'AAAm' Local Government Investment Pools

The 'AAAm' local government investment pool (LGIP) trends report shows metrics of U.S.-domiciled LGIPs that seek to maintain principal value ($1.00) and limit exposure to principal losses due to credit risk, as defined in S&P Global Ratings' principal stability fund ratings (PSFR) criteria. The LGIPs featured in this report all conform to our PSFR criteria, as shown in the affirmation of our 'AAAm' ratings during 2022. In our rating analysis, we place emphasis on the net asset value (NAV) per share, 'A-1+' credit quality, weighted average maturity to reset (WAM-R), weighted average maturity to final (WAM-F), net asset trends, and the underlying composition of LGIPs.

LGIPs are present in many U.S. states where, generally, the state treasurer oversees a pooled investment vehicle that operates in a similar way to a money market fund. Typically a cost-effective investment option, LGIPs allow municipalities and public entities to combine their idle cash and operating balances to obtain economies of scale, through a diversified range of investments, to earn an incremental rate of return. A key difference is that LGIPs are not registered with the SEC (U.S. Securities and Exchange Commission) but typically benefit from the purview of state statutes, which provide guidelines on LGIPs' investment policy and objective, as well from the standards and guidance of the Governmental Accounting Standards Board, where standard 79 allows the use of amortized cost to value an LGIP's portfolio assets.

Our LGIP metrics demonstrate the investment practices of 'AAAm' rated LGIPs and those conforming to our PSFR criteria. If an individual LGIP's metrics are below our benchmarks, this may indicate a more conservative approach to investment, while metrics well above them may signal a more aggressive approach, albeit still within the range for a 'AAAm' PSFR.

Market Comment

U.S. LGIPs we rate have substantial influence on the management and demand of high credit quality money-market instruments.  Such investment pools, with assets collectively exceeding $280 billion, follow a prime or government strategy and are rated under our PSFR criteria. Over the year to December 2022, rated LGIPs following a government strategy (government LGIPs) saw assets increase by 20.6%, while asset growth for rated prime LGIPs was 14.8%, due to improving tax receipts from increased home values.

Chart 1

Combined with asset growth, the most notable element that all LGIP investors would value is higher LGIP returns.   Looking back to December 2021, seven-day yields for government LGIPs and prime LGIPs were a paltry 0.02% and 0.07%, respectively. 12 months later, after several interest rate hikes by the U.S. Federal Reserve Bank (the Fed), LGIP seven-day yields have broken through the 4% barrier for the first time since the global financial crisis (see table 1). They are now well on their way to providing a rate of return that can compete with interest on bank deposits.

Table 1

Focusing on the NAV per share, rated LGIPs performed quite well despite the rapid interest rate rises by the Fed.  The NAV per share averaged 0.99976 in 2022, about 22 basis points higher than our lowest NAV threshold of 0.9975 for 'AAAm' PSFRs (see chart 2). Notably though, following the Fed's double rate rise in the second quarter of last year, including the 75-basis-point hike in June, the largest since 1994, we observed a decline in LGIP NAVs, with the lowest recorded at 0.99891 but still 14 basis point above the 'AAAm' threshold.

Chart 2

This NAV deterioration was common across most LGIPs, as well as among money market funds registered under SEC 2a-7 rules. Subsequently, LGIPs took steps to reduce risk and improve their weekly liquidity profiles, since they generally benefit from stable asset flows that are seasonal and very predictable. For example, government LGIPs (on average) had 51.7% of their assets maturing on a weekly basis for the first six months of 2022 and this improved to 65% by December 2022. For prime LGIPs, the adjustment was not as dramatic, but they still improved their weekly liquidity profiles (on average) to 45% in July to December 2022, from 39.3% in January to June (see chart 3).

Chart 3

Weighted average maturities, key indicators to interest rate risk, have almost halved over the last 18 months.  The bulk of the decline in 2022 (see table 2 and chart 4) can be attributed to fluctuations in global market conditions caused by geopolitical uncertainty and the rise in inflation that prompted corrective action from the Fed.

Table 2

Chart 4

Chart 5

In looking at 2023 and recognizing the nature of the underlying instruments in LGIP portfolios--generally high credit quality ('A-1' or higher; see table 3 and chart 6) government, agency, and bank investments--we cite some of the key takeaways from recent reports: "U.S. Banks Outlook 2023: A Strong Banking System Prepares For A Weakening Economy," Jan. 11, 2023, and "Credit Conditions North America Q1 2023: Worse Before It Gets Better," Dec. 1, 2022, published on RatingsDirect.

• S&P Global's economists now expect U.S. GDP to contract 0.1% in 2023, with a mild recession in the first half and below-trend growth for the remainder of the year.
• There are signs that inflation is easing; it's still running well above the Fed's target. Any perceived monetary-policy misstep (in either direction) could push financing costs even higher and tighten liquidity further, straining borrowers' debt-service capacity.
• Borrowers and investors face a prolonged period of elevated interest rates. With the high likelihood of a recession ahead and structural changes afoot--from decreased Treasury market liquidity to the retirement of LIBOR--market liquidity could dry up in earnest. Bank liquidity could decline more than expected due to a combination of higher-than-expected deposit runoff and stronger loan demand.
• The Fed will keep policy tight with the Fed Funds Rate peaking at 5.00%-5.25% in the second quarter with rate cuts possible late in the year.

Table 3

Chart 6

Chart 7

Chart 8

Table 4

Related Research

• U.S. Banks Outlook 2023: A Strong Banking System Prepares For A Weakening Economy, Jan. 11, 2023
• Credit Conditions North America Q1 2023: Worse Before It Gets Better, Dec. 1, 2022
• Rapidly Rising Rates Are Putting Some Money Market Funds At Risk, July 22, 2022