Investments giving low return, but ‘you are investing in what you can,’ adviser says

Should the city of Benicia divest itself of its investments portfolio because of low returns and management costs? Should it put the money in a bank account — or, as a City Council member suggested at this week’s meeting of the city Finance Committee, a tin can?

Are there better investments the city could make, or ways to make its portfolio perform better?

The Finance Committee heard answers to those questions Thursday when Carlos Oblites, director of PFM Asset management, San Francisco, explained the city’s limited options for investments.

Former committee ex-officio member and City Councilmember Tom Campbell has aired concerns about the performance of the city’s portfolio, both at committee meetings and at a Council meeting.

But Benicia’s options are few, Oblites said.

“You are really limited,” he said, explaining that Benicia can’t put money into stocks, most mutual funds, or anything with a 30-year maturity.

The investments it makes must be highly rated, too.

While he handed the panel 11 pages from California Government Code that regulates municipal investments, Oblites also gave them a colorful graph that showed the few types of investments the city can make.

Unlike members of the public, the city can’t put its money in fixed income overseas, commercial, high-yield, private placements, convertibles, emerging market debt and non-American investment grade investments, he explained.

Also out: an array of domestic and international equities, commodities, real estate, hedge funds, private equity, venture capital and tangible assets.

Most money market funds and local government investment pools are out, too, except for those that last only overnight, his chart showed.

The city can participate in repurchase agreements up to a year, asset-backed securities with mature dates no longer than five years, bankers’ acceptances of up to 180 days’ maturity, and commercial paper investments that mature in 270 days or fewer.

Benicia may invest in U.S. Treasuries, federal agencies, municipal securities and negotiable certificates of deposit. But if the maturity is longer than five years, the transaction requires City Council approval.

Nor can the city invest in anything below an “A” rating, Oblites said, as determined by Standard and Poor’s and Moody’s, two financial services companies.

He said the city is required to make safe, conservative investments in bonds, and can’t play the stock market.

The market value of its investment moves inversely to interest rates, Oblites said.

That means when interest rates rise, as they are expected to do in the near future, the market value of the portfolio drops. Likewise, as interest rates fall, the market value increases.

He described the example of a $1 million investment with a 5-percent coupon rate, earning an annual interest of $50,000. If the coupon rate rises to 6 percent, new bonds would earn $60,000 annually; but if the city chose to sell the bond it already has to buy the one with the higher coupon rate, it would have to sell the $1 million bond at a $10,000 discount to make up the $10,000 difference in interest, meaning the value of the original bond would drop to $990,000.

Bonds ultimately are worth what someone is willing to pay for them, Oblites said.

Bond prices become more sensitive and potentially volatile with longer maturity durations, he said. Even two-year U.S. Treasuries have had volatile rates in 2014, he said. The Treasury “has a long way to go” before it’s normalized.

Oblites said given the investment constraints, the city can’t make its portfolio perform much better than it already does, given the investment constraints. “You are investing in what you can,” he said.

What if the city sold its portfolio outright?

First, the city would lose $13,000 to $14,000 on the sale, Oblites said, but if it reinvested in five-year securities to earn 1.4 percent it might realize a net gain of $346,000.

However, as interest rates rose, the city would fall back again.

To counter the volatility, he said, his company diversifies the maturity lengths of the city’s investments. Shorter maturities give the city opportunities to reinvest at better rates.

“We’re monitoring on a daily basis. We’re proactively managing the portfolio,” Oblites said. That helps his company “capture higher returns and anticipate what’s coming at us in the future.”

That approach means the city’s return still is better than the Merrill Lynch U.S. Treasury Index, with a 0.93 percent yield to maturity in 2014 at cost for 2.09 years in duration.

“We did beat the index,” Chairperson Michael Clarke said. “That’s a clear indicator for me.”

Committee member Alan Nadritch, one of Benicia’s former finance directors, remained skeptical after the report. “We’re upside down $148,000.”

But Oblites said that number changes with fluctuations in the market, adding that currently, the city’s portfolio is in the positive range.

Other options such as the Local Agency Investment Fund (LAIF) and banks aren’t feasible, Benicia Finance Director Karin Schnaider said, explaining she favors the active management style of Oblites’s company.

LAIF is approaching that point, and is expected to become more costly, she said. And should the city try to put the money in a bank instead, that insitution would be asked to take its business elsewhere because banks must have collateral on hand in excess of the amount Benicia would want to deposit, Schnaider said.

Despite Nadritch’s concerns, he concurred with the rest of the panel in approving Oblites’s report and forwarding it to the Council.

The Finance Committee did the same for the Comprehensive Annual Finance Report (CAFR), which is an audit of the city’s books and a snapshot of its fiscal condition as of June 30, 2014.

Katherine Yuen, principal of Maze and Associates, the city’s auditors, said changes have been issued by the Governmental Accounting Standards Board, the body that provides generally accepted practices used by state and local governments.

While the changes caused a delay in producing the CAFR, ultimately it didn’t require much to be altered in the way the financial statements are recorded.

The CAFR has a “clean” opinion, meaning it conforms to those accounting principles, Yuen said.

However, Clarke had questions about CAFR notes on how Benicia pays no direct financial contribution to retiree health benefits, but that the city indirectly subsidizes their premiums through payments for current employees.

Schnaider said that’s how many insurance plans operate — those who do not use the benefits as much help pay for those who do. The note, she said, “says we need to be more realistic.”

Yuen told the panel that Benicia is one of the few cities that doesn’t pay for retired city employees’ health insurance.

However, how to approach the subsidy situation hasn’t been determined, Schnaider said.

The city has a net Other Post Employment Benefits obligation of more than $1.65 million, but Schnaider said it’s “a paper liability,” since retired employees ultimately pay that cost. “The city is not liable,” she said.

Committee member Kathy Griffin questioned notes on the promissory note for deferred connection fees for water, $381,750, and wastewater, $375,000, for 50 affordable, low-income homes in the Bay Ridge Housing Project.

The CAFR said that money wouldn’t be repaid unless there is a failure to comply with loan agreement terms, but bears a 5.5 percent annual interest.

Griffin asked whether the money should be marked as accounts receivable, which Yuen said is done in some cities.

But Schnaider said Benicia’s approach is both more conservative and transparent, allowing the situation to be clear to those who examine the report.

Yuen said in the past, her company has made notes of control deficiencies, situations that might prevent city employees from recognizing an accounting error.

She said employees corrected those situations, and this year her firm found no such deficiencies.

In another matter before the committee, the panel learned that city’s plan to upgrade its finance software programming on an organization-wide level has reached the point that a selection group has been chosen to evaluate the request for proposals that will be sent to potential vendors.

The matter has been an ongoing goal since 2011, when the change initially seen as a simple upgrade to the city’s longstanding vendor’s software.

But early last year, city employees told the committee that Benicia needed to change direction in the modernizing plan, because the software upgrade ultimately didn’t work with the city’s computers and existing programming.

That also meant the anticipated cost of the improvement skyrocketed from $66,000 to nearly 10 times that amount, while putting the project close to square one.

In the meantime, as Schnaider told the committee on Thursday, changes have been made to improve and streamline the current finance software operations, though the consultants who helped make those changes advised they were temporary since the city’s current system is becoming out of date and nearing the end of its lifespan.

The committee may see the vendors’ alternatives as soon as July so it can make a recommendation to the City Council, and planning for the conversion is expected to take place from July through October, Schnaider said.

The entire change is expected to take a year, and will take place in stages, she said. “It can’t happen simultaneously,” she said. As certain modules are put in place, some of the system will be experiencing parallel operations.

Vice Mayor Mark Hughes, who is succeeding Campbell as an ex-officio member, said, “For $600,000, people think you can pick something off the shelf. It’s a lot more complex.”

He said those who will manage the change “will become champions,” and he encouraged other employees who will have to learn the new system.

Schnaider said she and Assistant City Manager Anne Cardwell are thinking along the same lines, gaining employee participation so they’ll feel part of the process.

That includes the way the two refer to the improvement. “It’s not a finance system,” Cardwell said. “It’s a city system. Everyone needs to get on board.”