The details. Investment assets grew by 7.5% last year, propelled by strong state and local tax collections, budget surpluses and investment earnings at rates that finished the year at their highest levels in a generation. The growth came after two years, 2020 and 2021, where Covid relief funds swelled state and local budgets.
In that two-year period, investment assets expanded by $746 billion, or 28%. Investment portfolios were flat in 2022 and some forecast that 2023 would see a decline as Covid-related Federal aid was spent. But growth last year was boosted by a 6.3% expansion of nominal gross domestic product (GDP before adjustment for inflation). It was also boosted by investment earnings, with short-term investment rates that exceeded 5% for the first time in 25 years.
One way of gauging the relative size of investment assets and the role they play in budgeting is to compare them with current expenditures of state and local governments that are measured as part of the calculation of GDP. In 2018 investment assets amounted to about $0.88 per dollar of spending. Last year they amounted to $.99.
How the money is invested. The following two charts show how investment assets were invested in 2023 and in 2019—the last full year before Covid.
Treasuries made up 43% of investment assets last year.
The increase of nearly $800 billion in Treasury holdings represented most of the growth in overall assets in the five-year period. Treasuries are the safest and most liquid of fixed income investments and the increased allocation to this sector improved the overall credit risk profile of public funds investments.
Treasury issuance has grown as the Federal government finances its large deficits, with the total of Treasury Bills outstanding growing from $2.4 trillion to $5.7 trillion in the 2019-2023 period. Of course, longer-dated Treasury issuance has also expanded but the Bills, with their maturities of 12 months or less, are a prime source of liquid short-term investments.
Federal agency securities make up a shrinking segment of assets, with holdings dropping by $116 billion in the period. Issuance by government sponsored enterprises has not kept pace with Treasury issuance with the result that these securities no longer offer the yield advantage that they once did. They are also less liquid than comparable-maturity Treasuries. This market segment is also increasingly dominated by the FHL Banks as other issuers have reduced their fixed income financing needs.
Direct investment in corporate credit (corporate bonds and commercial paper) has declined both in absolute value ($287 billion in 2019 vs. $241 billion last year) and allocation (from 11.3% of investment assets in 2019 to 6.5% last year). This is despite the strong growth of investment grade corporate bonds outstanding in the period. Credit can offer incremental value but the challenges of managing credit exposure and the lower liquidity of credit instruments discourage direct investment by many public agencies.
In this same period investment in mutual funds and in money market funds more than doubled to $203 billion. Public agencies may be utilizing these funds to access the corporate credit markets.
It is notable that local government investment pools, which are the intermediary for investments totaling more than $600 billion, are not separately accounted for in the Federal Reserve’s analysis. They do not appear to be included in the mutual fund or money market fund totals. Their growth in the five-year period—the S&P Index of AAA and AA rated stable value LGIPs grew from $188 billion to $352 billion—provided another vehicle for public agencies to access the credit segment of the market.
Bank deposits represented 20% of investment assets last year, about the same allocation as in 2019. This is surprising because bank deposit rates have lagged the rise in short term interest rates, particularly in 2023. It seems that smaller public agencies without portfolio management capabilities and lacking an understanding of how to invest directly in Treasuries find no feasible alternative than to leave their balances at the bank.
For a look at our forecast of investment supply, see our research piece 2024 Investment Environment here.
The bottom line. The continued growth in investment assets is a surprise to some who expected that spending of Federal Covid aid and a slowing economy would more than counteract the impact of high interest earning rates. Strong cash balances and high rates provide a bit of a cushion for budgets, but the effects are not evenly distributed. “Rich” public agencies—those with strong balances—benefit the most. Agencies that lack the size or sophistication to access the public markets and do not access LGIPs or money funds to provide such access do not benefit from this dynamic.
The Federal Reserve’s Z.1. Report is the only source for comprehensive reporting on the nation’s financial assets, but it has some weaknesses when it comes to accounting for public sector assets. Its estimates of bank deposits, which come from Call Reports, are likely very accurate. On the other hand, its failure to acknowledge or account directly for LGIP assets throws into question much of the rest of the report. Still, it’s the only game in town at this point.
