Cash has been king for the past three years as rising interest rates boosted LGIP and money fund returns and depressed returns on longer duration investments like short term Treasury notes. Now that the Federal Reserve has shifted its policy to reducing rates there is a view that keeping large cash balances in an LGIP or money fund is a missed opportunity. But is it? We look at projected LGIP yields and also examine long-term historic returns to provide a perspective.

Among our observations:

• While fixed rate investments maturing in one to five years lock in an income stream over their term, moving money from an LGIP (or money market fund) to a Treasury note or bank CD at this point in the market cycle means the initial yield will be lower than the yield in the fund.

• The fixed income investment could earn more or less than that of the LGIP investment over a two- or three-year period. It all depends on how much and how fast the Federal Reserve cuts rates.

• Conventional investment lore that “longer is better” is not necessarily true in the constrained public funds investment world. When we analyzed the returns of a variety of investment strategies over the past 10 years, we concluded that a prime LGIP would have outperformed other common public sector investment strategies. A government-oriented LGIP was not far behind. Over 20 years the LGIP returns were above those of 1-5-year Treasury benchmarks and nearly equal to those of an aggressive Treasury/corporate bond strategy.

• That said, a strategy that relies on fixed rates has one important attribute not offered by LGIPs: income (and budget) certainty. The income stream over its term will be fixed. That could be a commanding objective for a public agency. And it may support investing in fixed rate bonds or bank CDs whose investment income could be less than income from investing in a cash pool but does not have reinvestment risk.

The details

Most public funds are invested in cash pools (LGIPS or money funds), government obligations, bank deposits and time deposits with maturities out to five years. Some more sophisticated public agencies may also invest in high grade corporate bonds. LGIPs, money market funds or internally managed cash portfolios offer a high degree of safety and a stable net asset value, but their income closely tracks the Fed’s main policy rate. Government and bank obligations can offer a fixed rate of income over their term, but their value will vary as market rates change.

Over the past three years as the Fed raised the Federal Funds rate from 0.25% to 5.50% (in July 2023) rates paid on LGIP and money fund investments rose apace, while prices of fixed term investments generally fell. The two-year Treasury note, which rose in yield from about 1.20% at the beginning of 2022 to over 5%, suffered a loss that at some points reached five or six percent of its value. Of course, under public unit accounting rules the loss would not have to be booked as investment results unless the investment was sold, and it would gradually be amortized as the investment moved toward maturity.

During this period of rising rates returns from an LGIP far exceeded that of a short-term government bond.

Current circumstances

Investors who were able to lock in rates on Treasuries when they passed 5% are assured of an attractive fixed income stream for the life of the investment. Other investors who maintained funds in an LGIP earned more than 5% for the past months but with the Fed now easing, LGIP rates will fall rapidly.

At this writing LGIP rates are in the range of 4.90% (for government-oriented funds) to 5.10% (for prime funds). Meanwhile the prospect of lower rates ahead has pushed the yields on two- and three-year government bonds down to about 3.50%.

Faced with the choice today of locking in a rate of 3.50% for two or three years or riding the yield on an LGIP that still pays nearly 5% but will decline as the Fed eases what should be the investment strategy? For funds that are not needed for the next several years this depends on the path of LGIP yields—historically, they track the Federal Funds rate closely—and the value of locking in a fixed income stream which insulates future income from market fluctuations over its life.

To illustrate, the below chart shows a forecast of the income from several investment strategies that are common among public agencies.

Investing $10 million in a two-year Treasury note at its current yield of 3.55% would yield $710,000 over its life. By comparison we estimate that investing that same amount in an LGIP would yield between $818,000 and $643,000. Why the difference? To estimate the result, we used the PFII model cash portfolio, inputting a Federal Funds rate or each of the next 24 months.

We used two forecasts of the future Federal Funds rates, one from the Fed’s Summary of Economic Projections (SEP) published at the conclusion of the Septemebr18 Federal Open Market Committee meeting and one a market-based forecast (the Bloomberg World Interest Rate Probability result).

The Fed’s projections would produce total income of nearly $818,000 for $10 million over two years. The market-based forecast produces income of $643,000. The lower result is from the market-based forecast. Both forecasts assume that Fed Funds will fall to about 3%. The SEP forecasts this to occur by the end of 2026; the market-based model forecasts this to occur more than a year earlier.

Which is right? Only time will tell, but it’s worth noting 1) neither forecast assumes a recession that could drive rates lower at an accelerated clip and 2) the WIRP model has not been a particularly accurate forecast of recent Fed policy moves, overstating the magnitude of policy rate changes over the past several years.

The bottom line: Cash could still reign, even as the Fed eases

Is Longer Better? There is a common view that investments in a cash pool are either parked awaiting a suitable time to invest in fixed term investments or “idle cash” that is not efficiently deployed. This view derives from a fixed income Investment thesis that over time longer-duration investments will produce higher returns than those with a short duration. This thesis would not support utilizing an LGIP (or a money fund or cash portfolio) as the main investment vehicle for surplus funds. But the thesis may not hold true in the constrained world of public funds investments where investment policies limit the investment universe to short maturities (usually less than five years) because governments are loath to commit to maintaining surplus balances beyond a few budget cycles. (Contrast this with pension assets.)

Given the constraint on public agency investments, a case could be made for using an LGIP, money fund or cash portfolio as a core investment strategy rather than as a parking place for cash waiting to be deployed into other investments. Such a strategy would trade off income (or rate) stability for liquidity. You’d not know how much you would earn over one or several budget cycles, but you would be able to spend at a moment’s notice.

How much income would you have to give up to secure liquidity? The answer, given the constrained universe of public funds investments, may be " less than you think."

To illustrate this point, we compared the returns of a number of benchmarks that represent public funds investment strategies over 20 years.

The returns shown on the accompanying chart and table below are for benchmarks representing 1–3-year Treasuries, 1–5-year Treasuries and a blend of 1–5-year Treasuries and similar maturity corporate bonds rated A or better. We also show returns for an index of three-month Treasury bills and for two institutional money funds that are proxies for LGIP returns. (There are no comprehensive LGIP benchmarks, nor are individual LGIP returns available over long periods, however government and prime money market fund returns track those of government and prime LGIPs very closely.)

20 Year Investment Returns for Selected Investment Strategies

Return differences over short periods are large—for example, the extraordinary performance of short-term bond portfolios this year—but for longer periods, cash pool returns are about equal to or, in many multi-year periods, ahead of returns of other typical public funds investment strategies. Over the last ten years the representative of a prime LGIP, which returned 1.80% led the performance of all other investment strategies, including that of a Treasury/corporate bond portfolio that invested out to five years

A proxy for a government-oriented LGIP was behind the prime fund by 13 basis points. Over 20 years the prime portfolio proxy was behind the 1-5 year corporate/treasury benchmark by only 17 basis points.

No doubt well-timed shifts of assets from an LGIP to longer-duration fixed rate investments and vice versa could improve cumulative returns over time, but successful market timing is notoriously challenging. Many try, but few succeed in the investment world.

Does that mean a cash pool should be the only investment vehicle in a public sector portfolio? The point of this analysis is NOT to argue that a city/county/state should keep all its assets in an LGIP or manage all investments in a cash pool. Rather, it is to point out that investments in a cash pool need not be considered “idle cash” awaiting investment with a goal to squeeze it to a minimum.

Over time, LGIPs (and cash pools) have had very competitive returns when compared with other investment strategies commonly employed by public agencies. And over time there is little if any penalty (measured by lower return) for funds invested in a cash pool.