Published: July 21, 2008
Forget John Grisham and Jackie Collins - this month’s essential beach reading is all about investment. The period which we are in has frequently been referred to as a time of ‘economic uncertainty’ - no-one knows quite what’s happening, what will happen and indeed, in many cases, what has happened. So does this mean that we should forgo our annual jaunt to the beach and be peering at our Bloomberg or Reuters screens instead?
Among the first 20 companies included in the Treasurers' Benchmark, only one had any long-term investments at all.
In fact, preparing for this article, and indeed the topic of investment in corporate treasury more widely, has been something of a revelation to me. Back in the balmy days when I was in treasury, admittedly of an extremely cash-rich company, we spent every afternoon switching in and out of USD investments - bonds, FRNs but in particular, every flavour of asset-backed security you could imagine: mortgages, credit cards, student loans, car loans. For us, the elements which defined treasury performance were i) cash balances at zero at the end of each day, without the odd collection sneaking in at the last moment, or not coming in at all, and ii) the yield on long-term investments. This is not to say that other priorities weren’t important: counterparty limits, credit ratings and endless investment policy reviews were also scrutinised, but ultimately, yield was what mattered.
Admittedly, that company was not necessarily representative of the treasury world as a whole. However, I had expected that at least some vestiges of long-term investment would exist. After all, every RFP to a treasury management system vendor gives an interminable list of all the investment types which the system is expected to manage. In the spring of 2007, the Treasurers’ Benchmark, which provides peer benchmarking for corporate treasurers, produced its findings on corporate investment. Short-term investment, yes, and in all varieties: commercial paper, certificates of deposit, repos, not forgetting the humble deposit and the up-and-coming money market fund. Medium-term investment? Long-term investment? Among the first 20 companies included in the Treasurers’ Benchmark, only one had any long-term investments at all. As the number of Benchmark participants grew, this number stayed resolutely the same. Then an insurance company joined, which was a rather different situation, so one became a tentative two. Fifteen months on, the number has fallen to one, which is the insurance company.
So what are we to make of this? Are there really no long-term investments among corporates out there? Well of course there are some exceptions, but on the whole, no there aren’t. As Jason Singer, Executive Director, Money Market Portfolio Management, Goldman Sachs Asset Management (GSAM) explains,
“We believe there is really no long-term investment alternative at the moment if preservation of principal is the priority.”
So, on this basis, the whole premise of this article needs to change. From talking about what type of medium- and long-term investments corporates are, or should be investing in, perhaps we need to look instead at investment policies and priorities. [[[PAGE]]]
The past year, as we all know, has shaken the financial industry considerably, with ramifications which could last for some years to come. While we saw the first ‘run on a bank’ for 80 years among retail customers, this has not happened at a corporate level. However, there is a definite flight to quality taking place amongst investors of all types. Jason Singer, (GSAM) summarises,
"Yes, clients of all types are looking to mitigate counterparty exposure."
Jonathan Curry, Managing Director, Head of European Cash Management, Barclays Global Investors (BGI) emphasises,
“Yield used to be a primary issue during earlier benign days, but security of capital and liquidity are now the priorities”
He continues, “We are seeing corporates which may have previously invested in bonds or enhanced yield investments (whether segregated or pooled) becoming more risk-averse. While these companies do not necessarily need a high degree of liquidity, their preference is to invest further down the risk curve. While this is likely to change over time, the primary focus amongst corporates at the moment is minimising risk”
So how are corporates changing their investment processes, and is this necessary?
Corporate treasurers have always had counterparty credit risk management policies, and tracked limit utilisation. However, in many cases, treasurers have been paying lip service to counterparty risk or treating it simply a process rather than as an investment priority. For example, according to figures from the Treasurers’ Benchmark, while the vast majority of treasurers who participate actively track credit limits, a large proportion (53%) take into account both credit rating but also subjective factors such as relationship when selecting counterparties with which to invest (fig 1).
Monitoring ratings and limits is not easy however, and for most corporates, it is a largely manual process, however sophisticated the systems they have in treasury. Furthermore, as Walter Dilewyns, formerly treasurer of SES Global emphasises in the TMI/ATEL Treasury Forum in this edition of TMI, corporates with smaller treasury teams do not have the resource to divide cash between counterparties, so there is a concentration of risk with one or few banks, which is undesirable however strong the bank’s credit rating. Credit rating agencies themselves are not infallible, not necessarily due to inadequacies in the process but because inevitably ratings are based on historic information (even if recent) and in such a volatile market, it only takes a scare which results in other banks ceasing to lend that could force a bank into crisis. As Jonathan Curry, BGI emphasises,
“Short-term credit is riskier than investors recognised previously, which creates a new starting point in determining investment policies”
So what should we be doing? An important issue is to review how credit limits are allocated. Are credit ratings alone used to calculate limits? If not, what other factors are taken into account and how objective are these factors? How is the maximum limit with each counterparty applied and for what tenor? What would be the financial and reputational impact if all the cash held at a particular bank were to be lost?
Some companies I see have such massive credit limits with their banks that there is no need to monitor them actively as they will never come close to 100% utilisation. This might satisfy board reporting to show that limits have been set and observed, but it means little in practice. Furthermore, companies have very different attitudes towards limit breaches. In some companies I have worked with, a limit breach is a serious disciplinary offence, while in others, it is simply a procedural issue which may require an additional approval but has no particular ramifications. Again, it is hard to see why one should bother to observe limits if they are not a serious risk management measure. [[[PAGE]]]
Credit limits need to be proportionate to each business: how much could you afford to lose? However, limits should also force diversification. It may be that your company could lose €10 million without a major impact on the organisation, but reputationally, could this have been avoided or limited to a smaller number?
One of the most significant outcomes of the increased perception of counterparty risk is that companies are placing cash for investment for very short periods, irrespective of whether they need the liquidity, as Jonathan Curry, BGI explained earlier. This inevitably means lower returns, but as Jason Singer, GSAM illustrates,
"Investors are willing to miss out on a couple of basis points on the upside to preserve liquidity and capital."
Credit limits need to be proportionate to each business: how much could you afford to lose?
While this may be an appropriate response to the current period of uncertainty, what about the longer term? Will shareholders seeking to invest in the companies which are making the most of their cash be satisfied with lower returns where this is, in some cases, an excuse for poor credit management policies or procedures?
Diversification is key to a high-quality investment policy, the awareness that no single counterparty can be 100% secure. But as we saw earlier, not all treasuries have sufficient resource to place cash on deposit with multiple counterparties and investing in investment management expertise may be considered by many companies to be outside their core business. Consequently, outsourcing to a fund manager of a pooled fund becomes an attractive proposition: outsource credit monitoring and investment management to an expert third party, gain the benefit of diversification and potentially also gain a slightly higher yield.
The growing enthusiasm for this approach explains to a large extent the growth of Institutional Money Market Fund Association (IMMFA) AAA-rated money market funds, which have continued to gain acceptance across Europe and further afield. We will not spend a great deal of time discussing money market funds here, as these are covered comprehensively in the recent TMI Money Market Funds 2008 Guide available at www.treasury-management.com. However, there are some important things to note. Firstly, not all instruments termed ‘money market funds’ are the same. The funds covered under the IMMFA provide constant NAV (net asset value) funds as opposed to the accumulating NAV which gained notoriety last year when many lost value as a result of the credit crisis. The rating of these IMMFA funds are specifically AAA with Fitch, AAAm with Standard & Poor’s and Aaa/MR1+ with Moody’s. They invest in the same types of investment that we might invest in ourselves (Fig 2) and have a duration of under 60 days. Funds which invest solely in government debt, considered the bastion of secure investments, are also becoming increasingly popular, particularly in the UK which have a longer history with money market funds than other parts of Europe.
The other benefit of a money market fund is that investors have immediate access to cash, which solves the problem of how long to deposit cash, particularly when cashflow forecasting may not always be reliable. [[[PAGE]]]
However, most treasurers would find it difficult to replicate the diversified nature of these funds and few if any treasuries have comparable credit analysis expertise and access to the market . Outsourcing investment management to a money market fund provider does not, however, mean that treasurers are abdicating their ultimate responsibility as guardians of the company’s cashflow. As Jonathan Curry, BGI explains,
“Investors are more interested in understanding the underlying investments held by the fund and the investment processes in place.”
While day to day counterparty risk management becomes less of a priority by outsourcing to a fund manager, due diligence of the fund provider takes its place.
We mentioned earlier that many companies are willing to sacrifice yield for greater confidence in the security and liquidity of cash. However, while the whole notion of investment performance has changed radically in the past year, investment performance benchmarking has not yet moved on. In the past, security and liquidity have been taken as ‘read’ and investment performance has been benchmarked against overnight rates such as EONIA, SONIA and Fed Funds or longer- benchmarks such as 1-week LIBID. As Jonathan Curry, BGI aptly summarises,
“The issue of benchmarking is fundamental going forward. A benchmark should ideally be replicable but the benchmarks currently used in the cash industry clearly aren’t - they are effectively only a return target. This makes measuring manager performance in the traditional sense difficult at times “
Credit should be more firmly entrenched in companies' policies than it has been in the past.
A treasurer could achieve his/her benchmark investment return but completely ignore the issues of security and liquidity, while failing to match a benchmark could mean that the treasurer has done the right thing for the company at a particular time. Furthermore, with shorter-term investments and increasing use of money market funds, it is not only the choice of benchmark but also the period which hardly makes sense - why use 3-month Euribor (for example) if very short-term investments or money market funds are used? This is still an issue which remains outstanding for many treasuries, and as participants in the TMI/ATEL Treasury Forum discussed, there is as yet no resolution. However, the lack of realistic benchmark should not be a reason to avoid investing in money market funds, rather the inadequacies of current corporate investment benchmarking practice are equally valid for all instruments. Hopefully the industry, in partnership with index providers, will grasp the nettle and develop an appropriate index to measure cash investment performance.
The current flight to security and liquidity will not last indefinitely and corporate treasurers should not be seeking to tighten their investment policies to the extent that they cannot take advantage of opportunities for yield which arise over time. Some companies will be ready to find new repositories for their cash earlier than others, and as Jonathan Curry explains,
“There are some interesting investment opportunities for companies with a long-term investment horizon which don’t need liquidity and can convince the board that it is acceptable for the value of capital to fluctuate month on month.”
However, whether your company is more or less risk-averse, credit should be more firmly entrenched in companies’ policies than it has been in the past. Investing in money market funds takes away much of the problem of analysing credit, diversifying risk and ensuring liquidity, whilst still ensuring a respectable yield compared with other short-term investments of a high credit quality. So, as long you have selected the right provider, put your money with a money market fund provider, kick your shoes off and head for the beach for the summer.
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