Bear County maintains an investment pool for school districts and other governments within its jurisdiction. Participating governments contribute cash to the pool, which is operated like a mutual fund, and receive in return a proportionate share of all dividends, interest, and gains.
They also, of course, must share in any losses. The governments may withdraw part or all of their funds at any time, receiving their share of the pool’s resources. As of year-end 2014, the value of the Bear County investment pool was approximately $1.2 billion. Governments have been eager to place their funds in the Bear County pool because it has provided historically higher returns than they could earn independently. The individual governments must restrict their investments to short-term, highly liquid securities, inasmuch as they will likely have need for cash within days, weeks, or months. By contrast, the investment pool can invest a substantial portion of its resources in longer-term, higher-yielding securities, since it is unlikely that all of the participating governments will withdraw their funds at the same time. The county pool places its funds only in U.S. government notes and bonds or securities guaranteed by the U.S. government. Hence, there is virtually no default risk; the county can be certain that it will receive timely payment of principal and interest.
1. Assume that the county invests $1 billion of the $1.2 billion of its pool portfolio in 10-year, 6 percent government bonds (retaining the balance in cash and short-term securities). Shortly after it purchases the bonds, prevailing interest rates on comparable securities increase to 8 percent. What would you expect would be the market value of the bonds after the increase in rates?
2. Suppose that the county invests $ 1 billion in the 10-year, 6 percent bonds just described. However, it also finances the purchase of an additional $1 billion of similar bonds by entering into reverse repurchase agreements. In effect, therefore, it borrows $ 1 billion, putting up the10-year bonds as collateral. Inasmuch as the loan is short-term, the interest rates are only 4 percent—substantially lower than on the long-term bonds.
a. Determine the net percentage return on the $1 billion in the portfolio, taking into account the total interest received on the entire $2 billion and the total interest paid (exclude consideration of the $0.2 billion held in cash and short-term securities).
b. Suppose that long-term interest rates were to increase to 8 percent. What will be the total market value of the portfolio, net of the amount borrowed (and excluding consideration of the $0.2 billion in cash and short-term securities)?
c. In the face of the sharp decline in the market value of the investment portfolio, county officials assured participating governments that they have nothing to be concerned about, since:
• The county intends to hold all bonds to maturity and therefore the fluctuations in market values are not relevant.
• Based on historical experience, the county will have sufficient funds on hand to meet all routine withdrawals. Assume also that short-term interest rates increased to 7 percent. If you were the treasurer of a participating government, would you be comforted by the statements of the county officials? Explain. Would it make sense for you to withdraw your funds from the pool?
d. Suppose you—and treasurers of other governments— were not comforted and did, in fact, with-draw funds from the pool. What would be the probable consequences to both the pool and the pool participants?