The county had a general fund of $60 million, but no cash-flow analysis had ever been done to determine its liquidity needs. Some 90 percent of its fund was invested in short-term investments — the longest maturity was under six months. The county had invested this way for as long as anyone could remember. Its investment policy stated that investment maturities as long as five years were okay, but no one wanted to show an unrealized loss if interest rates rose.
The biggest risk the county took is called reinvestment risk, or having to reinvest the money at a lower interest rate when the current investments come due.
In this example, the liquidity needs are $30 million — in other words, the county needed $30 million in cash to handle its operations at all times. This left an additional $30 million that could help improve the yield of the entire fund.
For the past 10 years the county put its money in six-month CDs figuring that the money was safe and the interest rates were the highest possible. To illustrate reinvestment risk, consider historical six-month CD rates. In June of 2000, a six-month CD rate was 6.91 percent, compared to a much lower bond rate of 5.5 percent. Over a six-month period, the difference on the investment is $211,500, so it looks like the smarter decision was the six-month CD.
Then interest rates fell, so much so that within two years that $211,500 good decision would have been replaced by a half-million-dollar bad decision. Over the entire 10-year term, missed opportunities would cost the county just under $6 million.
Hypothetical for educational purposes only and is not intended as offering specific investment advice. Investing in securities involves risk, including loss of principal. Please consult with a professional regarding your individual circumstances.