Investing cash

The bank failures and market turbulence of the past few years have made everyone, even individuals with no formal financial training, well aware that investing cash brings its own set of risks. Companies employing professional treasurers have always known this but even they have taken the opportunity to review their approach to investing and having the right policy to govern what they do and the right procedures to ensure they carry out the function properly. The lessons learnt and techniques used in the corporate sector are equally applicable to the public sector. This article will review the corporate approach and demonstrate the relevance to the public sector.
    
In some fields one might expect companies with a risk taking and profit making motive to be far removed from the public sector objectives, but in most non-financial companies cash investment is not the prime business purpose so it is managed with a high degree of caution and conservatism in order to ensure cash and liquidity is available at all times to serve the company’s main business purposes.

Identifying & segmenting cash
Before setting about designing an appropriate investment policy for your organisation the nature of the cash available and the amounts involved will need to be determined. Systems for centralising cash or pooling multiple bank accounts are widely available. Working on from the current balances a good process for forecasting cash inflows and outflows will allow an estimate to be made of the period for which the cash balance will remain.
    
Within a public authority it may be possible to segment the cash resources intelligently as to the reason it is being held and the likely holding period, be that short term arising from the annual cycle of payments and receipts or longer term due to some structural reasons. There may be some special funds, which by their nature have to be segregated and which have their own idiosyncratic characteristics eg a trust fund earmarked for a specific purpose.
    
Within a company the obvious first uses of liquid funds in any business unit is to repay any external short-term borrowings. The advantages are minimisation of costs paid to external lenders, and reduced credit exposure to external deposit takers. Simultaneous investment and borrowing usually costs money, and is therefore not usually recommended.
    
For public authorities with funding from the Public Works Loan Board (PWLB) using cash to repay loans is the ultimate in avoiding credit risk – the cash is not invested with an external party so the credit risk is zero. Even so this may well not be an attractive first course of action. For longer term fixed rate loans the authority may be cancelling an attractive loan rate and exposing itself to interest rate risk or if the rate was high in the first place there will be a penalty adjustment to pay. Even variable rate borrowings when repaid will incur a cost since the PWLB lending and repayment rates are different. External investment can thus become a necessity and where public bodies have a significant difference between their gross and net borrowing positions this should be clear in their strategy.
    
The old mantra for investing and which remains absolutely valid is: Security, Liquidity, Yield – in that order – SLY for short. After all, the treasurer’s job is to provide funds in the right amount in the right place at the right time.

Security
The overriding priority for the treasurer in managing the company’s short-term funds is security of principal. With interest rates so low at the moment the temptation is to hunt for higher yields but the first priority must be the return of the investment rather than the return on the investment. There are two main risks to investment security:

• counterparty risk
• market risk

Counterparty risk is the risk that the counterparty will not meet their obligation to repay the principal and interest in full and when due. One measure of this credit risk, which is used almost universally, is the opinion offered by credit rating agencies on borrowers and the particular tranches of debt that they issue.
    
Market risk is the risk that on any realisation prior to their maturity, investments may be worth less than expected. This may be caused by interest rate changes for fixed rate investments, or by changes in credit rating or other views adopted by the market.

Liquidity
Liquidity is the ease of converting an instrument or portfolio into cash at any time prior to its maturity without unduly affecting its value.
    
The most liquid investment is an interest bearing, on demand, bank account, sometimes called a deposit account. For instruments other than bank accounts, liquidity requires an active secondary market in the instrument.
 
Yield
Provided the security and liquidity objectives have been satisfied, the treasurer can then seek to maximise yield. There is usually an inverse relationship between yield and the attributes of security and liquidity. If, for instance, liquidity is a priority, some sacrifice in yield will have to be accepted.
    
Deposits/Certificates of deposit (CDs)
Traditionally, the most commonly used investment instrument for companies with cash has been the straightforward money market deposit. Cash is deposited with a bank for a set period, which could be anything from overnight to one year or so, and the rate to be paid for that period is set at the outset based off the interbank or LIBOR rates. If the company requires its cash back early because of changed cash requirements or because of worries over the credit worthiness of that bank there is no right of early repayment. If instead a CD issued by that bank is bought it can be sold back to that bank or to some other investor as a way to realise cash early. But be warned – in difficult markets liquidity disappears and, if achievable at all, selling these investments may be costly.

Money market funds (MMFs)
An idea imported from the U.S. where they have been extensively used for years is the Money Market Fund (MMF). The company invests in a fund (strictly speaking it buys shares in it) and the fund invests in a range of short-term instruments. By this means investors achieve diversification even on small amounts invested, they gain same day liquidity, but yet returns driven by the longer average duration of the fund’s investments,
    
Such funds usually have a high proportion of investments in financial sector obligations, limiting sectoral diversification. Some funds major on investment in government bills in the relevant currency and thus are seen as having lower risk but show a lower return.

Counterparty credit limits
A company would normally set a credit limit for each counterparty it invests with based largely on that party’s credit rating – paying attention also to its circumstances and available market information, for example how/if it is regulated and by what regulator.

The approach to investment security is not designed to be event-free under all circumstances but to be such that, systemic failure apart, a credit event, while damaging, unwelcome and embarrassing, is unlikely to be catastrophic to the overall liquid asset portfolio or the company/group overall. The limit will take account of the probability of default by the counterparty so that counterparties with lower credit ratings are set lower limits.
    
Ownership apart, other connectedness between counterparties would require an overall limit to be set for that factor – for example an overall limit for counterparties from a particular jurisdiction. The limits may vary with the maturities of the exposures. In times of uncertainty investment periods should be reduced.
    
In any case, credit standings can change very quickly and it is important to be responsive and to have up-to-date assessments to hand to permit prompt adjustment of limits and, possibly, protective actions. Keeping abreast of other indicators or news reports on your counterparties is advisable.

Internal processes
The treasury policy, encompassing the concepts above will need to be agreed by the company board or equivalent senior management committee. Over and above the policy suitable processes and control procedures are needed covering delegation of authority limits, division of responsibilities, reporting and monitoring and regular review at a senior level. Staff involved at every level should have the training, skills and experience necessary to fulfil their role properly.
    
Recent Communities & Local Government Guidance on Local Government Investments reinforces this message: “Even where significant reliance is placed upon external advisers, in-house expertise will still be needed to develop the proper kind of working relationship with them. The Government also hopes that elected Members involved in the scrutiny of treasury management issues will avail themselves of relevant training wherever possible.”
    
For those involved in public service organisations CIPFA has issued a Treasury Management Code of Practice and guidance-scoping out the essential principles and practices needed. The CIPFA treasury management code of practice identifies the need for formal and comprehensive treasury management policies in public service organisations and recommends certain treasury management practices (TMPs) covering different aspects of treasury. Details of the CIPFA Treasury Management Code of Practice are available at http://secure.cipfa.org.uk/cgi-bin/CIPFA.storefront/EN/product/PUBCF024
    
CIPFA, working with the Association of Corporate Treasurers, has developed a qualification in Treasury management specifically tailored to those in the public sector and this is available through an online distance learning programme which combines tutor support with optional tuition and revision courses and formal examination. Details of the ACT/CIPFA Certificate in International Treasury Management - Public Finance (CertITM-PF) are available at www.treasurers.org/certitmpf

For more information
Martin O’Donovan is an assistant director of the The Association of Corporate Treasurers (ACT), and a member of the CIPFA Treasury Management Panel. Useful information from the Panel is available at http://www.cipfa.org.uk/panels/treasury_management/index.cfm