Treasury Today Country Profiles in association with Citi

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Instituting a cash investment policy statement

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A cash investment policy statement, or cash IPS, is an important tool when it comes to articulating the company’s investment goals, optimising cash and promoting accountability. But an IPS is not set in stone – and in current market conditions it’s particularly critical to make sure the statement is fully up-to-date, whether that means reviewing the existing IPS or building an IPS for the first time.

In today’s evolving regulatory and interest rate environment, it is essential that organisations’ investment policies continue to meet the needs of current market conditions – and this means having the right tools in place. A cash investment policy statement is an important part of the equation when it comes to supporting sound cash investment decisions.

What is a cash IPS?

Organisations can use a cash IPS to set out their short-term investment goals and the strategies they will use to achieve them, as well as documenting the segmentation of cash into different categories based on the company’s liquidity needs. Typically the cash IPS will define the organisation’s parameters in terms of liquidity, quality and return, as well as specifying its return requirements, risk tolerance and permissible investments. The cash IPS should also document any investment constraints, such as tax considerations; environmental, social and governance guidelines.

There are many good reasons for adopting a cash IPS. As well as providing more clarity for everyone from the investment team to the board of directors, a cash IPS can help organisations optimise cash, while promoting accountability by building in governance. The statement can also be used to help navigate regulatory change and adapt to changing interest rates.

In with the new

While organisations may already have a cash IPS in place, current market conditions are prompting many investors to adopt a new cash IPS, or to update the existing statement. Regulatory developments such as Basel III or money market fund reform in the US and Europe may lead companies to adjust their cash IPS. Likewise, the evolving interest rate environment is making it more important for investors to be flexible in the face of market changes. As well as, evolution in products such as ultra-short exchanged-traded funds (ETFs) and liquidity private placement funds.

In any case, a cash IPS is not set in stone: treasury teams often update their cash IPS frequently so that they can take advantage of new investment opportunities and cash management products.

Of course, all of this takes time – so it is important to get the ball rolling at the earliest opportunity.

How to build a cash IPS

When it comes to creating a new cash IPS – or reviewing the existing IPS – companies will need to set out their cash investment objectives, draw up a cash forecast and, where applicable, segment cash into different categories based on considerations such as liquidity and purpose.

  1. Set objectives

    First and foremost, the cash IPS should detail the organisation’s goals for its short-term investment strategy, as well as specifying how the organisation will meet those goals. The objectives section of the cash IPS may include the following:

    • Capital preservation.

      Protecting the principal will likely be a primary goal.

    • Liquidity.

      The cash IPS should stipulate the level of liquidity needed in order to mitigate avoidable risks.

    • Yield.

      The organisation may include yield among its goals, although the cash IPS will need to weigh this against the likely increase in volatility of principal.

    • Tax-advantaged returns.

      In some cases, organisations may be seeking tax-conscious liquidity management, for example by using tax-free short-term funds.

    • Above-benchmark returns.

      Objectives may also include exceeding a benchmark that mirrors the portfolio’s underlying investments.

  2. Produce a cash forecast

    The treasury team should then inventory the company’s expenditures in order to produce a detailed cash forecast. This can be used to identify what portion of a portfolio needs to be readily accessible, and which portion can be treated as surplus cash.

  3. Segment cash

    Drawing upon this information, the cash IPS may then detail how cash should be segmented into different categories based on different objectives and liquidity requirements. Typically these categories will include key ‘buckets’ such as operating cash, reserve cash and strategic cash. Operating cash is used to fund the company’s operating needs and therefore requires same-day or short-term liquidity. Reserve cash – which may be earmarked for purposes such as acquisitions, research and development, or stock repurchase – may have an investment horizon of six to 12 months, while strategic cash may be invested for one year or more.

Key components of a cash IPS

Once the objectives of the cash IPS have been defined, and the cash segmentation strategy clarified, the next step is to provide greater detail about the level of risk which can be tolerated within each segment. In some cases, organisations will adopt a higher-risk strategic cash allocation – but the impact of the decision will need to be understood and documented within the IPS.

For each segment, companies should therefore consider a number of different risk factors, including their tolerance for liquidity constraints, the portfolio’s sensitivity to interest rate volatility and the possibility of liquidity fees being imposed in times of market stress. Companies should also assess their tolerance for short-term negative returns and the acceptable range of realised gains/losses over a given period.

When considering risk tolerance, the following types of risk should be taken into account:

  • Interest rate risk.

    A change in interest rates can affect the value of a security – so for each segment, the cash IPS should stipulate the organisation’s interest rate risk tolerance. Typically the operating cash will have the lowest interest rate risk tolerance, while the strategic segment will have the highest tolerance.

  • Liquidity risk.

    The cash IPS should define the level of liquidity needed so that companies can meet their obligations without needing to sell longer-dated securities.

  • Credit risk.

    The value of a security can change as a result of a rating downgrade or a credit risk default. The IPS should define the minimum credit quality required for individual securities. It is also advisable to specify an average credit quality limit on the portfolio as a whole in order to ensure credit quality diversification.

  • Loss of principal risk.

    In certain circumstances, a major downturn could result in the loss of principal for longer-duration cash products. The cash IPS should define whether the organisation can accept a level of short-term volatility, as well as its requirements in terms of steady dividend income and diversification.

Other considerations

As well as looking at the risk factors detailed above, companies should also consider a number of other elements when creating the cash IPS. For one thing, it’s important to state the types of securities permitted by the cash IPS, including any parameters relating to credit quality maturity and diversification. The IPS should also detail what the company should do if a security or issuer is downgraded, or if ratings differ between rating agencies.

When it comes to tracking performance, the IPS should specify portfolio benchmarks in line with the company’s investment strategy, as well as spelling out any tolerance for portfolio gains or losses. Likewise, the IPS should set out duration strategies for each cash segment, specifying in each case whether the strategy is a target duration or a buy-and-hold strategy.

In addition, the cash IPS should identify any sustainability or environmental, social and governance (ESG) parameters which may be applied.

Roles and responsibilities

Another requirement of the cash IPS is to provide clarity over the roles and responsibilities of those involved in approving, implementing and modifying the statement. Adopting an IPS is not a one-off exercise, so provision should be made for how the cash IPS will be evaluated on a regular basis, and how compliance will be enforced.

It is important to bear in mind that circumstances can change: regulatory developments may affect the company’s cash management strategy, while risk tolerance can change over time. Actions such as acquisitions and share buybacks may reduce available cash, while a divestiture or bond issue could generate a significant inflow.

The IPS should therefore define who is responsible for reviewing the IPS and who can recommend modifications. Typically this will include the CFO, treasurer, assistant treasurer and other members of the treasury group. Likewise, the IPS should specify who has authority for final sign-off: this will usually be the CEO, CFO and/or board of directors. Procedures should also be put in place for any exceptions to the investment policy which may arise, and how these should be approved.

Seeking an external asset manager

Finally, companies will need to consider how to go about implementing the cash IPS. Some will have the resources needed to manage short-term investments in-house, such as portfolio management systems and risk control expertise. Companies managing their investments in-house will also need to have a credit team and a procedure for providing the necessary compliance monitoring reporting.

In other cases, it will be appropriate to seek assistance from an external asset manager which may be better suited to provide the relevant knowledge, resources, time and infrastructure. When choosing an external manager, it is essential to ask some rigorous questions about the capabilities of any managers under consideration. For one thing, companies should assess the asset manager’s tenure in the short-term fixed income business and its track record in credit and risk management. Likewise, organisations should consider the size of the firm’s dedicated credit team, the background of team members and to what extent credit teams are separated from the portfolio manager.

Other criteria should include the asset manager’s geographical scale and business model, as well as the diversity of its client base. Last but not least, companies should pay attention to the firm’s total AUM in short-term fixed income, its share in the money market business and how this has changed over time.

In conclusion, it is essential that companies continue to evaluate their investment strategies in line with changing market conditions – and the cash IPS is an important tool in defining and enforcing an organisation’s investment goals. Whether companies are creating an IPS for the first time, or reviewing an existing statement, they will need to approach the process rigorously in order to create a robust IPS with the flexibility to meet their evolving needs.