If you are managing (or overseeing) public funds these days, you might feel as if you are tending a bucket with a hole in it. With interest rates at their highest level in decades earnings are flowing into portfolios at a strong rate. But Federal Reserve data show asset growth recently has slowed.

The reason? The growth of state and local tax receipts has slackened. Meanwhile, although the economy has escaped recession and its attendant pressure on social safety net spending, expenditures have recently outpaced revenue. The result is a flattening growth trend in asset balances.

• Recently published Federal Reserve data show that the growth rate of public agency investment portfolios slowed markedly to 2.0% in the first half of the year. This compares with total growth of 25% in the 2020-2023 period. The growth rate this year is not much greater than the increase in the overall rate of inflation so in real terms portfolio assets are treading water.
• Bureau of Economic Analysis data show state and local government expenditures grew 2.3% in the first six months of the year, while Census Bureau data show tax revenue grew 1.9%.
• With little in investment balances and what is perhaps an uncertain outlook for future revenue and expenditures, public agency portfolio managers in the aggregate have increased liquidity and improved the credit profile of their holdings by investing most of the modest growth in assets this year in Treasury securities. This continues a multi-year trend of improving credit and liquidity in overall public sector portfolios.

The details.

Investment balances. The Federal Reserve’s quarterly report on Financial Accounts of the United States documents the slowing growth in investment assets The above chart illustrates this.

Investment balances grew strongly in the 2020-2023 period as rising rates and an influx of Federal aid for pandemic relief swelled state and local government balances. Federal aid related to the Covid pandemic was received in 2020 and 2021 but spending this aid is still underway.

Proceeds of bonds issued to fund new projects are another (though temporary) source of investment assets. Recent volume of new issue municipal bonds has ballooned (despite high borrowing rates). The Bond Buyer reported that volumes for the first nine months of this year are 32.7% ahead of last year as of September 30, an increase of $114 billion. Proceeds should provide a temporary boost to investment balances.

Meanwhile a rise in investment rates boosted portfolio income. We estimate that public sector portfolio investment rates averaged five basis points (!) in 2021, rising to 5.25% last year. They are likely to average a bit more than five percent this year. The earnings on aggregate investment balances grew from about $1.5 billion in 2021 to an estimated $200 billion in 2023 and again this year.

During the 2021-2023 period the natural growth of portfolio assets from earnings would accumulate about $275 billion. This contributed the lion’s share of overall growth in assets ($307 billion).

In the first half of 2024 the outflow seems to have taken hold. Investment assets grew by 2.0%, or $74 billion in the first half of this year.  This compared with growth of 25% in the 2020-2023 period. We estimate earnings in the first half of this year of about $100 billion and portfolio drawdowns (from earnings) of about $26 billion.  A further decline in investment rates of one percent (to 3.75%) could mean governments would begin to tap the corpus of their portfolios in coming quarters to meet spending requirements. While each government’s circumstances may differ from the national trend, the overall picture is that portfolio managers may feel pressure on investment balances, even with the tailwinds of decades high interest rates and a strong economy.

Portfolio quality. Response to this pressure on portfolio balances could be to tilt portfolio investments in favor of shorter maturities, more liquidity and better credit in portfolios. In fact, the Fed report shows that nearly 65% of the growth in investment assets this year was invested in Treasuries.  

This continues a multi-year trend of increased Treasury holdings.

 They made up 37% of portfolio assets in 2021 and this grew to 40% this year. Total bank deposits, the second largest category of portfolio investment assets, represent about 19% of holdings. This share of portfolio assets has declined modestly since 2021; what is notable is that time and savings deposits have declined while transaction deposits (such as checking accounts) have increased. These accounts pay very low (or no) interest, though in many cases they accrue earnings credits to offset bank charges.

Repurchase agreements, whose use is likely limited to states, a few large municipalities and LGIPs, and commercial paper holdings grew during the 2021-2024 period, gaining about three percent of total investments.

The Fed report does not account for Local Government Investment Pool balances separately so we do not have a good picture of their share of overall investment assets. We estimate that state-sponsored and broadly-held local-sponsored LGIPs total about $900 billion, and many of these experienced robust growth in the past three years. This could be further evidence that public agencies have tilted portfolios in favor of high-grade liquid investments.

Bottom line.

As the growth rate of public funds investment assets has declined, the liquidity and credit profile of public funds portfolios has been strengthened in recent months. Further rate cuts could increase the pressure on balances. Portfolio managers should take this possibility into account in setting a strategy for their portfolios.

A note on sources:  The Federal Reserve Statement of Financial Accounts is a quarterly report prepared b the central bank.  It has data limitations, which we’ve commented on the the past, but is the best source of aggregate investment balances. The LGIP industry has no uniform reporting requirements, and many pools report assets only on an annual basis, but those that report more frequently.  The government expenditures data is compiled b the Bureau of Economic Analysis and is available here. Interest rate estimates are tried to the level of the six month Treasury bill.