These days, where is the return?

May 2010: 3M LIBOR is up for the first time in eight months or more. The market is showing some signs of recovery, rates are finally returning to normal, but then the Greek debt crisis hits and we go back to square one—but this time for how long?

The market

Economic data has recently taken a markedly softer tone, indicating a slowdown in economic recovery. US GDP growth for Q2 has been reduced to 2.4 percent and it is anticipated to slow further in Q3 and Q4 of 2010. Employment data also demonstrates a negative trend, with a net reduction in jobs in July of 161,000, mainly related to fiscal tightening at government and municipal offices, and minimal job creation in the private sector. Inflation within the US is close to non-existent. In reaction to the generally weakened state of the economy, the Federal Open Market Committee (FOMC) has continued to restate its policy of holding the target Fed Funds rate exceptionally low for an extended period of time. Currently, the market is pricing in the first tightening of monetary policy for January 2012, and the longerterm yield curve continues to flatten between two to 10 years. The US Treasury now yields 0.51 percent and the 10-year 2.54 percent.

Within this current environment, we expect that interest rates will remain characteristically low throughout 2011. Given this sentiment within the market, treasurers continue to be plagued with the question of how they should attain a higher return on their cash while still preserving capital. In order to fully consider their options, treasurers must first assess their traditional view of cash and examine whether or not the previous approaches will still be appropriate.

Evaluating the nature of cash

The amount of cash available for investment from a liquidity management system and cash flow forecast is made available to a company’s treasury department. It is critical that treasury understands the nature of any surplus cash before an investment decision is made.

Short-term cash surpluses will typically be required by group entities to finance ongoing activities. This cash cannot usually be invested for more than a few days. However, other surplus funds may be available for investment for a longer period. This may apply, for example, if a company has just sold a business unit or if it is simply in a cash generation stage.

By identifying the importance of cash to the company’s daily business, treasury can decide how much risk the company can assume. This will determine what type of instruments would be appropriate in each circumstance. One way to do this is to try to classify the cash to be invested.

Cash can be classified by looking at its different levels on the balance sheet. The total level can further be understood in various layers or ‘tranches’:

• Working capital (or operating cash)
This is cash that will be needed by the business in the very short term, such as within two days. It is typically the money that flows in and out, and is usually related to an insurance company’s premiums,sources of income and payments. This cash cannot easily be replaced in the external markets, so security is important. By definition, liquidity is also important.

• Short-term predictable cash (or core cash)
Core cash is slightly longer-term cash and is typically the level of total cash that treasurers like to have on their balance sheet. This is cash that will be required by the business in the short term. It may be needed, for example, to pay bills at the end of the month. Again, security is important, although liquidity is less important. Treasury’s main responsibility is to ensure that the cash is available when needed. Large predictable flows are also included in this tranche.

• Long-term cash (or strategic cash)

This is cash that is available to the business for the foreseeable future. It is not needed to fund existing projects. Ultimately, the board will need to decide whether to invest this cash in a new project, to deploy it to the core investment portfolio or to return it to shareholders. Treasury will need to manage this cash, but liquidity may not be as high a priority. Strategic cash is often referred to as the level of cash that can be allocated for investment purposes or longer-dated strategic decisions that affect the company, such as share buy-backs.

Nature of surpluses

Whether or not treasury decides to classify cash in this manner, before an investment decision can be taken, three factors need to be determined:

• The currency in which it is denominated

• The amount of cash to be invested

• The date when the cash will again be required by the business.

Currency

Treasury should also know the currency in which the significant bank accounts are denominated. For example, international companies often establish cross-border pools for the major operating currencies (typically the US dollar and the euro). At the same time, they will maintain local currency pooling arrangements in countries where it is sensible to do so.

Treasury will then need to decide whether it is possible and realistic to physically convert cash into another currency for investment purposes. In practice, cash would have to be available for investment for a number of days to make this worthwhile.

Quantity

For every significant bank account, treasury will have a daily balance forecast. Cash flow forecasts usually become more detailed as the forecast date comes closer.

Each day, treasury will need to update and confirm the cash flow forecast before making the investment. The choice of instrument will also determine which investment instrument is selected. For example, sweeps into deposit accounts require the funds to be available at the time of the sweep. A bond purchase will only require funds on settlement date.

Maximum investment period

A forecast of future balances over the next few days and weeks will provide treasury with the opportunity to invest in longer-dated instruments. It will also remove the need for treasury to reinvest all surplus cash on a daily basis. This lack of a requirement to reinvest funds will reduce the operational risk associated with investing.

Liquidity funds: not all cash is always ‘cash’

In a typical liquidity portfolio, there are many components that are very different to cash. One example is a T-Bill ladder and the components within the ladder itself. In other words, the nine-month and greater portion will not satisfy short-term liquidity needs.

There are times when the premiums to include longer components in a treasury portfolio do not compensate for the lack of liquidity and/or market risk. For example, assuming a market where the overnight rate is around 4 percent and six-month rate is 4.60 percent, the premium to increase the term to six months is +60 basis points (bps). In contrast, in times such as these when the overnight is 0 to 25bps, if you can get 0.55 percent in six months, the premium to go longer will be +30bps. Although the nominal figure is lower, it is more relevant as it represents double the return on the investment.

Therefore, adding longer-dated instruments into the cash management decision enables the returns to be improved without compromising liquidity and security objectives.

To provide an effective and efficient solution to implement this growing interest in short duration fixed income, HSBC has launched the Short Duration Fixed Income Fund. The fund* is distributed in a diversified portfolio of high-grade, short-term fixed income instruments. With an investment approach that balances income needs, maintains liquidity and reduces the risk of capital deterioration through a robust credit analysis and risk management process, the fund has become a welcome addition to clients’ investment portfolios, in particular amongst insurance companies. In order to satisfy client’s liquidity requirements, the fund offers daily dealing.

"Internal rates of return versus asset management yields will continue to be a critical balancing act."

The fund obtained an ‘Aa’/‘MR2’ rating by Moody’s, which reflects the high quality of the its portfolio, which is invested in corporate and government securities (see Exhibit 2), as well as rating agency’s expectations that the fund will exhibit low sensitivity to interest rates and other market conditions. It is expected that the fund will target benchmark yields and maintain a buy and hold strategy, rather than seek to earn excess returns. The fund’s duration profile will typically track the duration of its benchmark index, the Merrill Lynch 1-3 Years Corporate and Government Index ‘AA’. An important consideration for investors such as captives and reinsurance companies is how effectively the portfolio can be used as collateral for their letters of credit. In this case, a collateral value of 90 percent has been established.

As we come to the end of the year, review of internal rates of return versus asset management yields will continue to be a critical balancing act until there is an upswing in interest rates. As the rate environment changes, clients will continue to focus on their investment objectives and risk-adjusted returns. We will continue to work with our clients to ensure that they are employing the best strategies throughout market cycles.

As we anticipate that the US will enter a tightening cycle over the next year, the SDFI Fund’s portfolio is positioned to have a shorter duration than the benchmark and holds approximately 30 percent in floating rate notes, which will help to preserve capital when rates begin to rise. We also currently hold an overweight position in financials, as we are of the opinion that this sector will outperform over the medium term and will look to selectively diversify the portfolio going forward.

“The Treasurers’ Guide to Investing Corporate Cash”.

Investment considerations

Investment objectives

For each cash surplus, treasury also needs to identify the investment objectives:

Security : How much risk to principal can the company assume?
Liquidity : How accessible must the invested funds be?
Yield : Can the company afford to compromise the objectives of security or liquidity in order to earn a higher return?

Selecting the instrument

Once the objectives have been identified, treasury will need to identify the appropriate instrument(s) and market.

Constraints on investment

Are there any constraints that prevent treasury investing in particular instruments?

Internal
• What limits are set by the treasury and investment policies?
• Are there restrictions in terms of which instruments can be used?
• What counterparty limits are in place?
• Does treasury have an appropriate dealing mandate or other contract in place with potential counterparties?

External
• Are there any regulatory restrictions on investment?
• What are the tax implications of particular investments?
• Are there any practical restrictions (cut-off times, transmission issues) that prevent access to particular markets?

Appropriate instruments

Given these restrictions, treasury may have to choose between different potentially suitable instruments:

Characteristics
• Does the instrument match the investment objectives, without exposing the company to unacceptable risks?
• Is the instrument available in the desired market? If so, is the market sufficiently liquid?
• How would an investment in such an instrument affect the investment portfolio as a whole?

As of June 30, 2010, HSBC Global Asset Management has $411.3 billion in assets under management globally, including $99.5 billion in liquidity and $172.0 billion in fixed income. HSBC Global Asset Management Bermuda manages over $5 billion in insurance assets from more than 600 clients.

* The Short Duration Fixed Income Fund is a class of HSBC Specialist Funds Limited, which is managed by HSBC Global Asset Management (Bermuda) Limited. Source: Parts of this article were adapted from HSBC’s and WWCP’s