Published: January 01, 2000
The continued low interest rate environment, ongoing regulatory reform and record stockpiles of corporate cash have contributed to a renewed focus on the investment policy process. While most large companies have an investment policy statement to help guide their cash investments, many privately held or smaller firms may not.
It is considered a best practice for companies without an investment policy to implement one, and for those who do to conduct frequent reviews. Refreshing corporate investment guidelines can help clarify risk tolerance, prioritise investment objectives, and keep key stakeholders within the company current and up-to-date on cash and investment priorities.
When establishing investment policies, many organisations strive to balance a desire for safety and liquidity against a competitive rate of return. With interest rates and investment spreads being so low, companies have not had much incentive to seek greater returns. The global economy is gradually improving, however, and companies are beginning to deploy cash in more traditional ways to take advantage of evolving growth. At the same time, financial regulatory reform is expected to change the way banks view some deposits, prompting a need for companies to rethink how they optimise cash. This will also require close attention to guidelines related to short-term investments.
Specifically, treasurers conducting a review of their investment policies may want to review them against the backdrop of the following five trends:
Despite ongoing economic uncertainty, companies are starting to look at short-term investment priorities with a more optimistic view of the economy. During the height and aftermath of the financial crisis, many companies adjusted cash investment policies to emphasise safety, first and foremost. They reworked their guidelines to permit only AAA- or AA-rated securities or government-guaranteed securities.
As confidence in the economy steadily improves, other investment criteria are re-emerging as priorities. Liquidity, which is always an important investment goal, can become an even higher priority as companies look for opportunities to reinvest cash back into their business, or for mergers or acquisitions.
Moreover, we have begun to see signs that interest rates will eventually rise, presenting higher-yielding investment options that may not be addressed under current investment guidelines. Policies geared to a long-running low interest rate environment should be monitored and adjusted as the markets change and evolve.
As a result of new financial regulations, banks and other institutions are being required to hold more government securities and high-quality liquid assets (HQLA) in reserve. At the same time, the US government has been gradually winding down two of the historically largest sources of HQLA: Fannie Mae and Freddie Mac. Therefore, the pool of these types of securities available for corporate investors is dwindling, demand is outstripping supply, driving yields to near record lows. Thus, investors are having difficulty in trying to place money, further necessitating a review and possible expansion of current investment policies.
Another important consideration is portfolio diversification. When a high percentage of a portfolio is focused in one sector, US government-guaranteed securities for example, the portfolio is not as diversified as it should be to offset potential investment risk. Last year’s difficult budget negotiations and government shutdown in the US brought this point home to investors, causing at least some fear that liquidity could suffer.
Other investment vehicles might meet a company’s safety parameters and offer somewhat better returns, but may be restricted or omitted by an outdated investment policy. For instance, US state and municipal debt, sovereign and supranational debt issued by government entities, highly collateralised asset-backed securities, over-collateralised repurchase agreements using non-traditional collateral, covered bonds, floating rate corporate notes, and short duration bond mutual funds may meet a company’s prudent investment criteria and are worth consideration.
With an increase in global commerce, and US tax laws that make it more attractive to keep cash overseas, international cash balances will most likely grow, both for large and middle-market companies.
But uncertainties continue around the world, emerging market economies have shown recent volatility, and Europe continues to grind slowly toward recovery. Last year the European Central Bank (ECB) set the deposit rate paid to commercial lenders at zero, and stated they were willing to set negative rates if needed to ward off deflationary pressures. The impact has been significant for corporations with excess cash in the eurozone, all but eliminating money market mutual funds (MMMF) as a viable option, and making it very difficult to earn any positive return on bank deposits.
As companies grow and expand internationally, cash management practices and investment policy scope should be re-evaluated and broadened to include a more robust set of investment alternatives.[[[PAGE]]]
Investment policies are also being affected by two new financial regulations that have evolved from the financial crisis: Dodd–Frank Wall Street Reform and Consumer Protection Act, and Basel III – the international regulatory framework for banks.
Under pressure from the Federal Reserve, and the Financial Stability Oversight Council (FSOC), the Securities and Exchange Commission (SEC) has proposed new rules for the regulation of MMMFs. Although not finalised, one proposal would require some types of money market funds to be priced using a fluctuating net asset value (NAV), instead of the current stable amortised cost method. Should this rule be adopted, fund share prices would be allowed to fluctuate daily with changes in the market value of the securities in the portfolio, significantly changing the characteristics of this investment vehicle. Companies investing in MMMFs may have to look at their policies and amend them accordingly. They will either need to change their list of permitted investments to accommodate a fluctuating NAV fund, or find investment alternatives to MMMFs.
Many companies invest directly in the securities that typically make up MMMFs, as permitted by their investment policies. Companies that do not want to invest directly and have a large enough pool of cash can use an outside asset manager to structure a separately managed account (SMA). For this approach to add the most value, amendments may be required to the list of permitted investments. Again, the investment policy must cover any strategy under consideration.
Meanwhile, Basel III establishes liquidity standards to improve the stability of the global financial system in the wake of the financial crisis. The Liquidity Coverage Ratio (LCR) requires banks to make assumptions about the stability of their funding sources, and the amount of liquidity that must be held in reserve against potential outflows during times of stress.
Banks most likely will be more interested in seeking corporate operational deposits, as only 5% – 25% of the deposit value will be required to be set aside in HQLAs. Longer-term investment cash will require assumptions of up to 100%, depending on the type of depositor and the nature and tenor of the deposit. Some banks will be offering new liquidity management products structured to meet the LCR requirements, and will need to be considered and covered in an investment policy.
Finally, as rates rise, one important trend to re-emerge is investment policies geared to cash tiers. Prolonged low interest rates have blurred some of the distinctions between cash types, perhaps resulting in some cash not working as hard for a company as it could. Corporate cash can be put into the following three tiers:
In the investment policy, each tier can be defined in terms of purpose, dollar amount, risk profile and investment vehicles. Companies that tier cash in this manner should have greater latitude in altering investment policies to tailor permissible investments to the cash tier. For example, policies may be more restrictive for operating cash and more lenient for strategic or reserve cash. This makes it easier to manage the natural trade-off that can exist between safety and liquidity, versus potentially higher returns. On the other hand some companies — particularly commercial paper (CP) investors — may allow for split or lower-rated CP programs in their portfolio, but only in very short maturities of 30-60 days or less. This allows investors to capture higher-yield opportunities, while limiting their exposure to a very short duration at a time.
Another way of looking at an investment policy for cash tiers is to examine each tier in terms of who makes investment decisions. Operating cash investments that are directed by internal staff may have a more highly restrictive profile, while reserve cash invested by an outside asset manager may have a less restrictive risk tolerance. This permits an asset manager to leverage its research and credit selection process to focus more on returns.
Internal staff may not have the time or knowledge to consider and analyse some high-quality securities that could be excluded from a blanket investment policy. If investment guidelines are too restrictive, the asset manager may not provide adequate value, putting all their emphasis on safety and liquidity at a time when more competitive yields are being offered in the market.
The dynamic nature of a global economy in various stages of recovery presents potential opportunities for both business growth and investment returns. Investment policies geared to the long-running distresses of the financial crisis may no longer be effective during times of extensive change. Annual policy reviews can help keep the investment priorities of safety, liquidity and yield in the most optimal balance for the current business environment.
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