By Malcolm G. Nimick, CFA

The primary asset allocation goal is to optimize the investment portfolio to maximize return, subject to an acceptable amount of risk. Nonprofit organizations with outstanding tax-exempt debt have a unique opportunity to increase expected return without increasing risk.

Understanding efficient frontiers
Modern Portfolio Theory really started in 1952 when Harry Markowitz published a paper on the efficient frontier. The efficient frontier is the set of the portfolios that satisfy either:

• The maximum level of return given a level of risk
• The minimum level of risk given a level of return.

The graph below illustrates different allocations of stocks and bonds. Point A represents a portfolio that is 100% bonds, while Point B represents a portfolio that is 100% stocks.

The line between A and B represents the expected return of all possible combinations of stocks and bonds. Notice that the line is not straight, illustrating the power of diversification. Point D, for example, shows a point that has the same risk as Point A, but a higher return.

This is the goal of using an efficient frontier, to find “Point D’s” and generate higher returns for the same amount of risk. All choices between points C and B are efficient portfolios.

What is different about nonprofits?
Nonprofits such as hospitals, educational institutions and senior living organizations have the opportunity to issue tax-exempt debt. Organizations that integrate their thinking about investments and debt have a different efficient frontier than those that do not, such as a community foundation or a pension fund.

Stocks, bonds, and tax-exempt debt are all capital market securities. The difference is some securities are purchased while others are issued.

Investment committees and investment managers typically think of the investing and issuance questions in isolation. But what happens when we think of them in tandem: securities purchased being positive positions while securities issued are negative positions?

Imagine an organization that has a $20 million portfolio and needs to build a $10 million addition. Ignoring donations, there are two choices to fund the building: pay $10 million out of the investment portfolio or borrow $10 million and keep the investment portfolio intact. Let’s assume that there is no other debt or investments.

Typically, the investment committee would look at the latter choice as a $20 million portfolio with some percentage in stocks and some percentage in bonds, where the asset allocation, the percentages, add up to 100%. What happens when you factor in the debt as a negative holding, but stocks and bonds must have a holding greater than or equal to zero, and the sum of all the asset weights still must equal 100%?

The chart below shows the actual frontier for the example above based on the S&P 500, the Lehman Aggregate Index, and variable rate tax-exempt debt, modeled using the BMA index. (The Bond Market Association Municipal Swap Index , produced by Municipal Market Data, is a seven-day, high-grade market index comprising tax-exempt, variable-rate demand notes.)

It shows some important results:

Minimum Risk and Return
The absolute minimum level of risk comes from a traditional portfolio. Leverage will increase some level of risk.

More Money for Mission
Most organizations do not invest at a minimum risk profile, but rather at 50% to 70% in equities, represented by the chart's shaded area. Looking at the chart again: At that type of asset allocation, there is a portfolio on the “With Debt” line that has the same risk as the “traditional” line but with a significantly higher return, a more efficient portfolio. Modern Portfolio Theory illustrates why it is better to use debt financing than cash to fund capital projects: the organization will produce a higher net return and have more money for mission at the same level of risk.

Optimal Asset Allocation Depends on the Amount of Debt
The last and, for many organizations, most important point is that organizations with outstanding debt already have the “With Debt” portfolio, but many are establishing the risk parameters based on the “Traditional” model.

The chart shows the risk of a 60/40 (60% equities / 40% fixed income) portfolio. The drop line intersects the “Traditional” frontier at the 60/40, but it intersects the “With Debt” frontier much closer to a 75/75/-50 (or 50/50 in traditional terms) asset allocation.

Limitations and Assumptions
The example is based on one organization with a specific amount of floating rate debt. The inclusion of fixed rate tax-exempt debt, swaps, or even a different percentage of floating rate debt will change the efficient frontier from the one illustrated.
Tax-exempt floating rates were modeled based on the history of the BMA index. Because the BMA index was established in 1991, its relatively short history is a limiting factor in the modeling of the efficient frontier.

Conclusion
Nonprofit organizations that issue tax-exempt debt should take a holistic view of their capital market security decisions. Doing so can help an organization optimize its portfolio and create a better return for mission. This holistic view is part of more efficiently managing the balance sheet to maintain and sustain the mission for perpetuity.

For More Information
Lancaster Pollard can help organizations integrate their thinking on capital market issues, their thinking on how debt covenants impact the investment decision, and how to manage interest rate risk across the entire balance sheet.

Please contact me at mnimick@chiefinvestmentofficer.com or (614) 224-8800 to discuss the underlying theory, issues, or implementation of this information. Visit us at www.chiefinvestmentofficer.com.

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