Cash Segmentation, Diversification and Classification

Cash segmentation, where treasurers split their cash into operational, reserve, and strategic buckets and invest accordingly, has been a valuable strategy during the perpetual low interest rate environment. It has enabled corporates to take an amount of cash allocated to short-term investing and buy into ultra-short bond strategies that offer the potential to gain additional yield with only a marginal increase in risk.

Cut to the summer of 2022, and inflation in the US and UK is surging to heights not seen for at least 40 years. In response, the Federal Reserve and the Bank of England have implemented rate hikes. How will the strategy stand up to these new economic data points?

Daniel Farrell, Director, International Short Duration Fixed Income, Northern Trust Asset Management (NTAM), advises that cash segmentation works well when the market is pricing in more rate increases than fund managers predict will happen.

“We’re currently seeing aggressive rate hike pricing across all central banks, globally,” Farrell notes. “The question is, do you believe they will embark on all those rate hikes? If not, then an ultra-short strategy is a good place to be as you can start to invest at those higher yields. You can go slightly further out along the curve to five-year maturities, for example, which will provide higher yields than if you were investing out to one year.”

The market is still anticipating further rate hikes across the board in the next 18 months. But rate cuts are also being priced in specific markets by the end of 2023. The current reaction function of the central banks is to combat inflation. But they must also manage inflationary expectations, so that these do not become de-anchored, as this could lead to a continuous spiral of higher inflation.

“Central banks are going to be front-loading interest rate hikes – but there will be a point where they will have to stop, otherwise they would take economies into a deep recession,” continues Farrell. “There will be further rate increases, but there will be a point in the next six to 12 months where that will have to stop.”

With the current spike in inflation, cash is hurting and therefore holding it can cause a drag on investments. This is the case even when looking at forward rate inflation data. It is an appropriate time to make cash work harder. Cash segmentation offers a proven strategy to do this.

As Patrick Kunz, MD, Pecunia Treasury & Finance, puts it: “A treasurer who has a lot of excess cash at the bank and is not investing it for more return – but not necessarily more risk – is costing the company money.”

Forecasting guides the way

Cash segmentation is a strategic option that any corporate can apply to their short-term investment plan. However, the level of sophistication that a treasurer can achieve relies heavily on their cash flow forecast accuracy. Thankfully, there is help at hand.

“Treasurers need to have at least some ability to forecast what cash is available for short-term investments,” emphasises Farrell. “If that’s unknown, there’s too much risk that they would have to liquidate a portion of the portfolio that had been allocated to the longer-term strategies.”

Cash segmentation depends on where the treasurer can forecast out to, as this will determine the cash buckets they can set up and the level of cash placed in each bucket.

“If a treasurer can forecast out 30 days but no further, that’s operational cash,” explains Farrell. “That’s where MMFs are the most suitable investment. Any forecast between three and six months enables them to add a bucket for reserve cash. Finally, if a treasurer can forecast out to six months and beyond, that opens up the strategic cash bucket.”

Bespoke bucket lists

Cash forecasting is essential to setting up cash segmentation, but corporate treasurers require a deep understanding of their cash flows to optimise the strategy. How much cash goes into which bucket depends on various underlying issues, many of which will be unique to the individual organisation. Many corporates will partner with an asset manager at this point of the journey to tap into their market expertise and help to optimise their cash segmentation.

“We work with treasurers around understanding the uses and needs for their cash, and then defining the relevant allocation based on this information,” Farrell outlines. “Once this framework is understood, treasurers can think about how it should be deployed into different strategies to optimise the benefits. Cash segmentation for one corporate could be 90% in operational cash and 10% in reserve cash, whereas another could have 60% in operational cash, 20% in reserve cash and 20% in strategic cash. It becomes much more bespoke to an individual corporate based upon those uses and needs.”

Asset managers often use proprietary tools to help investors go through that process. For example, NTAM uses historical data and statistical analysis to understand how much cash is utilised on a day-to-day basis, what quarterly or annual payments can be identified, as well as stripping out the non-volatile, sticky cash balances that exist on an ongoing basis.

“We have a proprietary cash segmentation tool that lets treasurers input their historical cash data, risk metrics and parameters, and liquidity characteristics, and then see their optimised allocation,” reveals Farrell. “It illustrates to the treasurer that if they had deployed a cash segmentation strategy, how many movements they would have seen from an ultra-short bond fund allocation into a money fund or vice versa, to demonstrate that it’s very minimal. The optimisation process minimises the number of transactions investors have to trade on.”

The focus of this tool is to ensure that any corporate cash segmentation strategy is adequately liquid in the MMF while making the most of the piece that can be optimised and reducing transactions.

“The outputs enable investors to make it even more bespoke,” adds Farrell. “If a treasurer is not comfortable with the outputs and wants to increase the amount in an MMF, they can see what the new output would be if they increased that allocation. It enables treasurers to see what the difference in yield would be historically, as well as the underlying characteristics of the cash segmentation allocation.”

Future-proofing through diversification

In addition to the enhanced yield potential, treasurers that can take incremental duration and credit risk also get better diversification. MMFs are highly focused on financials, but investments out to one and three years can go into the diversified corporate sector.

“Getting exposure to the corporate sector through an ultra-short bond strategy is a good risk mitigator in time of crisis, as it spreads the risk,” notes Farrell. “Predicting future crises is very challenging. For treasurers, ensuring they have a well-diversified portfolio of underlying investments is key.”

Using MMFs and ultra-short bond funds in a diversified portfolio of investments, enabled by a cash segmentation strategy, helps lower counterparty risk while maintaining liquidity within a short-term investment portfolio.

Kunz adds: “MMFs have a higher return than cash that is just left in the bank. They also have the same and sometimes lower risk than the exposure from a bank, where cash would be sitting doing nothing. MMFs and bond funds are diversified, reducing the overall risk of failure.”

Energise excess cash

With the current market stresses of inflation and interest rate upheaval, a cash segmentation strategy enables treasurers to maintain a diversified portfolio of short-term investments that manage risks and optimise yields.

For those somewhat overwhelmed by how to start implementing such a strategy, using the expertise and tools on hand from asset managers can be a first step towards unlocking a bespoke strategy that focuses on the cash uses and needs of an organisation.

“A cash segmentation strategy generates more returns than a one-size-fits-all approach to investing, and the cash follows the treasurer’s business cycle and objectives,” concludes Kunz. “Shareholders will love the fact that the treasurer has not only thought of current cash but also future cash and how treasury is managing this to make returns while keeping risks low.”

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