Published: January 01, 2000
For Latin American corporates and financial institutions, US dollar-denominated products, such as bank-issued interest-bearing deposits and short-term fixed-income vehicles [1] play a critical role in executing their short-term investment strategies. Despite the low-rate environment in the US and the higher yields available from similar products denominated in Latin American currencies, Latin American investors continue to invest heavily in USD products because no locally denominated short-term debt instruments offer the same level of stability. The decision on the part of Latin American companies to allocate at least a portion of their liquidity to USD-denominated products is considered best practice given the volatility that has roiled the region’s debt markets in the past.
The US dollar (USD) remains the world’s leading reserve currency, and USD-denominated products are perceived to provide a haven from the geopolitical turbulence to which other parts of a company’s investment portfolio may be exposed. The risk profile of US assets drives treasurers at many Latin American companies to invest in USD-denominated products despite their low yields vis-à-vis corresponding products denominated in local currencies.
Treasury professionals in Latin American are well aware that they may be paid just 20 basis points for holding a US certificate of deposit (CD) at a time when Brazilian and Spanish bank CDs are offering yields that currently are at least twice that. For most of them however, yield is far less important than principal stability, which prompts them to allocate a portion of their cash to USD products.
While cash investors generally cite principal protection as their top priority, liquidity runs a close second. The importance of liquidity became painfully clear during the global financial crisis, when investors needed to liquidate assets to raise cash but had trouble finding a market for them. Here, too, USD-denominated products have broad appeal with Latin American investors. USD short-term investments, such as money market funds [2], historically have provided daily liquidity. Short-term debt instruments denominated in Latin American currencies typically are very illiquid because purchasers tend to hold them until maturity.
The size of the allocation to USD-denominated products will vary according to several company-specific variables, most notably the company’s home country, the source of its revenues and the financial regulations imposed by the country in which it is headquartered.
With regard to the source(s) of a company’s earnings, Latin American companies that derive most of their revenues from their home countries are likely to have a very different allocation to USD products than a European multinational doing business in Latin America. The reason: companies that generate most of their earnings in the region would face significant foreign exchange challenges were they to invest heavily in financial products denominated in USD. They would also be subject to a large tax bill if they wanted to repatriate the assets in those USD products. That said, many corporates and financial institutions in the region generally allocate at least 10% of their total liquidity to USD-denominated products because of the premium their treasury professionals place on the perceived stability and liquidity offered.
The allocation to USD-denominated products is also influenced by the financial regulations of each Latin American country. Most companies in Latin America are allowed to invest in financial products originating outside of their home countries, but many countries limit the size of those allocations to between 10% and 30% of the companies’ total investment portfolio. The restrictions on foreign investments are particularly stringent for financial institutions. However, even with the limits on foreign investment, USD-denominated products are in the investment portfolios of virtually all companies in the region. This is due to the regulatory and tax frameworks in Latin America and because of the companies’ investment policies, many of which mandate a certain allocation to USD-denominated products.[[[PAGE]]]
For any company in Latin America that selects USD-denominated products, it is essential to obtain sound advice and support. The rate environment has changed dramatically across Latin America – and in the US – in recent years. The operating environment has also changed, meaning companies may find that their liquidity requirements are changing along with the environment in which they do business.
Increasingly, organisations are making use of leading banks’ investment management capabilities. The post-financial crisis period has been defined by a turbulent market environment, driven by events such as the Eurozone debt crisis and quantitative easing programmes in the US and Japan. Given such a challenging environment, many clients are using customised, professionally managed portfolios called separately managed accounts to gain a higher level of control, manage risk and ease pressure on over-stretched treasury staff.
In a separately managed account, assets are held in an organisation’s name rather than being commingled with other investors’ assets, as they would be in money market funds or other pooled investments. Consequently, a separate account portfolio can be customised to each company’s risk tolerance, yield target, liquidity requirements and tax situation. Organisations can stipulate investment types, maturities, credit-quality requirements and sectors (potentially excluding certain Eurozone banks, for example). Separate accounts also offer investors potent diversification benefits [3] because their managers can tap a wider array of debt instruments than is available to money market fund managers.
Before executing any investment strategy, organisations should review their investment policies to confirm the contemplated investment is compatible with those policies. Investment policies should do more than just specify allowable investments; they should specify objectives, risk controls, and monitoring requirements for the entire investment programme. Non-compliance with one’s own investment policy – such as buying instruments with maturities longer than those prescribed in the policy – could significantly affect the risk profile of an investment portfolio.
Financial markets continue to be volatile, and the global economic outlook remains uncertain. Therefore, principal stability continues to be critical for corporations and financial institutions when investing their surplus liquidity in the foreseeable future.
At the same time, the regulatory environment is changing the investment landscape. The US Securities and Exchange Commission has proposed sweeping changes to the regulatory framework governing US money market funds to make them more resilient to the kind of market stress that defined the global financial crisis. Similarly, the European Commission plans to require some money market funds to establish cash buffers to help protect them from disruptive redemptions. Meanwhile, the introduction of Basel III will require banks to set aside liquid assets for long-term cash deposits according to a proscribed liquidity coverage ratio (LCR). Banks will be more selective in the types of cash deposits they accept, and will be competing for corporate balances linked to underlying transactional activity, as those will have a lower capital requirement. For long-term reserve cash not linked to transaction activity, banks may lower the rates they pay, in response to this regulation.
This confluence of market and regulatory change means that it has never been more important to select the right specialists to develop US liquidity solutions. Organisations should work with providers that offer a consultative approach, a strong familiarity with the different investments available to investors, and deep knowledge of the global debt markets. Ideally a company’s treasury staff, its outside asset managers and its cash management professionals would collaborate to optimise its liquidity investment programme. Finally, those external providers should understand the complex web of regulations that govern the investment of corporate cash in Latin America.
Notes
[1] Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.
[2] Mutual fund investments are subject to certain risks. An investor’s principal and return will fluctuate with changes in market conditions so that the shares, when redeemed, may be worth more or less than their original cost.
[3] Diversification does not ensure a profit or guarantee against loss.
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