The Investment Policy: Channelling Cash to Maximum Efficiency
Corporate cash is at record highs (US$1.5 trillion in US corporates and US$2 trillion in Europe) although, as confidence rises post-GFC, many are returning cash to owners and otherwise investing. Even in more normal times, and even for those companies that are net borrowers, it is good practice to maintain some cash buffers as a hedge against the unexpected.
It is generally accepted that cash itself is a non-productive asset, with a yield (if any) well below the cost of capital. So generally treasury aims for prudent and minimal cash buffers, while also trying to reduce the cost of carry by earning yield on cash at low risk levels.
Since the cost of carry makes cash an expensive insurance, the amount of cash to be held will be set by the board of directors, based on:
This target cash level is not normally in the investment policy but it will be a key input thereto.
In corporate treasury the common heuristic is SLY, made up of: Secure (do not lose the money); Liquid (make sure the money is available when needed); and Yield (subject to the above, try to maximise yield in order to minimise the cost of cash).
SLY drives the critical elements of investment policies such as:
Investment policies also state the purpose(s) of the cash buffer(s). For example, one layer might be operational cash held to ensure business continuity while another might be strategic cash to ensure strategic flexibility. Operational cash must be extremely liquid (same or next day availability) whereas strategic cash might have a longer horizon, say three to six months – assuming strategic decisions do not materialise overnight.
Like all policies, the credit policy will follow the governance principles embedded in each company’s management system. So, in the interests of brevity this article will not cover issues such as drop dead clauses; delegations; policy structure; compliance; reporting or standards for processes and systems used to manage the above
Bear in mind that the investment policy will often relate to adjacent policies like credit, treasury, and risk management policies.
Credit risk is an important part of investment and also affects many other treasury activities such as cash management balances, risk management dealing and trade instruments. All transactions with banks generate credit risk, as do commercial transactions with customers and vendors. For this reason, credit risk is often a separate policy, which then governs the credit risk aspect of investment. Often financial counterparty credit risk is distinguished from commercial counterparty credit risk – especially in businesses where banks are not commercial customers.
Most corporates think of credit risk in terms of agency ratings from Moody’s, Standard & Poor’s (S&P) and Fitch. Experience in the GFC showed that agency ratings are very slow, so treasurers tried following credit default swap (CDS) spreads. CDSs are actively traded, which makes them volatile beyond fundamental changes in credit risk, so this turned out to be hard to use.
Implied ratings such as Thomson Reuters StarMine, Bloomberg CRAT, and Moody’s KMV provide a useful middle road, with fewer false alarms and less susceptibility to market manipulation than CDS but much better at giving early warning than agency ratings.
In a gtnews article last June, the author proposed using implied ratings, which, like Reuters StarMine (free for Reuters’ users) give much earlier credit warnings than agency ratings while exhibiting less volatility than CDS. Implied ratings can be mapped onto agency ratings (AAA etc), so by simply using the lower of the agency or implied rating they can be retrofitted to an existing credit framework based on agency ratings.
Credit risk allocation is closely linked to concentration. In addition to the concentration limits described below, investment policies will often specify maximum concentrations for different credit ratings – the policy does not want to see treasurers investing exclusively at the lowest credit rating to maximise yield. This can also take the form of blended or average credit quality for different cash tranches:
Where the investment policy permits money market funds (MMFs), these must only be MMFs that publish their investments weekly according to Institutional Money Market Funds Association (IMMFA) standards.
Investment policies will specify how much can be invested at each rating level and for different tenors. Often some individual names – for example, key relationship banks – have specified exceptional limits to allow operational flexibility; these will generally be for short tenors.
Often rating levels will be specified separately for different counterparty segments, such as sovereign, bank, corporate, etc.
Typically the counterparty exposure limits will be different for different tenors. Generally longer tenors will only be relevant to head office and treasury centres. Typical tenor buckets might be: less than three months; less than one year; less than three years; and three years and longer.
Most companies make their exposure measures consistent across instruments by using some kind of loan or cash equivalence. The table below is typical:
If the company invests in MMFs and bond funds, the counterparty exposures from such investments have to be integrated in the overall credit exposure calculation. Best practice for this is to look through the fund to the individual investments. This requires first that funds can provide details of their investments in a timely and usable manner. Most reputable funds provide weekly transparency into their investments, but the industry has no standard format for such data. As a result, integrating fund data into the counterparty exposure consolidation can be a non-trivial data processing exercise.
A practical alternative is to choose funds with strict concentration limits and then to take a proportional haircut from our counterparty exposure limits.
A simplified investment grid might look like this:
With specific exceptional names looking something like this:
In drafting an investment policy, treasury needs to ensure a prudent diversification of investments to reduce the risk of loss and to ensure liquidity. If all of the cash is deposited with one bank, it involves taking a big and potentially fatal risk on that one bank.
Most investment policies stipulate that no single name can represent more than 5% or 10% of the portfolio. Exceptions might include sovereign risk. Some investment policies set maxima for specific instruments also.
If the investment policy allows investment in funds (normally money market and liquidity funds), it will have to specify some combination of:
Most money market funds publish weekly reports detailing all holdings. The format for this is standardised by IMMFA. Handling such reports to calculate aggregate concentration requires strong treasury management system (TMS) capabilities, which are often provided by fund platforms. An alternative is to apply a haircut to concentration limits so that the aggregate of direct and fund investments cannot exceed the policy limits, taking into account the fund’s own concentration limits.
Concentration limits are set to ensure portfolio diversification. The converse are the depth of market limits set in the liquidity section below to ensure that it prevents owning too large a part of any name and/or instrument.
Liquidity risk addresses the need for cash to be available when needed. Since corporate cash is essentially insurance against the unexpected, treasury needs to be able to convert investments to cash at very short notice. Holding an AAA instrument that cannot be sold until one year has elapsed is not much help in meeting an unexpected tax payment tomorrow.
Liquidity depends largely on credit risk and instrument type; well-rated names and common instruments tend to be more liquid.
It is also possible to specify contractual liquidity; for example MMFs with next day availability and bank deposits without punitive breakage clauses.
Investment policies usually limit investment in specific names or instruments or funds to no more than 5% or 10% of the name, instrument or fund. If more than 5% is held of a specific name’s debt or more than 5% of a specific fund, there may be difficulty in liquidating the investment when needed.
Even within the universe of AAA names, different instruments may carry different risks – as was evident in the GFC.
Investment policies therefore specify specific instruments that may be used, and process and delegations (if any) to approve new instruments.
The list of allowed instruments might include basic investments such as:
Because corporate cash may be needed, avoiding or minimising price risk is common – treasury needs to be able to liquidate investments at short notice without worrying about potential losses due to changes in foreign exchange (FX) rates, interest rates, equity prices and commodity prices.
From an FX perspective, this often means investing in the company’s base or operating currency – or swapping investments back to base currency. Some multinational corporations (MNCs) may have multiple base currencies but the same principle applies.
From an interest rate perspective, this typically means investing in short-term investments with short duration. This might include bonds that are close to maturity and, in some cases, the use of interest rate swaps (IRS) to move from fixed to floating.
Because of equity price volatility, most corporates do not invest in equities or equity linked instruments. The same principle applies for commodity risk.
Keeping the cash safe – the security and liquidity part of SLY – is clearly treasury’s top priority. Once that is assured, it is possible to look at the yield part of SLY.
Yield targets are normally expressed as benchmarks against which the treasury team’s performance will be measured. These benchmarks apply only within the universe defined by the policy limits. Compliance to policy limits must be strictly enforced with strong governance. The treasury team must understand the spirit as well as the letter of the policy limits – if in doubt, ask.
Different tranches of cash may have different benchmarks. For example, operating cash might be benchmarked again overnight or one month London Interbank Offered Rate (Libor), whereas strategic cash might be benchmarked against six month Libor.
Given the policy constraints and the target average credit qualities, treasurers can model different investments to work out what combination will achieve the highest expected yield within the policy.
Given the difficulty of making yield within the typically very constrained risk limits of corporate investment policies, the policy must be realistic (i.e. moderate) in setting yield targets.
Never has it been more critical for companies to have clear and coherent investment policies. Policy writing need not be rocket science. In fact, policies should be written to be understandable by intelligent non-experts.
Writing a coherent investment policy is greatly aided by clarity in the underlying corporate goals – how much cash do we have for what purpose and with what goals?