While much has been written about the impact of the financial crisis on companies looking to raise funds, the implications for investing have been just as profound. As always, treasurers and other investors have to balance their needs in relation to security, liquidity and yield but investment challenges have greatly increased due to the double whammy of depressed prospective returns coupled with elevated risk. In this Business Briefing, we look at the key drivers affecting investment decisions, consider how the structure of corporate investment portfolios has evolved and explore the wider changes in treasurers’ investment behaviour.
Treading the fine line between risk and return
As the global downturn continues, central banks around the world have reacted by adopting increasingly drastic monetary easing policies, moving towards a Zero Interest Rate Policy (ZIRP) environment and introducing quantitative easing. For investors and treasurers, this has resulted in the challenging and somewhat unappealing combination of reduced prospective returns, coupled with elevated risks when managing and investing cash balances.
Consequently, the financial crisis has led corporate investors to reassess their objectives and revisit the structure of their investment portfolios. The events of the past 18 months have shaken the market to such an extent that the rules have been rewritten. While the dust appears to have settled to a certain degree, investors remain highly cautious, risk premia remain elevated, and few feel confident enough to predict how the market will develop.
For many corporate treasurers, short-term investment may previously have been viewed as a relatively straightforward activity, where objectives were, on the whole, clearly defined, and the consequences of misjudgements were often mitigated by access to liquidity and capital at reasonable costs. Consequently, treasurers tended to focus on yield, and often viewed investment activities in the wider context of managing relationships and reciprocity across their partner banks.
Times have changed, however, and treasurers are now keenly aware of the need to avoid losses and the importance of liquidity for the company as a whole. The combination of increased risk and volatility, increasing tightness of cash generation and access to external funding, together with low prospective returns in a ZIRP environment, is making investment decisions substantially more complex than in recent history. This has upped the accountability of treasurers, who are consequently taking a more robust and proactive approach to their investments than ever before in order to navigate the challenges presented by a continually evolving market.
In addition to their corporate investment policies, investors usually take into account the following four key factors when making an investment decision:
How much risk is the investor prepared to accept?
Preservation of capital.
Is this essential?
Is daily liquidity required? For what percentage of the invested funds?
What yield is the investor looking for?
All investment options entail a certain degree of trade-off between these priorities. The lowest risk investments are also associated with the lowest yield, while investment options offering less liquidity, or entailing a higher level of risk, may offer greater yield. The ongoing financial crisis has led investors to re-evaluate the importance of each of these factors and to revisit their investment decisions accordingly.
While it is possible to observe broad trends in investment practices, it is important to remember that each investor has different priorities and requirements. Some investors will be concerned with yield and not counterparty risk; others will prioritise liquidity over every other consideration.
Cause and effect
The events of recent months have illustrated the complex interaction between market events, investor behaviour and investment options. Before the onset of the financial crisis, yield was viewed by many investors as the most important of the four investment goals. “Eighteen months ago, a lot of our clients were driving purely after return,” says Steve Elms, Liquidity & Investments Product Manager, EMEA, Citi. “They would have their own set of counterparties that they could deal with and as long as these counterparties were part of their investor list, then they would be looking for yield as their key driver.”
The conservative approach
As events unfolded at high speed in late 2008 following the collapse of Lehman Brothers, investors reacted by becoming more conservative and increasingly prioritising liquidity and capital preservation over yield. Counterparty limits were reduced and counterparties were removed from investors’ lists as investors fought to insulate themselves from counterparty risk.
The point of no return
However, as interest rates have dropped towards zero, the yield available on the most secure investment instruments has fallen dramatically. In December of 2008, the yield on three-month US Treasury bills temporarily dropped below 0%, meaning that investors were effectively paying the government to safeguard their funds.
In recent months, some investors have begun to turn their attention back to higher yielding investments, particularly as the widespread turmoil triggered by Lehman Brothers’ collapse subsided. “During late 2008, we saw the dust settle a little,” says David Li, Liquidity & Investments Market Manager, EMEA, Citi. “Investors had seen some winners and losers emerging amongst banks and investment counterparties, and yield started to come back into play.”
With interest rates on some bank deposits dropping in line with rate cuts, investors have exhibited increased interest in money funds, which can benefit from a lagging effect due to the longer maturities of some of their underlying assets. However, as David Li continues, “As rates reach a more stable environment, even if stability is a zero interest rate policy environment, other investment/deposit options will become relatively more attractive again, as the lagging effect with money funds starts to run off.”
While investor behaviour has continued to change in response to the evolving market conditions, some investment instruments have benefited while others have fallen out of favour. Notable developments include:
Investor demand pushed the yield on three month US T-bills below zero in December 2008, illustrating the extent of the scramble for low-risk investments.
Following the collapse of Lehman Brothers, volumes in the commercial paper market plummeted in the US and Europe. Between October and November 2008, the volume of outstanding European CP dropped by $100 billion. Corporate investors have dramatically reduced their holdings of commercial paper and asset-backed commercial paper continues to be largely rejected by investors despite a revival of interest in yield.
Money market funds.
Investment in money market funds has continued to grow. News that the Reserve Primary had ‘broken the buck’ in September 2008 (ie its share price had fallen below $1) resulted in some withdrawal from money funds; however, the category has reverted to its growth track, with inflows as fund managers sought to de-risk or clarify the assets underlying their funds. There is increasing differentiation by investors across money market funds, and after a surge of interest in government funds, recently there has been some flow from government backed money market funds to higher yielding prime funds in a renewed drive for yield.
Enhanced cash funds.
Investor appetite for higher yielding/higher risk funds has however decreased significantly, in a climate where risk premia remain elevated. Constraints on access to liquidity (typically part of these funds’ proposition) also inhibit their uptake under current market conditions.
Bank demand deposits.
Standard bank deposits are associated with relatively low yield but are highly liquid – funds can be transferred as soon as required. Bank deposits also reflect interest rate cuts instantly, so rate cuts may prompt investors to move to products such as money market funds which reflect rate cuts more slowly. Overall the move towards a ZIRP environment has dented the appeal of bank deposits offering slender returns and has prompted investors to consider different asset classes.
Investors keen to keep cash readily accessible have been less willing to tie funds into fixed-term investments. Time deposits have accordingly shifted towards offering shorter tenors.
These trends have also been reflected in the composition of money market funds, which have increased their holdings of government debt and reduced asset backed commercial paper (ABCP) and commercial paper.
Meanwhile, far-reaching changes are taking place in terms of how investors are engaging with the market.
Knowledge is power
The most important of these is the need for more information. According to David Li, “Previously depositors and treasurers would have focused on various characteristics of investment products, particularly yield vs liquidity. Now there is a sense that they need a much wider understanding, as well as depth to what lies beneath – the type of instrument, what that means for them, what the true risk is, and what due diligence was done by any investment partners. The increasingly challenges of investments, together with scarcity of generation of cash, are compelling treasurers to become much more involved than ever before.”
Increased accountability is an important part of the equation. The treasurer has become more visible as the financial crisis has developed and senior management is increasingly turning to treasurers to guide them through the turbulent market conditions. This has often been exacerbated where there has been an increase in the proportion of assets held in cash, rather than in non-cash asset classes which might previously have been managed by others outside treasury, such as a Chief Investment Officer. With this trend for increased visibility and accountability, it is essential for treasurers to understand and explain their investment decisions and to take responsibility for the outcome.
In order to achieve a greater level of understanding, investors are asking more questions. Where investment managers are involved, depositors are keen to meet those investment managers in person and are asking what funds are on offer, how those funds are structured and what investment strategies are being followed. They are also keen to know what control processes and credit evaluation due diligence processes are employed when assessing individual investments for inclusion in the portfolios being offered to the end client.
The demand for information does not stop with the investment decision, and depositors are increasingly requiring regular updates of their investments’ performance and condition, enabling them to adjust to market developments and amend their strategy if necessary.
Visibility and control
Increasingly depositors are requiring daily or real-time visibility over their investments. In the treasury context this may be achieved using a treasury management system (TMS) or using solutions offered by their banking partners. Citi, for example, offers a web-based platform, Online Investments, which gives depositors access to their investments including fund information, details of transactions and reporting tools as well as the ability to research and trade new investments.
With the investment environment constantly shifting, corporate investors are also increasingly willing to switch between products. With an increased level of knowledge leading to a greater degree of confidence in individual products, investors are more prepared to revise their policies on an ongoing basis and to move funds between products when the picture changes.
A diversified portfolio is essential with counterparty risk continuing to be a key concern and investors are looking to increase the range of products they are using.
Weighing up the risk
Particularly for treasurers, a heightened awareness of counterparty risk has led to a shift in terms of bank relationships. Whereas previously investment allocation may have been largely determined by factors such as maintaining a positive relationship with key banks as well as a focus on yield and pricing, the awareness of counterparty risk has to some extent overtaken the sense of reciprocity. Although bank relationships remain important in the interests of maintaining access to credit, investors are having to ask what happens if there is not a happy ending and are seeking additional documentation from investment partners to protect themselves in the event of insolvency.
While the importance of assessing counterparty risk has been highlighted by recent bank failures, other types of risk have also come to the fore. For example, with sovereign ratings of countries such as Spain and Greece recently downgraded by the ratings agencies, corporates are paying increasing attention to the issue of sovereign risk and asking whether this should be considered.
Treasurers have had to consider scenarios that were previously unthinkable and to seek increased levels of disclosure on the underlying investments. Accordingly, they are asking what would happen if an investment collapsed: are governmental or other guarantees in place? What recourse would the investor have? What jurisdiction would any insolvency be under? Is the investment ring-fenced?
Investors are taking into account both explicit and implicit guarantees. An explicit guarantee is concrete protection offered by the government, such as the FDIC (Federal Deposit Insurance Corporation) in the US. An implicit guarantee is a statement by the government that is interpreted as offering a certain level of protection, for example stating that a particular bank is ‘too big to fail’. Both types of guarantee can help to make particular products more attractive to investors, with the additional security compensating in some cases for lower yield.
As the financial crisis has developed, demands on treasurers have likewise increased. With treasury firmly in the spotlight, treasurers have found they have more demands on their time and more levers to pull than ever before. The risks are far greater and in the area of short-term investment the wrong decision can have serious implications.
As Steve Elms says, “Previously, the risk of getting it wrong was not that bad – approximately right was good enough. Now that’s changed. Corporate investors have to keep their banks happy to make sure they retain access to credit; they have to keep their company happy by making sure they’ve got adequate access to liquidity; they have to keep shareholders happy by protecting them from inappropriate counterparty risk – and while they’re at it, they are also trying to generate a bit of yield.”
In order to make the right investment decisions, corporate investors have to balance all of these needs. In order to achieve this, it is essential to have maximum visibility over their cash, with high speed solutions and analytics that will enable them to make business decisions quickly and effectively.
As investors’ priorities continue to shift, they are also taking more responsibility and looking for more information on their investments than ever before. Once made, decisions must be re-evaluated on an ongoing basis to ensure that they continue to represent the company’s requirements in the changing market.
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