A new year often brings uncertainty but for public funds investors the start of 2025 stands out. On top of the usual questions about financial market trends a couple of things amplify ambiguity.

• New policies or not. The policies proposed by incoming President Trump are breath-taking in their scope. Any one of mass deportations, widespread or universal tariffs, extending expiring tax cuts and adding new ones, large scale deregulation of financial services, cutting $2 trillion from Federal spending, could alter the way the economy functions and create winners and losers. But which proposals will be enacted and what their final form will be are unknown at this point. It will be many months until the details of actual policy changes are known.
• Policy effects. Nor is it clear what the effects of policy changes would be on the economy and markets. Not only is there no clarity on the details of new policies at this time, but there are also dueling views of how they might affect economic activity and interest rates. Take tariffs: The majority view of economists is that they would raise inflation and retard growth. But there is no consensus even among mainstream economists as to the magnitude of the effects on the macro economy. And other policy initiatives such as changes to the overall tax scheme could amplify—or offset—the effects of tariff changes. The effects of these policy changes are likely to be experienced over several years, and they will be iterative and interconnected. Good luck handicapping the effects on interest rates and financial markets at this point.
• Conflicting market signals. The Federal Reserve has cut short term interest rates by 100 basis points in the past four months, pushing its main policy rate to 4.25%, but investors have shunned longer-maturity bonds, pushing the yield on the 10-year Treasury up nearly one percent since September.  Remember the old saw that stocks and bonds move in opposite directions? Well, not this time. The markets seem to be signaling bullish (stocks) and bearish (bonds) sentiments at the same time.  Remember the strong assertion that an inverted yield curve (where short-maturity interest rates are higher than those of longer-maturity) “predicts” a recession? That failed in 2023 and 2024. Or the Sahm Rule that a three month rise in the unemployment rate of more than  0.5% predicts a recession? This indicator broke above 0.50% in July, August, and September 2024. Well, Claudia Sahm, for whom the rule is named, has said  the rule does not apply to current circumstances
• Low pay for risk. Bond investors who take risks are not being paid to make the bet. There are a lot of ways to Illustrate this, but a good one is to look at the spread, or difference in yields, between short-maturity investment grade corporate bonds and risk-free investments. The spreads between government bonds and credit instruments is at or near the lowest level seen since the Great Recession of 2008-2009. In other words, investors will receive meager compensation for taking on credit (and liquidity) risk by holding corporate bonds.

While all investors are subject to these forces, public sector investors are particularly vulnerable. States and localities count on Washington for about 20% of their overall revenue and a number of the proposed policies could impact Federal spending, if not directly, then in the form of offsets to reductions in tax revenue. So, uncertainty has implications not just for the investment markets, but also for receipts and spending that could lead to unplanned drawdowns of portfolio balances.

What to do?  This is a time for portfolio managers to emphasize investment quality and liquidity. Girard Miller has just published a piece in Governing that makes a strong case for positioning investment portfolios in a defensive manner given the widespread uncertainty.

Public funds managers may be doing just that. For LGIPs, comprehensive data on liquidity and credit quality is not widely available (it is for money market funds) but S&P Global data reporting weighted average maturities and the percentage of government obligations in portfolios for funds they rate showed this indicator of portfolio position to be consistent with an uncertain outlook.

Portfolio maturities were  in the 35–40-day range at the end of December, about the same as they were at the start of 2024 when the Fed was still tightening monetary policy. The maximum permitted for an AAA-rated LGIP is 60 days, so WAM positioning is modestly defensive.

According to S&P, rated Government-oriented LGIPs had about 88% of their assets in government obligations, while prime-oriented LGIPs had about 33%, also defensive positions. Of course positioning of individual LGIPs may vary and investors should evaluate these characteristics along with daily and weekly liquidity characteristics for each fund they use when investing in an LGIP or money fund.

For separate portfolios, investors should increase allocations to Treasuries in place of credit instruments because Treasuries offer high liquidity and are risk-free.  (Federal agency debt has own challenges these days; something we’ll report on in coming weeks.)   It simply doesn’t pay to invest in corporates, given the uncertainty we’ve described.  The risk and liquidity-related  compensation offered—measured as the spread (in basis points) between the universe of short-term Treasuries and that of short-term corporate bonds—now stands at 51 basis points, down from 78 basis points a year ago and well below the average level for the past two decades.   Hardly worth the trouble and not worth the risk in this uncertain environment.

Separate Portfolios: A Good 2024; Caution in 2025

Cash reigned again in 2024 with average returns of LGIPs over five percent, but our model 1–3-year portfolio had a very respectable return of 4.49%. And holding investments beyond the 30–60-day maturity average of an LGIP provides a more stable income stream for a period of months/years.

The model portfolio return is notable because despite the Federal Reserve easing monetary policy, yields on longer-maturity investments rose over the year.  The change in yields over the year reduced rates on cash and reduced market values on longer-maturity bonds, but the constrained maturity of our model minimized the principal loss. (It was about seven basis points of principal.)  

The model portfolio is invested in a market-weighted basket of Treasuries (60%), investment grade corporate bonds (30%) and cash (10%). The Treasury component returned 3.96% while the corporate bond component returned 5.18%. The higher return from the corporate bonds was due to the higher income generated by this component. At the start of 2024, the income spread over Treasuries was 78 basis points.  Spread narrowing last year boosted the return of the corporate bond holdings and a reversal of this narrowing would depress their return in 2025, so the benefit is unlikely to recur.

At the beginning of 2024 cash/LGIP yields were in the range of 5.50%. The separate portfolio gave up this high (but variable) rate opportunity (its yield to maturity in January 2024 was 4.61%) to invest in fixed rate securities with maturities as long as three years. The market value of the portfolio ended the year pretty much where it started (a small loss offset the income return to produce the overall result of 4.49%).

Taking a look over the longer term, the return of the model in 2023 was 3.59%--significantly below the return of an LGIP but the highest level of returns for short-term bond portfolios in more than 15 years. In sum the  short-duration separate account did not  out-perform cash but the results were nevertheless good ones for two years in a row.

looking forward, to be consistent with our views on the importance of liquidity and lack of compensation for risk we have modified the 1–3-year model to reduce corporate bond holdings by 10% and put 5% more into Treasuries and cash.

We’ll track the two and report on relative results periodically through the year.