returns in excess of 14% and for the year contributing to the full year return of 4.68%
In a universe where investment maturities are capped at three years, the reality for many public funds investment strategies, cash was king in 2023.
A longer-maturity portfolio would have improved on this result. Our 1–5-year portfolio returned a full 1.00% more than the 1–3-year portfolio, but at significantly greater risk. The duration of the 1-5 model portfolio at year-end was 2.33 compared to 1.63 for the 1–3-year portfolio. A representative 1–5-year Treasury ETF returned 5.54% compared to 4.31% for a fund with a maximum maturity of three years. But before you kick yourself for not investing in longer-duration securities, consider that this same 1–5-year ETF LOST 6.03% in 2021, so even with the 5.54% return in 2023 an investor would have less money at the end of the two-year period than at the start.
(Note that you can estimate the expected return for a portfolio by selecting the model portfolio category (1-3 year, or 1-5 year) and weighting the investment sector returns in the above graph by investment policy limits or targets. For example, an estimated return for a 1–5-year portfolio with a policy of investing 20% in investment grade corporate bonds and 10% in a cash equivalent would be [.7*5.54%+.2*6.17%+.1*5.20%] or 5.63%. This would not be a precise result as it would not account for cash flows, re-balancing and limits on corporate holdings but nevertheless provide a ballpark measure.)
Whether cash will remain king in 2024 remains to be seen. LGIPs and money fund returns track central bank policy rates closely. If the Federal Reserve cuts rates this year the 5% plus returns of LGIPs and money funds in 2023 will be history. But if not, cash could reign in 2024
Q: When is a Default Not a Default?
A: When it involves a Treasury Security.
In the Alice in Wonderland world of Washington politics and high finance we have had periodic drama around the debt ceiling. The most recent was last May when the Treasury was about to reach the end of its authority to borrow to fund government operations.
The “crisis” was averted when Congress and the President agreed to suspend the debt ceiling until January 2025—an action that practically guarantees that the issue will be back on center stage after the Presidential election.
A debt ceiling crisis could prevent the Treasury from borrowing to pay interest on outstanding debt or refunding maturing Treasuries. The classic conditions of a debt default.
But. . .Some investors have speculated that any “default” of a Treasury security that resulted from a failure to raise the debt ceiling would not be real. Recently a blog by Nathan Tankus identified a Federal Reserve staff memo from 2011 that lays out a plan to manage through such a default. You may remember that the 2011 crisis was kind of a first in recent history and resulted in S&P cutting the credit rating of the United States from AAA to AA+.
The staff memo, which was made public last November after Tankus filed a Freedom of Information Request, lays out options for a series of “say it ain’t so” steps that the Fed could take in the face of default. Here is the plain bureaucratic language from the memo:
“The staff’s recommendation is to make no changes to our current procedures, thereby treating defaulted Treasury securities in these transactions on the same terms that apply to other (non-defaulted) Treasury securities.”
Among the procedures:
● Outright purchases of Treasuries.
● Rollovers of maturing securities into new securities.
● Accepting defaulted securities in securities lending, repurchase agreement and discount window transactions, and
● Purchasing or swapping defaulted securities for non-defaulted Treasuries to remove them from the market.
The bottom line: Fortunately the Fed has not been called upon to take these steps. Central bank policy makers have been coy on what steps they would take to stabilize the markets in responding to a debt ceiling event. The existence of the policy memo is interesting as evidence that perhaps the debt ceiling play, which is likely to recur this year, is a bit of a tragicomedy. It is sure to capture media attention and roil the markets, but it seems that behind the scenes there is a powerful safety net.