HomeMy WebLinkAbout1996-05-07 City Councilr’UDGET 1996-98
City of Palo Alto
City Manager’s Report
TO:HONORABLE CITY COUNCIL
ATTENTION: FINANCE COMMITTEE
FROM:CITY MANAGER DEPARTMENT:ADMINISTRATIVE
SERVICES
AGENDA DATE: MAY 7, 1996 CMR:247:96
SUBJECT:PROPOSED CHANGES TO THE CITY’S INVESTMENT
POLICY
REQUEST
The City of Palo Alto Statement of Investment Policy requires review by Council annually,
as part of the budget process. Staffis proposing changes to the current policy for the 1996-
97 Budget.
RECOMMENDATIONS
Staff recommends that Council approve the following changes to the Investment Policy:
Ao Revise the text to reflect newly enacted State legislation.
1)Provide for detailed quarterly reporting on the investment portfolio and on the
City’s ability to meet future expenditure requirements.
2)Add language to reflect the current practice of having investments delivered
to the City’s safekeeping custodian.
3)Expand and clarify the language regarding investment decision priorities:
first, to protect the safety of principal; second, to meet liquidity needs; and
third, to achieve a return.
Bo Add several clarifications to the existing Policy to make it consistent with current
investment practices.
CMR:247:96 Page 1 of 6
1)Revise the existing Policy to reflect a position title change that is part of the
1996-98 Budget.
Co
2) Make miscellaneous clarifications to the language in the policy.
Establish a new category in the Policy to specify "Prohibited Investments" and
combine policy limits on callable securities and multi-step-up securities.
Formalize the current practice of buying and holding investments until maturity. As
a consequence of formalizing this practice, revise the action to be taken if the market
value of securities falls below 95 percent of book value. Require approval of the
Director of Administrative Services prior to selling any security.
POLICY IMPLICATIONS
Item A contains changes to the City’s Investment Policy, but does not change current
investment practices. Item B does not change existing practice and has no policy
implications. Item C is an Investment Policy change to add certain restrictions in order to
provide additional safety. Item D formalizes a buy and hold philosophy. While this
philosophy is consistent with current practice, it does reflect a change in the formal Policy.
EXECUTIVE SUMMARY
Annually, during the budget process, staff submits the Investment Policy to Council for
review and approval. Staff is proposing modifications to the Investment Policy to add
language from recently enacted State laws to clarify the wording of existing policy; to reflect
a position title change in the proposed 1996-98 Budget; to restrict certain investments and
to specify which types of investments are prohibited; to add a statement of philosophy that
the City’s intent is to buy securities and hold them to maturity; and to change the action
required to respond to a decline in market value of securities, in view of that buy and hold
philosophy; and, finally, to restore the requirement for the approval of the Director of
Administrative Services to sell a security prior to maturity.
NEW STATE LEGISLATION
State law regarding local investments was changed effective January 1, 1996. The two
new laws were enacted primarily in response to the investment problems in Orange
County.
SB 564 (which amends the California Government Code Section 53646) requires that the
City’s Statement of Investment Policy be presented to the governing body annually, and
CMR:247:96 Page 2 of 6
that all changes to the Policy be formally approved by that body. The law also contains
a requirement to provide a detailed report on all investments on a quarterly basis. This
report must contain details of all securities, investments, and moneys held by the City; a
statement of compliance with the City’s Investment Policy; and the ability of the City to
meet its expenditure requirements for the next six months. The City’s existing Investment
Policy already requires Council review of the Policy annually as part of the Budget
process. Staff began the detailed quarterly reporting requirements in January 1996, to
ensure compliance with this new legislation. Staff recommends the addition of language
in the Investment Policy to reflect this new legislative requirement (page 12).
SB 866 (which amends various sections of the California Government Code) requires that
delivery of securities to a local agency shall either be made directly to the entity or shall
be held by a custodial party (third party) by formal agreement. The latter is the City’s
practice. City securities are held by the Bank of California under a formal safekeeping
contract. Staff recommends changes to the Investment Policy to formalize the City’s
practice (page 11).
CLARIFICATIONS TO EXISTING POLICY
The City’s Investment Policy makes specific reference to certain positions. From time to
time, the titles of these positions may change. The title of the Finance Manager is
proposed to be changed to Manager, Investments, Debt and Projects, as contained in the
1996-97 Proposed Budget (page 8).
Current policy provides limitations on the percent of the portfolio which may be invested
in certain investment types. There is a statutory limit on the days to maturity for local
agency investments in Bankers’ Acceptances and Commercial Paper. Proposed
clarification to the City’s policy is to incorporate the maximum term permitted in State law
for these two categories of investments (pages 10 and 11).
SPECIFY PROHIBITED INVESTMENTS
Various investment insma’nents are permitted by State law for local investment. Since the
City’s Investment Policy describes only those investments which are authorized for
purchase, it is not as clear as it could be that certain investment types are prohibited. In
particular, the City has not specifically prohibited investments in derivatives, negotiable
certificates of deposit, or in medium-term corporate notes. While staff has not purchased
these instruments, it is recommended that they be expressly prohibited (page 9).
CMR:247:96 Page 3 of 6
Derivatives
Derivatives received much attention during the recent Orange County investment problems.
As staff informed the Council in December 1994 (CMR:542:94), "a derivative is a fmancial
instrument created from, or whose value depends on (is derived from), the value of one or
more underlying assets or indices". The term "derivative" refers to instruments or features,
such as collateralized mortgage obligations, forwards, futures, currency and interest rate
swaps, options, caps and floors.
The term "derivatives" could be liberally interpreted to include callable and step-up
securities, because they contain "options" that apply either to the maturity date or the interest
rate. Callable securities are defined as fLxed interest rate government agency securities, that
give the issuing agency the option of returning the invested fimds at a specific point in time.
Step-ups are government agency securities on which the interest rate increases ("steps-up")
at preset intervals. Step-up securities also have a callable option that allows the issuing
agency to return the invested funds at various preset dates.
Staffbelieves there is little risk in investing in callable and multi-step-up securities. These
securities’ "options", for call dates and interest rates, are known at the time of purchase.
Furthermore, these options are not tied to another set of indices which may move in
unpredictable ways. Finally, the City’s principal is protected in these investments. However,
because they could liberally be called "derivatives", staff is adding language to the
Investment Policy specifically prohibiting derivatives, with the exception of these callable
and multi-step-up securities (pages 9, 16 and 17).
Staff proposes to combine the limitations on callable and multi-step-up security types from
the current limits of 10 percent-of the total portfolio each, to a total limitation of a
maximum of 20 percent of the portfolio. This increases investment flexibility with no
increase in risk (page 11).
Negotiable Certificates of Deposit
Although the City’s policy permits the investment in negotiable certificates of deposit
(NCDs), staff has not used this investment instrument. NCDs are unsecured, that is, they
are not backed by any form of collateral. The risk involved in NCDs is considerably
greater than collateralized certificates of deposit, which are readily available. While
NCDs provide liquidity, by permitting sale prior to the maturity date, the City has more
than sufficient liquid resources to cover this need. Staff feels that the risk involved with
NCDs outweighs any of their advantages.
Medium-Term Corporate Notes
Medium-term corporate notes (MTNs) are unsecured, corporate debt obligations issued by
major industrial and financial corporations. State law permits local agencies to invest in
CMR:247:96 Page 4 of 6
MTNs, which are rated with a rating category of "A", or its equivalent or better, by a
nationally recognized rating service. The City’s Investment Policy has never included
MTNs as a permitted investment. Staff recommends that MTNs of greater than 180 days
be prohibited.
Staff recommends that a category of prohibited investments be established and that these
investments be described in a new Appendix B (page 17).
BUY AND HOLD PHILOSOPHY
The City’s practice is to buy securities and to hold them until their date of maturity. It is
a prudent, conservative practice. It contrasts with a more activist portfolio management
style, wherein securities are actively traded and/or sold prior to maturity in order to
potentially increase yields. The City’s practice is consistent with the priorities established
by State law, which are safety and liquidity above yield. This more conservative approach
eliminates the possibility that the City will realize any principal loss, because investments
held will pay the full principal back to the City upon maturity. Therefore, any decline in
the market value during the term of the investment will have no effect on the safety of the
principal. Staff recommends text be added to the Philosophy section of the Investment
Policy to formally reflect this practice (page 7).
The current Investment Policy stipulates that if the market value of the portfolio declines
below 95 percent of the cost basis of the portfolio, the City must take action to invest in
shorter term investments and/or sell certain securities until the desired ratio is achieved.
Staff believes this is not necessary or even prudent. Under an explicit buy and hold
investment practice, a decline in the market value of a security sometime during its life
will not affect the full value of the principal at maturity. That is, the decline in market value
is a loss on paper only.
Staff believes that under a buy and hold philosophy, the real risk to the City would be
precisely to sell that security at a loss and, therefore, realize a real loss in principal. Staff
therefore recommends that, if the market value declines to below 95 percent of the cost basis
of the portfolio, staff will report to Council with the facts of the situation and provide a
recommendation for action to be taken, if necessary (page 12).
Given the normal practice of holding securities to maturity, selling a security prior to that
time should be done only in extraordinary circumstances. Therefore, staff recommends the
requirement that prior approval be required from the Director of Administrative Services,
rather than the Assistant Director, be restored (page 8).
CMR:247:96 Page 5 of 6
ENVIRONMENTAL ASSESSMENT
This is not a project for the purposes of the California Environmental Quality Act (CEQA);
therefore, no environmental assessment is required.
ATTACHMENTS
1) City of Palo Alto Investment Policy
PREPARED BY:Linda Craig, Senior Financial Analyst
Jim Steele, Finance Manager
DEPARTMENT HEAD APPROVAL:
Deputy City Manager,
Administrative Services
CITY MANAGER APPROVAL:
Fleming
Manager
CC:n/a
CMR:247:96 Page 6 of 6
CITY OF PALO ALTO
Statement of Investment Policy
INTRODUCTION
As a charter city, Palo Alto operates its pooled idle cash investments under the prudent
investor rule and in conformance with California law. Investments are made with the
judgment and care, under the circumstances then prevailing, which investors with
prudence, discretion, and intelligence would make, considering the safety of their capital
as well as probable income. This affords the City a broad spectrum of investment
opportunities, so long as the investment is deemed prudent and is allowable under current
legislation of the State of California and the charter of the City of Palo Alto.
Palo Alto strives to maintain the level of investment of all idle funds as near 100 percent
as possible, through daily and projected cash flow determinations. Investments are made
so that maturities match or precede cash needs of the City.
PHILOSOPHY
The basic premise underlying Palo Alto’s investment philosophy is to ensure that sufficient
money is always available to meet current expenditures.
The City is able to take advantage of the relatively large reserve balances maintained by
its utilities, which allow it to take advantage of the general tendency of the market to
provide a higher return for longer-term investments (known as liquidity preference). Up to
20 percent of the portfolio may be in investments maturing in more than five years.
Consequently, in the long run, the City should average a higher total return than most cities
without such reserves to invest.
The economy, the money markets, and various financial institutions (such as the Federal
Reserve System) are monitored carefully to assess the probable course of interest rates.
In a market with increasing interest rates, the City will tend to invest new cash in securities
with relatively shorter maturities. This will allow the funds to be available for other
investments when the interest rates are higher.
AUTHORIZED INVESTMENT PERSONNEL
Idle cash management and investment transactions are the responsibility of the
Administrative Services Department.
The Administrative Services Department is under the control of the Director of
Administrative Services, who is accountable to the City Manager. The Department is
composed of Administration, Accounting, Investments, Revenue Collections, Budget,
Purchasing, Real Estate, and Information Technology, as set forth in Sections 2.08.150 of
the Palo Alto Municipal Code.
The Investment function is under the supervision of the-Fiftaftee-Manager, InVestments,
Debtand Projects;who is accountable to the Assistant Director of Administrative Services.
The duties of the ~ include managing
the City’s portfolio of treasury investments, remaining accountable for the City’s treasury
balance, developing and monitoring the City’s cash flow model and developing long-term
revenue and financing strategies and forecasts.
A Senior Financial Analyst/Investments reports to the ~Manager, Investments Debt
and Projects. The Senior Financial Analyst/Investments assists the ~ Manager,
8ts, Deb~aBd ~rojects in the purchase and sale of securities. The Senior
Financial Analyst also prepares the monthly report, and daily records all investment
transactions as to the type of investment, amount, yield, and maturity. Cash flow
projections are prepared as needed.
The Assistant Director of Administrative Services, or designee, is authorized to make all
investment transactions allowed by the Statement of Investment Policy. He or she may
authorize the--Fiftaftee Manager, !nvestments, Debt and ~rojects or Senior Financial
Analyst/Investments to enter into investments within clearly specified parameters.
In all circumstances approval from the ~Director of Administrative Services is
required before selling securities from the City’s portfolio. The ~ Manager,
Investments; Debt and ~rojects and the Senior Financial Analyst/Investments may also
transfer no more than $5 million a day from the City’s general account to any one financial
institution, without the prior approval of the Assistant Director of Administrative Services.
No other person has authority to make investment transactions without the written authority
of the Assistant Director of Administrative Services.
TYPES OF INVESTMENT
~e~itted investments are limited to the following
8
Securities of the U.S. Government, or its agencies. ~hi~h~ll include
Callable ~id. ~!ti ~tep ~p securities;~provi~ ~t:
3.
3.
4.
5.
6.
7.
8.
9.
Certificates of Deposit (or Time Deposits) (CD);
Banker’s Acceptance Notes (BA);
Sh0~ te~ Commercial P aperi ie ; matUdng in !8o or fewer days;
Local Agency Investment Fund (LAIF);
Short-term Repurchase Agreements (REPO);
City of Palo Alto Bonds;
. Money Marke~DeP~itAccounts; and
Mutual Funds which are limited essentially to the above investments and
further defined in note 9 of Appendix A.
Appendix A provides a more detailed description of each investment vehicle and its
security and liquidity features. Most of the City’s short-term investments will be in
securities which pay principal upon maturity, while long-term investments may be in
securities which periodically repay principal, as well as interest. Most of the City’s
investments will be at a fixed rate. However, some of the investments may be at a
variable rate so l~ng tha~ in rmi~ed
INVESTMENT CRITERIA
Criteria for selecting investments are (in order of importance):
1.Safety
2.Liquidity, and
3.Yield
Use of Brokers and Dealers
The Administrative Services Department maintains a list of acceptable brokers and
dealers. Any broker or dealer must have at least three years experience operating with
California municipalities, maintain an inventory of trading securities of at least $10 million,
and be approved by the Assistant Administrative Services Director before being added to
the City’s list of approved brokers and dealers. A broker or dealer will be removed from the
list should there develop a history of problems (i,e., failure to deliver securities as
promised, failure to honor transactions as quoted, or failure to provide reasonable
information).
Specific Investment Strategy
Depending upon the City’s financial situation and conditions in the money markets, the
investment strategy will change to achieve the appropriate balance of safety, liquidity and
yield.
O No more than 10 percent of the portfolio in collateralized CD’s of any
institution.
- An institution must be federally insured; and
-Have been in operation for at least three years, with
positive earnings for at least three of the past four
quarters of operation; and
- Report equity in-excess of 3 percent of assets; and
- Report scheduled items not in excess of 2.5 per of
assets.
No more than 30 percent of the portfolio in Banker’s Acceptance Notes, not
- No more than $5 million with any one institution.
]0
o No more than 15 percent of the portfolio in commercial paper, not to ex~ed
- No more than $3 million with any one institution.
O Limit investments exclusively to those 9t:,pu’,atcd ’~;ndGr p~itted types of
investments ’ .... :=~-’"" ÷~" ...... :" ’-- : ..... "-^-’^ ~ .... "’~-- ~ .......
o No more than 10 percent of the portfolio in Farm Credit Securities.
O No more than 2 percent of the portfolio in the Guaranteed Portion of Small
Business Administration Notes.
o No more than 15 percent of portfolio in Mutual Funds.
O No more than-l-e 20 percent of portfolio in callable and MUlti step~up agency
securities.
Usually, the longer term the investment the larger degree of interest rate risk. If interest
rates increase, it is likely that the long-term investments would decrease in value. This is
primarily a factor for securities which have maturities in excess of two years. Since almost
all of the investments held by the City of Palo Alto with maturities in excess of two years
]]
are U.S. government securities, it is possible to maintain fairly accurate records on the
market value of these securities and show the market value and potential loss to interest
rate risk. This risk is a part of all long-term investment portfolios and does not become an
important factor unless there is a need for the cash, and the loss (if any) must be realized.
The following are liquidity constraints:
o Liquidity enough to meet one month’s cash needs.
o At least $50 million maturing in less than 2 years.
O No more than 20 percent of the portfolio shall be in investments maturing in
more than five years.
Any security purchased with a maturity greater than 10 years may pay
principal, as well as interest, on a periodic basis.
~,.,,,,~,,,,~. Should the ratio
fall below 95 percent, the Administrative Se~i~S
~Department wi!! report ~!~ ifact to ~ ~t~.~ity ~!! Withi~ a
~!~ :of ~lding a~y
Commitments to purchase-~ew securities newly introdu~d on the market
shall be made no more than three (3) working days before pricing.
Yield, which is defined as the return on an investment, will be the third criteria for
investments, after safety and liquidity.
Whenever possible, the City will obtain three or more bids on the purchase or sale of
~p~le securities and take the higher yield on purchase or higher price on sale. This
rule will not apply to new issues which are purchased at market no more than three (3)
working days before pricing, LAIF, City of Palo Alto bonds, money market accounts or
mutual funds, which shall be evaluated separately.
]2
POEICY REVIEW AND REPORTING ON INVESTMENTS
Monthly, the Administrative Services Department will review performance in relation to the
Council-adopted Policy. Monthly, the Department will report to the Council, in a manner
approved by the Council, its performance in relation to this policy and explain any deviation
from the policy and recommendations for changes, if any. @uarte[ epartment will
Po! he Council will review this policy annually as part of the Budget
Process. All changes in policy must be approved by the Council prior to implementation.
Adopted by City Council October 22, 1984.
Monthly reporting effective January 1985.
Amended and Adopted by City Council June 24, 1985.
Amended by City Council December 2, 1985.
Amended by City Council June 23, 1986.
Amended by City Council June 22, 1987.
Amended by City Council August 8, 1988
Amended by City Council November 28, 1988.
Amended by City Council June 26, 1989.
Amended by City Council May 14, 1990.
Amended by City Council June 24, 1991.
Amended by City Council June 22, 1992.
Amended by City Council June 23, 1993.
Amended by City Council November 18, 1993.
Amended by City Council June 20, 1994.
Amended by City Council June 19, 1995.
APPENDIX A
EXPLANATION OF ~ PERMI~ED INVESTMENTS
U.S. Government Agency Securities. U.S. Government Agency Obligations include
the securities of the Federal National Mortgage Association (FNMA), Federal Land
Banks (FLB), Federal Intermediate Credit Banks (FICB), banks for cooperatives,
Federal Home Loan Banks (FHLB), Government National Mortgage Association
(GNMA), Federal Home Loan Mortgage Corporation (FHLMC), Student Loan
Marketing Association (SLMA), Small Business Administration (SBA), Federal Farm
Credit (FFC) and Tennessee Valley Authority (TVA). Federal Agency securities are
debt obligations that essentially result from lending programs of the Government.
Federal agency securities differ from other types of securities, as well as among
themselves. Their characteristics depend on the issuing agency. It is possible to
distinguish three types of issues: (A) participation certificates (pooled securities),
(B) Certificates of interest (pooled loans), (C) notes, bonds, and debentures. The
securities of a few agencies are explicitly backed by the full faith and credit of the
U.S. Government. All issues, however, have defacto backing from the federal
government, and it is highly unlikely that the government would let any agency
default on its obligations.
Certificates of Deposit. A certificate of deposit (CD) is a receipt for funds deposited
in a bank, savings bank, or savings and loan association for a specified period of
time at a specified rate of interest. Denominations are $100,000 and up. The first
$100,000 of a certificate of deposit is guaranteed by the Federal Deposit Insurance
Corporation (FDIC), if the deposit is with a bank or savings bank, or the Savings
Association Insurance Fund (SAIF), if the deposit is with a savings and loan. CDS
with a face value in excess of $100,000 can be coilateralized by U.S. Government
Agency and Treasury Department securities or first mortgage loans. Government
securities must be at least 110 percent of the face value of the CD collateralized in
excess of the first $100,000. The value of first mortgages must be at least 150
percent of the face value of the CD balance insured in excess of the first $100,000.
Generally, CDS are issued for more than 30 days and the maturity can be selected
by the purchaser.
Bankers’ Acceptance. A Banker’s acceptance (BA) is a negotiable time draft or bill
of exchange drawn on and accepted by a commercial bank. Acceptance of the
draft irrevocably obligates the bank to pay the bearer the face amount of the draft
at maturity. BAs are usually created to finance the import and export of goods, the
shipment of goods within the United States and storage of readily marketable staple
commodities.
]4
In over 70 years of usage in the United States, there has been no known instance
of principal loss to any investor in BAs. In addition to the guarantee by the
accepting bank, the transaction is identified with a specific commodity. Warehouse
receipts verify that the pledged commodities exist, and, by definition, these
commodities are readily marketable. The sale of the underlying goods generates
the necessary funds to liquidate the indebtedness.
BAs enjoy marketability since the Federal Reserve Bank is authorized to buy and
sell prime BAs with maturities of up to nine months. The Federal Reserve Bank
enters into repurchase agreements in the normal course of open market operations
with BA dealers.
BAs are sold at a discount from par. An acceptance is tied to a specific loan
transaction; therefore, the amount and maturity of.the acceptance is fixed.
Commercial Paper. Commercial paper notes are unsecured promissory notes of
industrial corporations, utilities, and bank holding companies. Interest is discounted
from par and calculated using actual number of days on a 360-day year. The notes
are in bearer form, with maturities from one to ~Fe 180 days selected by the
purchaser, and denominations generally start at $100,000. There is a small
secondary market for commercial paper notes and an investor may sell a note prior
to maturity.
Commercial paper notes are backed by unused lines of credit from major banks.
Some issuer’s notes are insured, while some are backed by irrevocable letters of
credit from major banks. State law limits a City to investments in United States
corporations having assets in excess of five hundred million dollars with an "A" or
higher rating for the issuer’s debentures. Cities may not invest more than 30
percent of idle cash in commercial paper.
Local Agency Investment Fund Demand Deposit. The Local Agency Investment
Fund (LAIF) was established by the State to enable treasurers to place funds in a
pool for investments. The City is limited to an investment of the amount allowed by
LAIF (currently $20 million). LAIF has been particularly beneficial to those
jurisdictions with small portfolios. Palo Alto uses this fund for short-term investment,
liquidity, and yield.
Repurchase Agreements. A Repurchase Agreement (REPOS) is not a security, but
a contractual arrangement between a financial institution or dealer and an investor.
The agreement normally can run for one or more days. The investor puts up funds
for a certain number of days at a stated yield. In return, the investor takes title to
a given block of securities as collateral. At maturity, the securities are repurchased
and the funds repaid, plus interest. Usually, amounts are $500,000 or more, but
some REPOS can be smaller.
15
Money Markey D~p~S~ Accounts. Money Market Deposit Accounts are market-
sensitive bank accounts, which are available to depositors at any time, without
penalty. The interest rate is generally comparable to rates on money market mutual
funds, though any individual bank’s rate may be higher or lower. These accounts
are insured by the Federal Deposit Insurance Corporation or the Savings
Association Insurance Fund.
Mutual Funds.,. Mutual funds are shares of beneficial interest issued by diversified
management companies, as defined by section 23701 M of the Revenue and
Taxation Code. To be eligible for investment, these funds must:
ao Attain the highest ranking in the highest letter and numerical rating provided
by not less than two of the three largest nationally recognized rating services;
or
bo Have an investment advisor registered with the Securities and Exchange
Commission with not less than five years experience investing in the
securities and obligations, as authorized by subdivisions (a) to
inclusive, of Section 53601 of the California Government Code, and with
assets under management in excess of five hundred million dollars; and
Invest solely in those securities and obligations authorized by Sections
53601 and 53635 of the California Government Code. VVhere the
Investment Policy of the City of Palo Alto may be more restrictive than the
State Code, the Policy authorizes investments in mutual funds which shall
have minimal investment in securities otherwise restricted by the City’s
Policy. Minimal investment is defined as less than 5 percent of the mutual
fund portfolio; and
The purchase price of shares of beneficial interest purchased shall not
include any commission that these companies may charge.
ce~ain ded~ati~e pr0dec-tS haye CharacteristiCS Which could i~lUde high price
highly ree of ~0phisticati0n t0 manage, and
According to california law;a local agency shall not invest any funds in inverse
3,