Published: February 01, 2013
Over the last five years, European treasurers have learned to manage counterparty risk. They have become less trusting and more cautious in investing their funds. Return had become necessary to correspond to risk. Unfortunately interest rates are so low today that security now has a cost. This is an economic paradox, if ever there was one. What can treasurers do to find a return while keeping down the risk incurred?
Over the last five years, corporate treasurers have (re)discovered a forgotten and theoretical risk, that of possible default by their bank counterparty. Therefore they gave priority to counterparty security. Clearly, for negotiating financial instruments the risk of non-delivery is small, and the possibility exists of recovering deposited collateral - if any, in the case of Credit Support Annex, or CSA, a legal document which regulates credit support (collateral) for derivatives transactions. For cash deposits, on the other hand, there is indeed a real risk of losing the whole amount. Treasurers have therefore become extremely cautious when investing their cash – and these cash surpluses, by the way, have kept on accumulating. This is paradoxical. While counterparty risk was rising and interest rates were falling, the amounts being invested were growing. Fearing uncertainty and because of future needs, treasurers have preferred short-term investment (a maximum of three months to fulfil the IAS 7 ‘Cash and Cash Equivalents’ conditions). Moreover, short-term investing is a way of mitigating default risk.
Another strategy involved investing in money market funds, particularly ones with a high credit rating (AAA) so as to subcontract the management and achieve greater diversity. This strategy worked well especially in an environment of falling interest rates, which gave returns of EONIA plus double digits basis points. Unfortunately, rates ended up hitting the floor and returns became ever slimmer, finally becoming nil or negative. The plan was to preserve the principal, even at the expense of return, but there is no longer any room for sophistication. Stay ‘short’ and stick with low risk. However, today this security has a cost. It is this cost that presents a problem for many treasurers.
Security now has a price: no return or even a negative return, the last straw for treasurers with cash surpluses. How strange it is to have to pay to invest your funds. And perhaps in the short term we may even end up booking an interest charge on a bank investment. Unbelievable, isn’t it?
IMMFA AAA rated funds are closed to new investment, victims of their ‘Constant NAV’ approach. We can readily imagine that, if the low interest rates situation persists (and we have to fear that it will), these same IMMFA funds may possibly even have to repay their investor clients. The economic situation is such that it is not impossible to envisage this. So what should we do? The real challenge lies in reviewing investment strategies and revisiting policies to adapt them to one of the most exceptional economic climates ever. The alternatives are merely theoretical unless we accept that certain principles have to be reviewed.
Many companies have made use of share buyback operations or have distributed large dividends. However, for the remainder of their cash surpluses, they have to adopt mixed and varied strategies. By combining different products, they can increase their returns while keeping risks reasonable and still achieving an investment duration that is certainly longer but still acceptable. The solution therefore consists of maximising return by using a variety of solutions to offset a yield curve that is rather flat and close to rock bottom. There is no perfect solution. The first concession you should allow is that of not qualifying as a cash equivalent under IAS 7. You need to be able to use investments of greater than three months, which do not count as cash equivalents. The average investment term should then improve the portfolio’s overall return. By fragmenting deposits and investing them with different institutions, we can reduce risk and achieve a better spread over time. Time and the length of the investment period are the key factors to be considered. Sometimes short-term rates (
In the same line of thinking, some banks offer loyalty products of various types: for example deposit accounts for savings or ‘notice accounts’. These give a better return in exchange for a minimum notice period of between 35 (qualified for IAS 7) and 100 (non-qualified for IAS 7) days. These accounts have restrictions on the maximum deposit that the bank will accept. They can form part of the gamut of alternative techniques used to offset low interest rate levels. The solution certainly involves a combination of different products.[[[PAGE]]]
Nothing or less than nothing? That’s the problem. Interest rates are so low that they have become negative. Is your ordinary customer ready to pay up to 15 basis points to have someone deign to take care of his funds? Plenty of treasurers will tell you “No way, in your dreams, pal”! This is a lose-lose situation. We have to accept extending to the medium term to start to obtain any small return at all. “Thank you kindly, good sir!” the treasurers reply to their bankers. We have to accept actively managed multi-product funds. Usually, their volatility percentage corresponds to the return above the reference interest rate. For example, a fund of this type with a volatility of 2% might give a return of around 2% – that is the general rule. The price to be paid is a small amount of volatility in the principal in the short term, and patience in the medium term. Forearmed with patience, treasurers can go some way towards boosting their return. But none of it is simple, and most certainly everything has a cost.
What is even more paradoxical is that companies are still shedding debt and hoarding cash in spite of the (more) difficult economic situation. The economic situation leads to caution, and nobody dares to re-invest for fear of overpaying for assets in an uncertain and depressed economic environment. They build up cash at a time when it would be better to spend it shrewdly on operational activities, which have a higher potential return. There are opportunities to be grasped but also over-cautiousness, as if winter was going to be long and very harsh, which is unjustified. Should realising how difficult it is to manage cash surpluses not give us an extra incentive to invest? Winter will certainly come to an end one day. Of course, we might experience a situation like that in Japan that has already lasted for 22 years There has been a rejection of debt with leveraging effect, as if it were shameful and financial madness to take on debt in a reasonable way. In these times of economic turmoil, financiers can sometimes become irrational and forget the first principles of modern finance. Fear is sometimes the explanation of rather illogical behaviour.
Finally, happy treasurers are treasurers with borrowings. What a blessing it is to have debt when money is so cheap! The not so absurd idea of treasurers lending each other money may resurface. Which is the more risky at an equivalent credit rating: a European bank or a corporate? With the high risk of a bank run, thinking of Shell recently or Siemens in 2011, the future of some European institutions is fragile and precarious. Governments are struggling with their own borrowings and cannot endlessly support an industry mired in crisis. With low or negative growth rates, we may fear that governments will have other fish to fry. Ruling out a bank failure would seem to me to be foolhardy. Nobody looked to see Greece leaving the euro, but nevertheless… We need to be cautious and we need to tread carefully before changing our investment strategies. But there are also other options to be considered for diversifying risk or maximising borrowings.
An interesting option that we have suggested on a number of occasions consists of utilising your cash as collateral to cut the cost of hedging, particularly foreign exchange hedging, in the medium term. Indeed, beyond one year, the cost of counterparty credit on a forward foreign-exchange contract is such that using collateral can prove to be a worthwhile means of investing funds to make a significant reduction in the cost of hedging. This is a positive way of taking action on the bottom line.
Some banks offer structuring ideas to optimise your tax situation and reduce your tax expense or to boost investment returns. The idea is often the simple one of maximising the interest rate differential between two countries in which you operate.
There are also what is referred to as ‘dynamic’ funds which have longer investment horizons, higher risk concentrations or underlying assets with lower credit ratings. Here again, treasurers can invest a reasonable amount to seek a return which, at the end of the day, will improve the portfolio’s overall return.
At a time when handing money over to our bank, maybe one with a pretty poor credit rating, costs us money, surely we should ask what alternatives the market is offering us? The background of interest rates which are going to stay low for quite some time and the economic situation, particularly in the finance industry, forces us to react. In absolute terms, returns will remain low even though they may become better and positive. Conversely, in relative terms, the performance thus achieved will be much more attractive in a context of interest rates calculated on basis points.
Today, we do not talk about percentages or fractions of a percent, we have to talk about basis points, and the fingers of one hand are often enough to count those. The misfortunes of cash rich companies are offset by the good fortune of borrowers for whom the resource of money is abundant and almost given away free. Some companies are taking advantage of this to fix rates for the very long term and to provide finance for the future on good terms.
The solutions are many and varied, provided you concede that you need to make some modifications to your investment policy, to take a certain minimum risk that is contained and controllable and to diversify your portfolio. Miracles can never happen in investment. However, a little bit of opportunism together with a little bit of boldness and change can improve your overall return. Value creation, obviously, is impossible. But when it comes to destroying value by hoarding cash which ends up costing dearly, it is best to try to destroy as little as possible. It is a fair bet that we are going to live through many long months of dearth and rock bottom, zero or even negative interest rates. The work of treasurers will consist of limiting loss in this period of recession. We will end up almost regretting that the periods of inflation and higher interest rates are gone. This is one of the challenges that awaits treasurers in 2013. They will have to modify their investment strategies in any way they can to face up to this particularly tricky and difficult economic environment.
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