Treasury Today Country Profiles in association with Citi

Short-term investing: a new era

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With interest rates remaining at historic lows, Basel III discouraging banks from taking certain deposits, and MMF reform in Europe, corporates continue to struggle to find short-term investment vehicles in line with their investment policy. In this Section, we look at how structural changes are reshaping best practice short-term investment in Europe.

Negative rates, banks turning away non-operational cash deposits, and a changing regulatory environment in the money market fund (MMF) space to boot: it is hard to imagine another time when the liquidity management environment has seen such a powerful concurrence of headwinds.

Defining a strategy fit for this new external environment is tricky enough, so the last thing that treasurers will want is the task being made all that much harder by internal factors like investment policies. Yet for some treasurers it would appear that this is precisely what has been happening, with anecdotal evidence suggesting that many companies’ investment policies do not permit negative yields. Other treasurers may be finding, meanwhile, that the new instruments they are now considering (since the Liquidity Coverage Ratio (LCR) made it harder to park some of their excess with a bank) or since MMF reform was mooted, are not covered in their investment policies either.

Time for a review

Without doubt, then, hundreds of treasurers across Europe are thinking now may be the time to revise the rules that govern their liquidity investments. In fact, in July 2015, Fitch Ratings published a report suggesting that if they are not already doing so, then they really should be. The report said that it is indeed time for “a proactive, strategic update of investment guidelines” and that corporate investors should give particular thought to future changes in cash management products and ratings coverage.

When reviewing their current investment policy in light of the regulatory and economic climate, there are three areas treasurers may wish to focus on, says Hugo Parry-Wingfield, EMEA Head of Liquidity Product at HSBC Global Asset Management. First, as ratings agencies continue to review and in some cases downgrade banks, corporates should be thinking about whether polices remain ‘fit for purpose’. “Companies should not simply adjust their criteria downward in response,” says Parry-Wingfield, “rather there should be a deep analysis to decide whether they have the right (and sufficient) counterparties.” The second area for consideration is the investment products referenced in an investment policy.

If the ability to place some short-term deposits with banks is becoming limited, then perhaps treasury needs to explore if other instruments are needed, such as MMFs or direct securities. There is likely to be innovation in both the bank and asset management markets to launch new products that meet emerging investor and regulatory demand. Finally, in light of Basel III and the introduction of the LCR, corporates should also be thinking about how their investment policies define their liquidity profile. “The treasurer should now be reviewing what liquidity they really need to run the business. There is always an opportunity cost to holding too much liquidity but we believe that is going to be accentuated in the months to come,” adds Parry-Wingfield.

Investment policy: a refresher

All of a company’s investments should be governed by pre-determined criteria, designed to balance risk and return in a way which meets the company’s risk appetite: in other words, by an investment policy. For corporate treasuries who have yet to establish or have not recently evaluated their existing cash investment policies, now is the time.

The investment policy sets out who has permissions to carry out certain investments, which funds, banks and other counterparties are permissible and in what amounts (percentage limits can be set), the credit ratings, returns and maturity lengths which are acceptable and how the policy may be updated in future as the company’s risk profile changes, new investment products become available or counterparties change.

It is important to determine:

  • How will the policy be reviewed and modified on an ongoing basis (eg in light of new regulations)?

  • How often will it be reviewed?

  • Who will be involved in that review process (internal or external)?

  • Who will have the ultimate decision-making authority?

However, before developing an investment policy, it is important to conduct a thorough evaluation of the company’s cash needs and to pinpoint its risk profile. Effective forecasting of liquidity needs and assessment of risk tolerance allows for the best opportunity to ensure preservation of capital, while achieving returns within a cash portfolio.

According to asset management firm, BlackRock, a typical investment policy statement should include these 12 components:

  1. Definition of portfolio.

  2. Investment objective.

  3. Benchmark.

  4. Maturity/duration guidelines.

  5. Asset guidelines.

  6. Asset allocation.

  7. Credit criteria.

  8. Other investment practices.

  9. Reinvestment of income.

  10. Custodian.

  11. Accounting agent.

  12. Other vendors, ie treasury consultant.

By way of an example, a company’s investment policy may say that deposits may only be placed with banks with AA ratings or higher; or it may ban investments in illiquid securities with a maturity of over 90 days. Products based on equities are often not to be allowed. In general, investment policies also usually advise investing only in currencies and countries where the corporate already has business, to avoid creating unnecessary FX exposures.

Increasingly, corporate investment policies now also incorporate some socially responsible criteria. That might see companies avoid investing in bonds issued by regimes and companies deemed to be ‘unethical’. Some borrowers are taking advantage of the trend to be seen to be socially responsible – various public bodies around the world have issued ‘Clean Energy Bonds’, for example, to fund renewable energy projects.

Keep it flexible

Any treasurer that does conclude there is now a need to review departmental policies around investments should try to maintain a long-term view though. If there is anything at all to be learned from the investment policies that have struggled to keep pace with the developments we have seen over recent years, it is that any parameters should not be so rigid that they are unable to accommodate changing conditions.

“Investment policies are not supposed to change every six months,” says Jim Fuell, Head of Global Liquidity, EMEA at J.P. Morgan Asset Management. “They are broadly written, but with a level of constraint. Having said that, though, I think it is also important to build in some level of flexibility that allows you to navigate through some of the impending changes without necessarily having to go back to the board for further approval.”

That would be helpful, not least because when the investment environment changes (especially to the extent that we have seen it do of late) a VNAV MMF that once seemed so unpalatable might, when options are constrained elsewhere, suddenly look like the best option. That is a particularly useful example since MMFs is an area where there still remains considerable uncertainty as to how things will ultimately play out. “I would say that the full implementation of MMF reform in Europe still seems some time away and potential changes being discussed that you might find less desirable today might not seem as objectionable in several years’ time when other alternatives have also changed – ie the bank that used to accept your deposits is less accommodating than it once was,” adds Fuell.

On that note, let’s review the impact of Basel III on the treasurer’s short-term investment options.

Basel III and bank deposits

Unfortunately, in today’s market, even less well-rated banks are unprepared to bid aggressively for deposits that may be categorised as wholesale markets funding. This is because regulatory impositions will increasingly require them to maintain high quality liquid asset buffers that, themselves, generate returns at or below official rates.

This represents a structural market shift that will see all banks willing to pay a premium for longer-term, assured funding; in particular to corporates that are existing customers with an established, operational relationship. Depending upon the jurisdiction and the funding mix of a bank, the pricing of corporate deposits will have natural breaks at one month, three months and one year. Evergreen deposit arrangements (ie call and notice accounts) are valuable in terms of bank liquidity planning and anything over one year, whether fixed term or subject to notice, is highly desirable in the new world.

Relationship banking has taken on greater significance in recent times for many reasons. From a corporate perspective, re-pricing of wholesale credit by the banks will reflect increased scarcity of credit although a more holistic approach to relationship pricing for ancillary business – such as treasury deposits – should enable a bank to justify a better bid for cash deposits.

From the perspective of the bank, repeat business from a corporate depositor supports an argument that the client is loyal and deposit is ‘sticky’, the objective being to demonstrate to a regulator that a smaller liquidity buffer (and avoidance of associated opportunity costs) can be justified. As a result, it can be worth rebalancing treasury policy to permit increased placement with relationship banks.

Spreading short-term (say less than one month) wholesale deposit business around the market enables counterparty risk to be diversified and can improve returns. But, it can be counter-productive, particularly where there is no obvious relationship angle and the improvement in returns for short-dated cash might be marginal at best. It can also be highly time-consuming for any thinly-staffed treasury. There are, however, occasions when banks are prepared to pay well for short-term cash; the difficulty is in knowing which banks and when. Current knowledge of relative appetite and capacity among the banks is central to the management of short-term cash and requires constant monitoring.

The corporate/bank relationship

Five areas are identified by Moody’s where Basel III could affect relationships between corporates and banks including: arranging undrawn backup lines; accessing debt capital; managing surplus liquidity; arranging other banking products; and concentration of banking relationships.

Although much has been made in the financial press about Basel III pushing up the cost and restricting the availability of corporate financing, the report concludes that the impact of this will most likely be negligible for many organisations. For investment grade companies, Moody’s says that even if fees on credit facilities were to double or triple that would have only a marginal effect on earnings and cash flow. Higher fees could be more meaningful, however, for speculative grade companies, as these tend to be more reliant on borrowings from banks and have higher leverage.

The most significant change, however, is likely to come in the cash management services banks provide. With idle cash accumulating fast on corporate balance sheets and banks actively discouraging the depositing of anything other than operational balances, the corporate investor faces some genuine challenges. Again, however, the implications will vary somewhat between companies.

“In terms of bank deposits, those companies that hold cash resources to fund long-term development projects or companies that receive large up front funding from customers – the construction sector, the pharma sector and the aerospace sector, for example – will be most affected,” says Carlos Winzer, Senior Vice President, Corporate Finance Group, and a co-author of the EuroFinance Basel III Index. “That is because banks will now be more reluctant to accept less ‘sticky’ deposits from customers.”

MMFs: change is afoot

Another challenge for the treasurer when it comes to short-term investments is regulation in the money market fund (MMF sector). New regulations announced in March 2015 by the European Commission (EC) will, if formally approved within the coming year, radically reshape the Europe’s money fund industry. But not in a way that many investors, including corporate treasurers, are going to feel very happy to see over the long run. News of the long-awaited reforms came after a compromise was finally reached between members of the European Commission’s ECON Committee who had, until then, been divided over whether to introduce a 3% capital buffer on CNAV funds.

We now know that this particular proposal will not, thankfully, see the light of day. Instead, under the proposals now awaiting formal ratification by the European Parliament and the Council of Ministers, CNAV funds will continue to be permitted, providing they are either designed for retail investors or invest only in European government debt. Most radically, however, an entirely new category of fund is being introduced: Low Volatility (LVNAV).

The creation of a LVNAV fund category would appear to be a sensible compromise. There are members of the European Commission’s ECON committee that firmly believe – rightly or wrongly – that CNAV funds are vulnerable to first mover advantage and, as such, pose a systemic risk that needs to be eliminated. LVNAV funds would seem to do something to address these concerns by forcing funds to better reflect market changes (to a small extent at least). Crucially, however, LVNAV would also largely preserve the favourable tax and accounting treatment perceived by many to be an intrinsic value of MMF investments.

However there is a catch: LVNAV funds will actually be nothing more than an ephemeral feature of European mutual fund landscape. After five years, the regulation decrees that they should be completely phased out, and for everyone other than retail investors the only CNAV funds on the market will be EU government MMFs.

The creation of LVNAV products therefore represents, perhaps, the only workable compromise between those who believe CNAV funds pose a systemic risk and need to be regulated like banks, and the fund industry who saw earlier proposals as too disruptive for CNAV investors.

Reaction to this so-called “sunset clause” has not been entirely positive, as one might expect. Stakeholders including the Institutional Money Market Fund Association (IMMFA) and European Association of Corporate Treasurers (EACT) – both of whom have lobbied hard in favour of CNAV funds over recent years – quickly made their dissatisfaction with the proposals known.

“The options presented to the CNAV industry are disappointing,” IMMFA said in a press release published shortly after the announcement. Both the retail CNAV and EU public debt options presented by the EC were criticised for their limited scope in Europe (accounting for only 10% of AUM). And while the LVNAV option might serve as an effective substitute for CNAV funds both feel the eventual phase out will make it difficult for such funds to even get off the ground. “Given the time and effort required fund managers are unlikely to offer, and investors are unlikely to approve and invest in a product which will go away five years after it is created,” IMMFA said. EACT added that it is also concerned that the sunset clause will act as a deterrent to fund managers and, as such, would “not favour including any sunset clause in the final text.”

Nevertheless, the commentary around the regulatory announcement hasn’t been entirely negative. Analysts at the credit ratings agency Moody’s told Treasury Today that the EC realised it would not be practical to follow, to the letter, the model for MMF reforms established by the US (where only retail prime and municipal funds as well as government funds will be authorised to be CNAV funds) as these types of funds are of a negligible number in Europe. The creation of LVNAV products therefore represents, perhaps, the only workable compromise between those who believe CNAV funds pose a systemic risk and need to be regulated like banks, and the fund industry who saw earlier proposals as too disruptive for CNAV investors.

LVNAV funds will not become a permanent fixture of the European MMF landscape as some might like, but treasurers should at least now have sufficient time to prepare themselves for the switch.

Advantage big funds?

Treasurers should take note, however: the forthcoming changes are still likely to alter the fund landscape in Europe, including the competitive balance between large and smaller players. In addition to new disclosure and credit requirements, new LVNAV funds will have to go through a registration process which will not be without costs for asset management firms. This may mean that the people who are managing your corporate liquidity today, will not necessarily be best placed to serve your investment needs tomorrow. “It (the introduction of LVNAV funds) will come with compliance costs. We think that larger asset managers may therefore be advantaged compared to smaller firms dealing with the same regulatory requirements,” says Vanessa Robert, Senior Credit Officer at Moody’s.

Nevertheless, it should also be noted that most analysts are now not expecting a huge outflow of funds from the industry, but rather a reallocation within the industry.

Opportunity for SMAs

This won’t prohibit some corporates from re-evaluating alternative ways to invest their short-term cash though. And a solution popular for many years among US corporates is quietly piquing the interest of European investors looking for MMF alternatives, namely the separately managed account (SMA).

Most fund providers already offer separate accounts or segregated asset management in which investment mandates are agreed on a bilateral basis and can be tailored to an individual investor’s requirements. These arrangements exploit a fund manager’s resident credit and markets expertise but leave an investor in control of investment and risk limits.

The only real difference between a MMF and a separate account (sometimes called a segregated mandate) is that, in a fund, the investment mandate is governed by a prospectus whereas a separate account is governed by a discrete, bilateral investment management agreement (IMA) which gives a mandating party an ability to shape the mandate and to direct how the portfolio is invested with regard to risk, liquidity and return objectives. Separate accounts may themselves be pooled where the IMAs are similar or standardised but this does not undermine the fiduciary duty owed by the fund manager to the investor.

An IMA may incorporate per issuer/counterparty investment limits, exclusion of specific instrument types, restrictions on maturities applicable to instrument types, counterparties, issuers and countries of domicile, mark-to-market loss limits and so forth. It may also outline how an investor’s liquidity requirements would be met.

The adoption of a standard investment mandate enables a fund manager to pool similar mandates and make more efficient its own market engagement (albeit on behalf of individual investors). In doing so, the investment manager may be able to justify a reduction in its management fees. Whether or not investors’ positions are pooled by the fund manager to achieve transactional efficiency in the market, bilateral agreements on matters such as diversification, liquidity provision and asset maturities are unaffected.

The appointment of an investment manager under such an agreement would generally cover use of the fund manager’s operational infrastructure although there could be a separate charging structure for service providers’ (eg custodian) expenses. Larger investment management firms with existing separate account mandates and greater scale are generally better placed to achieve the best terms from service providers.

Separate accounts at a glance

Advantages

Customisation

Treasurers can select the parameters for their investments and specify a risk-reward profile that suits their requirements.

Potential to earn higher yield

Separate accounts can enable the generation of improved yields when compared with MMFs or bank deposits.

Flexibility and control

If investment circumstances change, the investment guidelines can be rapidly changed to reflect this and keep in line with the treasurer’s goals.

Transparency

Assets within the fund are owned directly by the corporate, giving full transparency of the securities within the portfolio.

Disadvantages

Set-up

Separate accounts require detailed guidelines, documentation and legal agreements, along with the appointment of fund managers and custodians.

Understanding

Treasurers require a high level of understanding of the risks and rewards associated with each type of security in order that they can agree the investment guidelines for their portfolio.

Minimum investment

A higher minimum is typically required when compared to MMFs.

Loss of liquidity

In comparison to a MMF the corporate’s money may be tied up for a minimum period of time rather than being available on a same day access basis (one of the major benefits of a pooled MMF).

Fees

Separate accounts attract higher fees than MMFs.

A tailored fit

SMAs provide an attractive option for those investors in search of higher yields (than those currently offered by fixed NAV instruments). In order to fully embrace this tailored portfolio approach, however, corporates would be well advised to ensure they have a good, strategic hold over their available liquidity from the outset.

For those corporate investors who have the flexibility to consider a broader scope of relative-value opportunities across slightly extended time horizons, a bespoke SMA can be constructed to capitalise on a broad range of strategies, sectors, and securities.

Exchange traded funds: on the up

Elsewhere, the appeal of ETFs generally continues to grow among institutional as well as retail investors. Indeed, Europe has seen ETF growth of 20% or more in recent years according to EY’s Global ETF Survey: 2015 and beyond. So, what’s the attraction?

As with MMFs, wholesale investors in ETFs (‘authorised participants’) are able to subscribe and redeem at the fund NAV (in so-called creation units) through settlement either in kind (delivery of underlying instruments) or in cash. In contrast to MMFs, however, it is also possible for regular investors to transact throughout the day at the secondary market price as listed on the stock exchange at the time. Natural market forces (ie the ability to subscribe for creation units) ensure that secondary market exchange prices do not deviate materially from the fund NAV.

The character of ETFs is very different to that of MMFs. Being unrated, they are not subject to the same ratings strictures as MMFs and are variable NAV by definition. Neither are they subject to regulation in the same way as MMFs. As such, ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features. A degree of caution should be observed, however, as these types of fund typically assume greater levels of risk, compared with traditional MMFs, in order to secure marginally higher yields.

To date, MMFs are still much more popular with European corporate treasurers, but ETFs are worth having on the radar, in particular given their growing appeal.

Spotlight on fixed-income ETFs

Much has been written in the financial press of late about fixed-income ETFs. But are they an effective way for treasurers to gain access or exposure to certain markets, or a product that creates an illusion of liquidity around underlying assets difficult to get out of should investors decide to exit en masse?

The answer one gets to that question depends very much on who is asked. On one side of the debate are asset managers who argue that, with banking regulation causing liquidity levels to fall in nearly all segments of the bond markets, ETFs present investors – treasurers included – with opportunities to invest in fixed-income securities in a way that is very transparent, diversified and offering them the ability to trade on exchange in addition to the primary market where traditional MMFs transact. ETFs typically offer a very competitive price, whilst still maintaining intraday liquidity with T+2 settlement.

“If you are comparing ETFs to the underlying, these funds actually provide an additional layer of liquidity that is incremental to the underlying bond market and that is becoming increasingly important as we see liquidity in primary issuance decline. Fixed income ETFs are increasingly seen as part of the solution for investors seeking liquid fixed income investments,” Ashley Fagan, Head of EMEA Treasury, and UK Institutional for iShares at BlackRock told Treasury Today.

Fixed income ETFs are available that provide investors access to a diversified set of underlying investment-grade corporate bonds. For treasurers, investing longer-term, strategic cash into these types of instruments might also be justified on grounds of diversification and yield. “If we look at the whole portfolio, fixed-income ETFs can add diversification to those traditional MMF investments which tend to be heavily weighted towards the financial sector,” she adds.

Perhaps this is why ETFs have proved increasingly popular in recent years. Although there are no specific figures relating to corporate investor use of ETFs, the overall picture is one of growth. A study by Greenwich Associates published in May this year showed that liquidity has grown more than four and a half times, or at an annual rate of 33%. Overall, 59% of fixed-income ETF investors in the study reported that they have increased their usage since 2011.

Tom Byrne, Director of Fixed Income at US-based wealth planners Wealth Strategies and Management (and author of the daily Bond Squad market report), positions an alternative perspective as he says the best way to look at ETFs is as a chain. “A chain is only a strong as its weakest link, and an ETF is only as liquid as its underlying investments,” he explains.

Investors should think about what would happen if there were a change in the paradigm and a ‘burning room’ scenario begins to play out. This occurs when there is a change in circumstances that causes market panic (say the Federal Reserve raises interest rates sooner than many anticipated, for example) and everybody attempts to rush out of the room via the same exit.

Unlike the investor who has bought a laddered portfolio of individual securities, though, the investor with an ETF cannot hold to maturity. “With an ETF you have liquidity in that you can sell your shares – but at what price?” says Byrne. “That is the point that the ETF and mutual fund industry always gloss over: the ability to hold to maturity. With those funds, if the price goes down and the fund manager has to sell the bonds into the down prices then you will share in the realised losses.”

On this point, Fagan notes that the inability to hold to maturity is a common misconception as, “investors in iShares ETFs have the ability to take ownership of the underlying physical bonds rather than a cash redemption, therefore enabling them to hold the bonds down to maturity if they wish to.”

There is one further thread to this debate that is perhaps worth noting. In its June 2015 annual report, the Bank of International Settlements (BIS) suggests that these ‘liquidity-guaranteeing’ ETF products might actually be contributing to a global liquidity illusion, disguising the true ability to trade positons in the fixed income markets. Asset managers are less well placed, the report argues, to act as market makers. “They have little incentive to increase their liquidity buffers during good times to better reflect the liquidity risks of their bond holdings. And, precisely when order imbalances develop, asset managers may face redemptions by investors. Therefore when market sentiment shifts adversely, investors may find it more difficult than in the past to liquidate bond holdings.”

However, any treasurer that does invest cash into an ETF may well, as Ashley Fagan sets out, find them a useful way to gain access to fixed-income markets without needing to buy individual securities – like investment grade or high-yield bonds – that have become increasingly illiquid. But as with any investment, a certain amount of buyer beware is always required. Yes, investors may be able to offload their shares, if it comes to that, but as Byrne highlights, in circumstances when everyone else is trying to do the same thing, they may not be too happy with the price.

Rise of the tri-party repo

In an environment where banks continue to feel the impact of regulation, collateralised products such as tri-party repos are also catching the eye of corporate investors.

Of course, corporate treasurers could be forgiven for viewing tri-party repos as a complicated type of transaction – they were initially created as a means for broker-dealers to maximise the use of small asset positions left in their accounts. The reality, however, is not nearly as complex as some might think. Indeed, tri-party repos are one of the simpler forms of secured investment: they are essentially bank deposits secured by independently held and managed assets.

One of the key drivers of the growth in the tri-party repo market is regulation. For large corporates who have obligations under the European Market Infrastructure Regulation (EMIR) to post collateral for OTC derivative transactions with central counterparties, tri-party repo offers a significant advantage over alternative products – namely that the collateral corporates hold against cash can be sold immediately should a counterparty default. This collateral can also be used to cover derivative liabilities that corporates have with their prime brokers and clearing members.

For this reason, tri-party repo is increasingly being considered as an alternative to MMFs for corporates with cash to invest in securities. Additional regulation in the MMF space is also causing corporate investors to turn towards tri-party repos. So, against the backdrop of regulatory pressure on investors, tri-party repo presents an opportunity for corporates (who to date have largely invested their cash on an unsecured basis) to invest in collateral-backed deposits.

Treasurers interested in finding out more about tri-party repos would do well to investigate the ever-evolving corporate services provided by the likes of Clearstream and Euroclear.

Investment portals

Away from investment instruments, technology advancements are also shaping the way corporates invest their short-term cash. In the MMF industry for example, users seem to be swinging towards independent portal providers like MyTreasury, ICD, and SunGard, and away from proprietary bank platforms.

In brief, the benefits of MMF portals include:

  • They save time and provide a one-stop-shop with access to multiple investment options with fully automated sweep options available.

  • Portals improve portfolio management and allow the investor to diversify their investment portfolio, manage limits and analyse holdings.

  • They also improve transparency and provide timely information and analytic data.

  • MMF portals provide streamlined options, transparency reporting and analytic tools.

  • They show the entire MMF market place in one application, giving a holistic overview of the short-term investment market.

  • They also consolidate the need for multiple applications to trade the funds and automate the process downstream.

In addition to analytical capabilities, portal vendors have also developed methods of controlling and managing risk, as well as creating the opportunity to set credit limits with the various funds and providing in-depth information on each fund’s performance and portfolio. These are welcome developments that bring a degree of additional certainty in an uncertain world.

For more information on investment portals, including cost and integration issues, please see Treasury Today’s The Treasurer’s Guide to Digitisation.

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