Published: March 01, 2012
Deciding on how to invest a company’s surplus cash would appear to be a nice problem to have. In an environment of constrained liquidity, flat growth in many countries and considerable uncertainty about the future, having surplus cash is an important cushion against market shocks and depressed performance. Indeed, despite the challenging economic environment, treasurers are having to deal with more cash than ever. According to J.P. Morgan Asset Management’s Global Liquidity Survey 2011 (‘Global Liquidity Survey’), 47% of treasurers reported that they had larger cash balances than the previous year, compared with only 27% who were managing less cash.
Finding appropriate repositories for this cash is an essential treasury function, particularly to ensure that principal is protected and cash is available when it is required. Although seeking a return on this cash has been unfashionable since 2008-9 in comparison with security and liquidity, the persistence of low interest rates means that treasurers’ responsibility to protect principal has to involve not only managing the risk of counterparty default, but also preventing erosion of this cash through inflation. Yield, as an investment objective, is coming back. According to the Global Liquidity Survey, while 44% of treasurers were prepared to take additional risk in their investment portfolio in 2010, this figure rose to 61% in 2011. This is not to say that treasurers have cast aside all their mothers’ warnings about keeping their dinner money safe in their pockets so it doesn’t get lost or stolen; indeed, treasurers have become more sophisticated in their risk analysis. As Kathleen Hughes, Head of the Global Liquidity Sales, Goldman Sachs Asset Management (GSAM) describes,
“Treasurers are becoming more focused on counterparty risk, whether investments are held directly or through MMFs, leading to greater sophistication in investment decisions and demands for enhanced transparency.”
However, they are increasingly willing to compromise on liquidity (26%) or duration (34%) risk to enhance their returns.
Ever since interest rates started to tumble, few regulators or commentators have been able to indicate with any degree of certainty how long the low interest rate environment is likely to persist. Treasurers have therefore been faced with a complex dilemma. On one hand, as well as interest rates being low, liquidity has also been constrained, so companies have not been inclined to tie up their cash over a longer period in case it is required for contingency during a market downturn, or for strategic investments such as M&A. Similarly, treasurers have been disinclined to tie up their growing cash war-chests in medium- or longer-term instruments at low rates, as they may miss the opportunity to invest at more favourable rates should conditions improve.[[[PAGE]]]
2012 has brought a change. While interest rates are still low, there is also greater confidence that this is likely to remain the case for some time to come. Travis Spence, Managing Director & Head of Global Liquidity, Asia Pacific, J.P. Morgan Asset Management explains,
“Market volatility is here to stay, so treasurers are having to adjust accordingly. It is clear that crises such as in the Eurozone are not easily or quickly resolved, which will further prolong an already extended period of uncertainty.”
While this may appear a rather bleak picture, increased certainty about the medium-term interest rate environment is positive for treasurers. Travis continues,
“Since the Federal Reserve announced that rates will remain low for at least the next two years, treasurers’ behaviour is changing. There was a wait-and-see approach for some last year, who expected that rates could start to rise in 2012. With more certainty on medium-term rate prospects, treasurers now need to plan their investment strategies for the next couple of years.”
Kathleen Hughes, GSAM agrees,
“Treasurers are taking a more strategic view of their cash, particularly bearing in mind the low interest rate environment. According to the Fed, this is likely to persist in the US until at least 2014, with a similar scenario also probable in Europe. Treasurers recognise that they are effectively paying a premium for immediate access to liquidity by placing all of their cash in short-term instruments, so they are devising more detailed investment strategies that match their liquidity horizons more closely.”
Taking a more strategic view of cash investment involves looking at new opportunities for investing their cash. While bank deposits and MMFs typically form the basis of many treasurers’ short-term investment strategy, these are not necessarily suited to longer-term investment. Forty-nine per cent of respondents to the Global Liquidity Survey indicated that they invested directly in securities, with commercial paper, certificates of deposit, short-dated government and corporate bonds the most popular instruments, but this still represents the minority of treasurers. While deposits can be placed for almost any maturity period, many companies with large cash balances are already struggling to find a sufficient number of highly rated banks in which to invest, which is one of the factors that has contributed to the growth of MMFs. MMFs provide an excellent repository for short-term cash in that they are inherently diversified, secure and provide same-day access to liquidity, but as Kathleen Hughes explained above, immediate access to liquidity is not necessarily required for all of a company’s cash. At the same time, preservation of principal remains the linchpin of every treasurer’s investment policy, so this needs to remain pivotal to every investment policy.
Kathleen Hughes, GSAM continues,
“Having identified the portion of cash that they can afford to invest over a longer term, treasurers are increasingly seeking to use separately managed accounts that are customised specifically to their investment criteria. For example, some companies are conscious that they have a high level of exposure to financial institutions through their holdings in deposits and MMFs and are therefore diversifying their portfolio to include investment grade sovereign and industrial debt.”
According to the Global Liquidity Investment Survey, 52% of treasurers are now segmenting their cash in this way, with 69% of treasurers in Asia doing so.
Segregated or separately managed accounts are not new, but as Kathleen continues, they have typically been more popular amongst specific profiles of organisation,
“In the past, it has typically been US multinationals with European subsidiaries that have been most attracted to separately managed accounts. These companies, wanting to avoid the negative tax implications of repatriating funds back to the US, have therefore been using separately managed accounts to invest cash ‘trapped’ in Europe. Today, however, we are seeing a wide spectrum of organisations, including firms headquartered in Europe, looking to invest in separately managed accounts.”
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Travis Spence, JPM AM concurs, but he also outlines how treasurers are leveraging their international footprint to devise an appropriate investment strategy,
“While risk remains a primary consideration, return on investment is becoming a higher priority. Treasurers are acting on this in a variety of ways, but the two most common we see are:
“Firstly, they are segmenting their cash into operating and reserve, or strategic, buckets. After ensuring operating cash is sufficient to cover short-term requirements, they are focusing on identifying a portion of reserve or strategic cash that can be invested over a longer time horizon. Credit risk management remains very important, but treasurers are prepared to take more duration risk and forgo daily access to liquidity. We are seeing many treasurers open separate (also known as segregated) accounts with fund managers to manage reserve cash investments, tailored to the company’s requirements and investment policies.”
Secondly, he notes,
“Treasurers are also looking more carefully at locations with higher relative value where they have a natural build-up of cash from operations. In some cases, the returns available in these markets can have a material impact on global investment returns, without compromising companies’ strategic or investment objectives. A prime example is China, where most multinationals have growth ambitions leading to a substantial demand for AAA-rated RMB MMF products.”
He continues by explaining why MMFs have potentially greater appeal than bank deposits amongst international investors,
“The market for deposits in China is highly regulated, so there is no differentiation in deposit rates irrespective of the credit quality of the counterparty bank, leading to asymmetric risks in the deposit market. The fixed income market, however, offers both security (as much of the issuance is government-backed) and a higher yield. Investing in MMFs provides convenient access to the markets without the need to maintain internal investment resources.”
While investing in China, for example, has attractions for many companies with an existing presence and continued strategic ambitions in China, treasurers are understandably cautious about investing cash in a jurisdiction that is geographically remote from group treasury (particularly after treasury functions have often taken such pains to centralise cash investment activities and repatriate cash) and highly regulated. Travis emphasises, however, that recent regulatory changes makes investing in China a more comfortable prospect,
“Since the end of 2010, it has been possible to manage separate accounts in China in a similar manner as in other international jurisdictions. This is an ideal solution for reserve or restricted cash, given the lack of alternatives in China, offering rates that are typically 3-4% higher than in Europe or the United States, with attractive credit quality, since government securities dominate the underlying fixed income market.”
While China is often the flagship strategic market for North American and European corporations, other fast-growing Asian and Latin American economies are also of key strategic importance. Investment in these countries therefore has similar appeal to China, often with the advantage of a less complex regulatory environment and MMF products that closely resemble their North American and European cousins. Travis Spence, JPM AM confirms,
“The global MMF market is developing beyond traditional USD, EUR and GBP funds, and since 2004, J.P. Morgan Asset Management has introduced similar liquidity funds in many of the Asian currencies, as well as in Brazil. We are witnessing exponential growth in the use of these funds across both multinational corporations that are already familiar with MMFs through their activities in other regions, and domestic corporations.”
Before the financial crisis of 2008-9, when corporate investors sought the reassurance of high quality, same-day liquidity instruments, so-called ‘enhanced’ funds were being discussed with greater regularity amongst the corporate investor community. These were largely modelled on AAA-rated, IMMFA MMFs, but enabled investors to earn an enhanced yield in exchange for loss of same-day liquidity. While in theory such instruments could become more attractive to corporate investors, the consistency and quality of MMFs are important factors in their appeal. Funds that may resemble MMFs, but which lack the same consistency, quality or regulatory protection, are likely to be received with less confidence. Kathleen Hughes, GSAM suggests other reasons too why ‘enhanced’ funds are unlikely to make a comeback.
“There does not currently seem to be considerable interest in ‘enhanced’ funds amongst corporate treasurers. There are two key reasons for this: firstly, treasurers typically have quite specific investment criteria for their strategic cash, which could be difficult to match in a fund. Secondly, companies typically have rigorous investment policies that are specific in permitting investment in AAA-rated IMMFA-style funds, and therefore would not allow investment in other fund types.”
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Recent regulations in both the US and Europe have resulted in two different styles of MMF: short-term MMFs (which is the definition used to describe AAA-rated IMMFA funds) and MMFs. Although defining MMF products unambiguously is an advantage, having two distinct product types may already create some confusion, as Travis Spence, JPM AM emphasises,
“Treasurers are still looking for cash-equivalent funds, which has made the two levels of MMF definition difficult. The growth in MMFs in recent years has largely been the result of a homogenous definition, and with ambiguity comes confusion. As treasurers become increasingly confident in investing their reserve or strategic cash over a 6-12 month time horizon, we are likely to see continued diversification into separately managed portfolios matched against these maturity buckets in addition to the use of short-term MMFs for cash required for working capital purposes.”
Ongoing regulations also have the potential to change the cash investment landscape for corporate treasurers further, including MMFs, as Kathleen Hughes, GSAM illustrates,
“Looking ahead, ongoing changes to the regulatory environment will undoubtedly affect MMF providers and investors. The industry has already become more robust as a result of recent changes by the SEC in the US, and ESMA and IMMFA in Europe, and MMFs have performed strongly in a volatile environment. Going forward, the SEC and Financial Stability Board (FSB) will be embarking on a consultation process on further proposals, on which both users and providers of MMFs will have the opportunity to comment. From the feedback we have received, most corporate investors are not in favour of radical change to MMFs, particularly if tax and accounting treatment are negatively impacted.”
This is substantiated by the findings of the Global Liquidity Survey, in which 67% of respondents indicated that they would not invest in floating NAV (net asset value) funds in the event that stable NAV MMFs (e.g., AAA-rated IMMFA funds) were no longer available. Wider changes to banking regulations will also make their mark on the MMF community, as Kathleen notes,
“Basel III is already affecting the investment world. Banks are being pushed to finance themselves longer, while MMFs need to run shorter portfolios with higher liquidity, leading to a mismatch between supply and demand.”
As banks move towards Basel III compliance, this challenge is likely to grow, leading to potential changes in the way that banks deliver their investment and financing products to address this mismatch.
Despite regulatory and economic changes, it is clear that corporate demand for highly diversified, secure, liquid investment products that short-term MMFs represent will continue. Even if treasurers manage to develop the sophistication and accuracy in their cash flow forecasts that is so desirable (and yet so elusive) there will still remain a significant portion of cash that is required for working capital purposes, to which short-term MMFs are best suited. While there may be regulatory challenges ahead, this fundamental business demand will still have to be met.
For reserve or strategic cash, the medium- to longer-term investment options that meet corporate treasurers’ requirement for preservation of principal, are only now emerging in response to changing investor behaviour and priorities. While segregated or separately managed accounts (that have been available for many years) offer a viable alternative for large corporates with large cash balances, they may be less feasible for smaller companies. Overseas investment in strategic growth markets offers a very interesting alternative to companies of all sizes. However, treasurers who still feel a chill down their spine when they remember the problems of fragmented investments across the business, will realise that this needs to be managed carefully, with centralised control. Furthermore, investment in new regions requires considerable local expertise to ensure compliance with local regulatory requirements. Working with the right fund manager can help significantly with this, but treasurers still need to be confident that their investment objectives are in no way compromised by investing in less familiar markets.
For treasurers unwilling or without the resources to invest directly in securities, the options are therefore relatively limited at present to match corporate investment requirements. Over time, therefore, as treasurers become more confident in identifying their reserve or strategic cash, they will need to become more creative in the types of instruments in which they invest, and in which locations, which in some cases will require the development of new skills or additional resources. In addition, it seems likely that new investment products to meet the needs of corporate investors with varying amounts of strategic cash will emerge. This demand exists both in traditional and emerging markets, to meet corporate investment priorities and strategic ambitions, and satisfy the changing regulatory and economic demands.
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