Portfolio risk: staying out of harm's way.

• Author: Davis, Henry
• Position: Managing government entities' investment portfolio - Forum

The economy, at the beginning of 1992, has been mired in a recession, the duration of which remains highly uncertain. For municipal governments, revenues from all traditional sources have declined considerably. As a result, fiscal belt tightening and concerted efforts to enhance revenue have come to the forefront, opening the door to potentially risky activities.

Of these risks, those associated with investment portfolio interest income is of paramount importance to local government management. If prudence in the investment of governmental funds is not strictly observed and losses occur, depending on the severity of the losses, the ability of government to meet its obligations could be seriously impacted.

There are always a number of positive techniques for active portfolio management that can have beneficial results when performed in a professional and prudent manner. However, during financial downturns, imprudent and sometimes rash investment decision will occur as a result of either implied or perceived mandates to increase the yield of the investment portfolios.

One remembers the events of the 1980s, when a number of governmental entities took unprecedented losses in their investment portfolios. Most of these losses occurred in 1983 and 1987 when yields on the U.S. Treasury 30-years bond rose approximately 125 to 130 basis points in two and four months respectively. These sharp increases in yields followed a sustained decline in overall yields averaging 330 basis points for each of the two periods. This interest rate scenario created an environment that set the stage for those losses to occur. External factors, such as volatile interest rate shifts, cannot be controlled, but internal reactor to them can be prudently and effectively managed.

Disastrous Results

To learn the lessons of that recent history, one must ask, "What internal factors were present or lacking that led to such disastrous?" The answer suggests that the commonality of factors were: 1) speculation, 2) abrogation of responsibility, 3) lack of internal controls and 4) lack of supersion.

Speculation. Traditional investment policies stressing safety of principal and liquidity gave way to interest rate speculation stressing yield, a policy that embodied both higher market and credit risks. Such changes in basic philosophy are often the result of poorly written investment policies or of a lack of understanding that quantifying market risks and credit risks should be included...