Security, liquidity, yield: the three objectives of investors have been aligned in this order since the start of the financial crisis, with yield coming emphatically bottom of the list. However, with interest rates expected to remain near zero for the time being, some investors are starting to look more proactively at the possibility of increasing return on their investments – without compromising on all-important capital preservation.
When the financial system looked to be on the verge of collapse in September 2008, investors around the globe retreated from risk and deposited funds in the safest investments they could find: most notably government bonds. However, the safest investments usually offer relatively low returns – particularly when they are in high demand. Combined with the low interest rate policies adopted by governments in response to the financial crisis, the result was that investors received unusually low returns on their investments – and in some cases found they were effectively paying others to look after their money.
“Now mattresses have become fully competitive as a place to put your money.”
Indeed, when the short-term yield on US Treasuries dropped to zero in December 2008 – and briefly turned negative – investor Warren Buffet remarked, “Now mattresses have become fully competitive as a place to put your money.”
Two years on, central bank interest rates around the globe remain close to zero and yields remain correspondingly low. However, the threat of a complete breakdown of the financial system – or ‘financial Armageddon’, as it was darkly referred to in 2008 – has subsided somewhat. While many investors remain highly conservative, the word in the market is that others are beginning to consider higher-yielding investment opportunities.
Trends in investor behaviour
Treasury Today’s 2010 European Benchmarking Study in association with J.P. Morgan found that bank deposits remain the investment vehicle of choice for most corporate treasurers, used by 91% of the 450 respondents. AAA-rated money market funds came in second, at 40%.
Before the financial crisis, yield was top of the priority list for 30% of treasurers, according to the Benchmarking Study. In contrast, only 4% of treasurers stated that they are currently prioritising yield.
The Benchmarking Study also found that 33% of respondents cited security as the most important factor when determining their investment policy prior to the crisis. In 2010, this has increased to 61%.
Nevertheless, several respondents remarked that they had invested in government bonds at the height of the crisis but that they have more recently been reducing these investments.
Some money market fund providers have recently reported renewed interest in yield among corporate investors. “As fears of financial system failure have started to recede, clients are again searching for higher yield,” comments Jim Fuell, VP and Head of Global Liquidity for EMEA, J.P. Morgan Asset Management.
Of course, in an ideal world, any investor would prefer to see a sizeable return on their investment. However, this cannot be achieved without a trade-off of either liquidity (duration) or credit risk.
“To improve yield you must increase risk,” explains Travis Barker, Head of Liquidity Business Development, HSBC Asset Management. “There are two forms of risk that you can increase: you can increase credit risk (in other words, you can accept lower quality credits), or you can increase liquidity risk (in other words, you can give up daily access or periodic access to your cash). It is like having an old style radio with two dials that you can turn – either the credit dial or the duration/liquidity dial. In my experience, investors are generally leaving credit alone, but they are playing around with duration/liquidity.”
In the current climate, however, not all companies will be able to achieve a significant improvement in yield, even if they are prepared to accept more risk. “You might be able to pick-up another five to ten basis points, but the risk and the potential impact to your business could be significant,” comments Jose Franco, Global Liquidity Executive, Bank of America Merrill Lynch.
Nevertheless, according to Travis Barker, there are two camps of investors. The majority of corporate treasurers remain cautious and continue to place yield third in their priority list, below security and liquidity. However, while investors continue to avoid credit risk, a smaller second group, comprising larger corporates with large cash surpluses, are increasingly looking to increase yield, usually by sacrificing liquidity on longer-term cash.
‘Conservative’ is in the eye of the beholder
VP and Treasurer
One treasurer that has a large cash balance to manage – over $26 billion, in fact – is Brent Callinicos, VP and Treasurer of Google. Between late 2008 and mid-2009, Google adopted an ultra-conservative investment strategy which invested almost exclusively in sovereign debt. As the crisis subsides, this strategy has begun to loosen somewhat.
“The period between April 2009 and today, give or take a couple of months, is when we went to get approval for and rolled out our new portfolio policy, which was moving away from a super-conservative portfolio,” comments Callinicos. “We moved further out the yield curve in terms of taking out more duration risk, and we started taking some credit risk in the portfolio. We started going into some non-sovereign backed fixed income.”
As Callinicos points out, however, to a certain extent what constitutes ‘conservative’ is in the eye of the beholder. “If you ask someone who still has one-year T-bills as 100% of their portfolio, then we’re not conservative. If you ask somebody who has equities and commodities in their portfolio, then we are conservative.
We still have a relatively short-term portfolio because there obviously needs to be the ability for the company to have an instantaneous call on that cash and we have to be very liquid from that standpoint. However, we do now have a decent amount of investment grade and non-investment grade corporate bonds – so we are taking credit risk but it’s still in the fixed income arena. Again, it’s in the eye of the beholder as to whether you view that as conservative or not.
Commensurate with that small amount of risk, it’s a pretty significant increase in the interest income that we will pick up on that portfolio versus where we were at the height of the crisis: you can see that reflected in our interest income.”
Tranches of cash
Google is not alone in looking to move further out the yield curve. Active tranching of cash has been a key outcome of the crisis, with treasurers increasingly looking to assign the correct amounts of cash to different durations according to purpose – ie for debt repayment or investment. Corporates use cash flow forecasts to determine how long surplus cash can be invested for. Different investment instruments with different risk-return and liquidity profiles will be available depending on the time period identified.
Short-term or operational cash may be needed at any time to cover working capital shortfalls, so preservation of capital and liquidity are paramount. Return on short-term investments is likely to be comparatively low, but so is the risk.
Medium-term cash – ie cash that can be invested for three or more months – will likely generate higher returns in return for longer maturity than short-term cash, while long-term cash can be invested for longer periods again and can therefore achieve a significantly higher return than on short or medium-term investments – but at a greater risk.
Proactive and open-minded
Andy Nash, Group Treasurer of Ahold, explains that the retailer has benefited from being proactive in its investment management. “We started to speak to fund managers of money market funds (MMFs) in 2007 to understand their investment process and the different instruments they were invested in. Whilst the MMFs we used were AAA and targeted stable net asset values, we found that some of the funds held a large number of Structured Investment Vehicles (SIVs). The SIVs did not match our risk profile and lacked transparency so we moved to other funds that had no SIVs or Collateralised Debt Obligations (CDOs).
“It was important to have open discussions to know how the fund managers were reacting to the market events and that they had active watch lists. The regular calls were also useful when exchanging views on the markets and our CFO also joined us for some of them.”
As with many other corporate treasury teams, with the crisis in the financial markets, the Ahold team was focused on capital preservation of its investments followed by liquidity; yield coming third on the list. “We looked at a lot of alternatives and at the height of the crisis we did use government bond MMFs; they served a purpose at the time, but after a certain point it made no sense at all,” comments Nash.
The treasury team has kept an open mind when looking into higher yielding investment vehicles and explored many alternatives, such as bespoke funds and dual currency products that were not eventually used.
Nash puts a lot of emphasis on the importance of working closely with the operating companies and following cash generation and forecasts together: “If you’ve got good cash flow forecasting, you have more opportunities to improve yield via term investments, while still keeping capital preservation at the forefront.” Ahold has consequently been able to increase yield by investing in six-month LIBOR tracker funds in both US dollars and euro.
Despite some movement towards a greater focus on yield, the financial crisis is still very fresh in most treasurers’ minds and it wouldn’t take much for corporate investors to retreat back to safer investments. Even those investments previously deemed to be the safest – ie government debt – have to be looked at with renewed caution in the context of the sovereign debt crisis in some European countries.
According to ECR Research, the outlook for yields in the coming quarters remains bleak: “Slowing European and US growth will ignite fears of a double dip, resulting in safe haven flows from risky assets (stocks and speculative corporate bonds) towards safe assets, which are mainly the safest corporate and government bonds and highly rated money market paper. Therefore, we expect the yield on ten-year government bonds of the US, Germany and the UK to decline further towards 1.5%, 1.5% and 2% respectively. At the same time, we expect the corporate spreads (rated A and lower) to increase substantially.”
Near-zero interest rates and low yields are most likely here to stay – at least for the time being. Consequently, investors are unlikely to see sizeable returns unless they are prepared to compromise on either liquidity or credit risk. Even then, opinions vary as to whether the potential pick-up in yield is worth taking on any additional risk.
Even for those who are pursuing yield more proactively, capital preservation remains top of the priority list for most. To borrow another quote from Warren Buffet:
“Rule no.1: never lose money.
Rule no.2: never forget rule no.1.”