A flexible and up-to-date investment policy is essential if companies are to react promptly to market developments and take advantage of new investment products. How can treasury shape such a policy? Jason Straker, Managing Director, Head of Client Portfolio Management for Global Liquidity EMEA at J.P. Morgan Asset Management, explains.
Managing Director, Head of Client Portfolio Management for Global Liquidity EMEA
From regulatory changes to high liquidity costs, current market conditions present many challenges for corporate investors. For one thing, interest rates continue to be historically low in most of the major currencies. But with rates already rising in the US – which has seen three increases since December 2016 – the days of near-zero rates may be coming to an end. Europe and the UK have yet to follow suit, but expectations of future increases have driven the benefit of investing for longer maturities higher than it was 12-18 months ago.
Meanwhile, regulatory developments such as the arrival of Basel III have made liquidity more expensive. As a result, if treasurers build too much liquidity into their investments, this may result in the loss of potential yield benefits. Treasurers may therefore wish to consider any opportunities that enable them to invest in higher-yielding, longer-dated investment products.
First, though, they will need to review their investment policies and make sure these continue to be fit for purpose.
Reviewing the investment policy
Choosing when to review the investment policy involves striking a balance. Making meaningful changes to a policy takes considerable internal effort, so the policy should not be updated too frequently – but nor should it become too stale.
In practice, treasurers may review their investment policies for a number of different reasons. For one thing, scheduled reviews will be carried out on a regular basis, typically annually. However, market changes, such as interest rate developments, can also prompt a review, as can developments in the credit market.
Regulatory change is another common trigger, as illustrated by our recent 2017 Investment PeerView SurveySM. The research found that in light of the current regulatory environment, 46% of respondents plan to change their investment policies in the coming six-12 months, up from 38% in 2015.
Should you consider lower quality investments?
Following a review, treasurers may choose to make some changes to the policy – and this may include widening the range of permitted products. In some cases, this could mean looking at lower-rated investment products, for example by reducing the minimum acceptable credit rating from A to BBB. This won’t always be appropriate – but in the current market, with interest rates on the rise and credit health appearing to be at historical highs, lower quality investment solutions may be attractive to some companies.
Treasurers may encounter some internal resistance to such a move, but there can be a strong argument for considering this approach, depending on the type of investment. Where banks are concerned, a lower credit rating simply means that their cost of borrowing will increase, which can negatively affect profitability. But companies which are rated BBB are often solid industrial and utility businesses which are happy with the amount of debt they have on their balance sheets and are therefore comfortable with their BBB ratings.
Of course, corporate investors will still have some types of investment that they will not consider – and for most, dropping from BBB to BB is out of the question. Sub investment grade or high-yield investments are more likely to attract speculative investors and are therefore unlikely to be suitable for risk-averse investors such as corporate treasurers.
It is important to note that if treasurers do opt to invest in lower-rated products, the investment policy still needs to be flexible enough to react to any market changes so that treasurers can revisit the position if needed.
The benefits of cash segmentation
When reviewing their investment policies, treasurers may also build in the ability to segment cash – in other words, divide cash into different ‘buckets’ depending on how soon that cash will be needed. These balances can then be invested in accordance with suitable investment horizons, giving the company the opportunity to invest in high-yielding, longer-dated investment products.
It’s fair to say that more companies are segmenting their cash compared to a few years ago. In light of new money market fund regulation in the US – and the upcoming changes in Europe – companies have access to a greater range of investment products than in the past. We are certainly seeing companies take advantage of that greater choice and put more segmentation in place.
Typically, companies adopting this approach will divide cash into three tranches as follows:
For the company’s working capital, treasurers tend to use same day investment solutions such as money market funds, liquidity funds, overnight deposits or overnight repo.
The next portion of cash relates to funds which may not be needed for three months or longer – for example, cash which is earmarked for M&A activity or capital expenditures.
The longer-term tranche includes cash balances with an investment horizon of one year or more.
While companies which segment their cash broadly follow this approach, different treasurers may define their investment horizons in different ways. Some will broadly match the maturity of a particular investment to the investment horizon, whereas others may think about how long they will need to invest for in order to expect a positive return.
For example, some treasurers would equate a tranche of cash with a three-month investment horizon with a three-month bank deposit. But where asset management solutions are concerned – such as longer-term bond funds – it may be more appropriate to ask how long you need to invest before you get a positive return. The underlying investments within that product may be much longer, but on average, when you look at the fund or portfolio as a whole, the expected gain will take at least around three months.
Flexibility and planning
Above all, investment policies need to be flexible. If a company’s situation changes, its need for cash – and its chosen investment solutions – may vary considerably from one quarter to the next. Flexibility is important for three reasons:
Taking advantage of new products.
Where new products are concerned, the types of product available will be affected by the investment solutions that are offered by different banks or asset managers, as well as by changes in regulation.
The company’s changing circumstances.
Changes in circumstance can have an impact on its ability to implement cash segmentation and forecasting successfully. Corporates’ ability to forecast cash does change over time – sometimes future flows will be much more certain, and sometimes less certain. Market developments such as interest rate rises and changes to the creditworthiness of issuers may also require flexibility in the investment policy.
When reviewing the investment policy, forward planning is also important as this can give treasurers the ability to move more quickly when needed.
What does flexibility look like in practice? One example is that a treasurer might decide to approve a new type of investment solution before the company needs to use it. The process of opening a new account or carrying out the due diligence on a new solution can take some time – so there is a clear argument for doing the groundwork, getting a new type of investment approved and then waiting until the right moment before actually using it.
In practice, time-strapped treasurers often do not start doing the necessary groundwork and due diligence until a solution is needed, which can mean that the process is more rushed than it would otherwise be. By planning ahead, treasurers can give themselves the flexibility needed to seize opportunities as they arise.
With considerable regulatory and market changes under way, it is more important than ever for treasurers to keep their investment policies up to date. By doing so, treasurers can achieve the flexibility needed to segment their cash effectively and take advantage of different products and investment horizons when opportunities arise.
However, the demands of this task should not be underestimated: more than three quarters of respondents to our 2017 Investment PeerView SurveySM mentioned that implementing a change would take moderate or considerable effort. Treasurers should therefore seek support from a trusted partner who is able to provide guidance about market developments and assist with the creation of a suitable investment policy.
To find out more, visit www.jpmgloballiquidity.com