The first step in managing the short-term investment portfolio is the development of an investment policy.1 A formal investment policy establishes a clear understanding of the firm’s investment philosophy and objectives. This allows the treasury team to better manage liquidity, monitor compliance, and minimize risk, regardless of the treasury department’s structure (e.g., centralized or decentralized). The investment policy also serves to protect staff in case any problems arise, such as disputes between the company and a counterparty.
In general, the more decentralized and geographically widespread the investment decision making, the more crucial an investment policy becomes to ensure a consistent, enterprise-wide approach. Formal written policies also help to delineate the relationship between the parent/holding company/corporate office and the subsidiary in decentralized operations.
The objectives of an investment policy reflect the organization’s philosophy about risk and return. Therefore, the objectives must be appropriately written to reflect the organization’s structure, competitive environment, and overall goals and objectives. For example, the objectives should reflect the business and environmental factors affecting the organization, such as company size, capital structure, and industry competition and regulation.
Companies may have a single investment policy covering all types of investment, including the investment of short-term cash, or a separate short-term investment policy as part of a wider set of treasury policies.
There are three core objectives when making any investment over any time period: (1) to preserve principal (i.e., safety objective), (2) to retain access to invested funds (i.e., liquidity objective), and (3) to achieve a return (i.e., yield objective). It is not possible to maximize all three objectives at any one time, as it is usually necessary to take a higher risk (either in terms of putting principal at greater risk or by restricting access to invested funds) to achieve a higher return. This is explained further in the discussion of the risk/return trade-off below.
The three core objectives apply for any investment activity over any investment term, from overnight cash deposits to the long-term management of the company pension fund, and treasury professionals may focus on different objectives depending on the type of investment being made. This chapter focuses on short-term investment, including the investment of working capital cash and surplus cash generated by a company. Long-term investment is discussed in more detail in Chapter 19, Long-Term Investments.
When making short-term investments, treasury professionals, especially those in organizations with significant cash surpluses, may also tier cash into separate buckets and then set different investment objectives for each bucket of cash. So, for example, a treasury professional may decide to tier cash into three buckets:
- Working capital, or operating, cash (e.g., cash required by the business within 90 days)
- Medium-term cash (e.g., cash required by the business within the current year)
- Longer-term cash (e.g., cash required by the business in about one year)2
Depending on risk appetite and cash volumes, the treasury professional could combine the two buckets with shorter time frames into one (i.e., cash required by the business within a year). Having identified different buckets, a treasury professional may then be prepared to sacrifice some liquidity for the medium- and longer-term cash in order to target a slightly higher return. The ability to tier cash successfully depends on the deployment of an appropriate cash flow forecasting process. This process is discussed in more detail in Chapter 14, Cash Flow Forecasting.
- Safety
- Assess the credit quality of all counterparties. Limiting the list of approved counterparties to only those with good credit quality will reduce the risk of loss through counterparty default. The investment policy can list a minimum credit rating for approved counterparties, which can differ according to different tiers of cash.
- Select appropriate investment instruments. To preserve principal, treasury professionals will try to avoid investment instruments with volatile prices. For short-term cash, this might mean selecting investments where price does not change (e.g., bank deposits) or aiming to hold more volatile instruments until maturity (e.g., commercial paper).
- Achieve portfolio diversification. Treasury professionals will seek to achieve diversification within the cash portfolio so that the company is not overly exposed to loss based on either a particular counterparty (e.g., a bank) or instrument class (e.g., bank deposits).
- Liquidity
- Yield and Risk/Return Trade-Off
Investment safety is usually viewed from the perspective of preservation of principal. There are a number of ways treasury professionals can reduce the risk of loss of principal when investing cash:
Multinational companies in particular also need to consider foreign exchange (FX) risk when investing cash.
For a short-term investment portfolio, maintaining adequate liquidity is usually defined as the ability to quickly convert an asset into cash without a significant loss. For medium- and longer-term cash investments, especially where the maturity of the investments can be matched closely to the need for funds, liquidity may not be a primary objective.
The importance of maintaining liquidity within the cash investment portfolio will be determined by the company’s cash forecast, which in turn allows the treasury professional to tier the company’s cash. A less accurate forecast will require the treasury professional to place more emphasis on liquidity when investing cash.
Liquidity needs vary across companies. For example, some firms (e.g., broker-dealers) require daily liquidity, while others (e.g., pension funds or insurance companies) may have long-term liquidity requirements. Even firms within a specific industry may have differing liquidity requirements depending on their cash flow cycles, current profitability, and investment opportunities. Some firms may not have sufficient investment balances to consider long-term investment horizons (covered later in this chapter). Seasonality may also define the required liquidity needs (e.g., higher cash flows in the summer months). It is critical that both static and dynamic liquidity concerns be considered in the development of the investment policy.3
An important objective of any investment policy is to achieve an acceptable return on invested assets, whether this is short-term cash or long-term capital. Careful consideration must be given when ranking investment return in relation to the other objectives of safety and liquidity. A key determinant in the return/safety/liquidity balance is the firm’s risk tolerance with respect to the assets being invested. Risk tolerance refers to the willingness to take on additional risk in order to increase the expected rate of return on a portfolio. Risks that should be considered include credit, counterparty, interest rate, reinvestment, prepayment, FX, and sovereign risk. The investment policy should address specific procedures that must be followed to minimize the various types of investment risk. Like many elements of the investment policy, guidelines pertaining to risk tolerance must be tailored to each organization. As mentioned earlier, enhancing yield is typically subordinate to preserving principal and retaining liquidity when investing short-term cash. Companies that tier their cash often target an enhanced yield by sacrificing some liquidity when investing longer-term cash.
Exhibit 13.1 provides an illustration of how it is only possible to target two of the three investment objectives at any one time and further demonstrates how treasury professionals have to prioritize their investment objectives to reflect the nature of the cash being invested.
Some firms are more sensitive and susceptible to certain risks than others. Firms that engage in international commerce may face significant FX risks while other firms face none. Furthermore, every firm has its own perspective on and benchmarks for risk taking, principal preservation, and investment return, and ranks them in order of importance. Investment benchmarks are covered later in this chapter.
A short-term investment portfolio will consist primarily of money market instruments, which are typically low-risk investments. Such low risk levels are accompanied by lower returns, but this is consistent with the primary short-term investment objectives of preservation of principal and maintenance of liquidity. There are four major risk factors associated with short-term investments: default/credit risk, liquidity risk, interest rate risk, and FX risk.
- Default/Credit Risk
- Liquidity Risk
- Interest Rate Risk
- Foreign Exchange (FX) Risk
Default or credit risk refers to the likelihood that the payments owed to investors will not be made under the original terms. Issuers of money market instruments with higher default risk must offer investors a higher yield to compensate for the increased risk. This increased yield represents a risk premium (i.e., the incremental yield above an otherwise comparable security).
The default risk of money market instrument issuers is usually assessed by credit rating agencies, such as Moody’s, Standard & Poor’s (S&P), Fitch, or DBRS (formerly Dominion Bond Rating Service).4 Most issuers of money market instruments have an acceptable (typically investment-grade rather than speculative-grade) credit rating.
Some short-term investments may be unrated, which means additional research effort for potential investors. Initially, the investment must be evaluated for credit risk, which could be an involved process. Another concern is that if the security must be resold, then the new purchaser would most likely need to perform a credit risk evaluation on the security. This process could make it difficult to find a buyer—or at a minimum, delay the sale—leading to increased liquidity risk on the investment.
The volume of defaults in various periods provides an indication of the extent of credit risk on money market instruments. For the period beginning in 1972 through the first half of 2017, a total of 80 issuers defaulted on approximately $13.8 billion of commercial paper (both rated and unrated). Twenty of these defaults were US issuers and 24 were related to European issues. The number of commercial paper defaults peaked in 1990 (with eleven defaults), but was also high in 1989 (nine defaults) and 2016 (also nine defaults, of which eight were Chinese issuers). The largest dollar volume of default occurred in 2008, largely as a result of the $4 billion default of Lehman Brothers. Default volumes of over $1 billion were also recorded in 2001 (due primarily to the effects of the California energy crisis) and 2014 (as a result of the bankruptcy of Espirito Santo).5
A liquid security is an instrument that can be converted quickly and easily into cash with very little exposure to market price risk and for a small transaction cost. Subsequently, liquidity risk refers to the likelihood that a security cannot be sold quickly without incurring a substantial loss in value.
The primary determinants of liquidity are marketability and maturity. The existence of an active secondary market ensures that the short-term securities suitable for liquidity management purposes are readily marketable. In terms of maturity, most financial instruments other than money market funds have a maturity date on which the obligation is redeemed. In general, money market instruments with shorter maturities are more liquid. Note that different money markets around the world have different levels of liquidity and for different instruments.
Interest rate risk involves the uncertainty associated with future interest rate levels. Interest rate risk has two components: reinvestment risk and price risk. The potential for lower interest rates results in reinvestment risk. After market interest rates drop, the proceeds from maturing investments will be reinvested at a lower rate. Price risk refers to changes in interest rates having an adverse impact on the value of a security. Securities with longer maturities have increased price risk as their market values are more responsive to changes in interest rates. As interest rates increase, the investor demand will be lower for previously issued securities with lower coupon rates. In general, price risk refers to the potential for an increase in interest rates. The relationship between the price of the market interest rate and the price of a debt security is illustrated in Exhibit 13.2.
FX risk arises when investors purchase securities denominated in foreign currencies. An adverse change in the FX rate can result in a lower rate of return when the proceeds from the investment are converted to the firm’s home currency. If the foreign currency depreciates relative to the investor’s local currency, then the value of the investment declines. For example, a French investor may purchase US Treasuries. The French investor’s FX risk is conditional on the volatility of the exchange rate between the euro and the US dollar. During the holding period, a depreciation in the US dollar relative to the euro will reduce the French investor’s return. This occurs because the French investor will exchange the US dollar proceeds (earned on the Treasuries) for fewer euros.
FX risk is present whether the investment is sold prior to maturity or is redeemed at maturity. To limit FX risk, the investment policies for many firms will only permit investment in foreign securities if the security is (1) issued in an economically and politically stable country, and/or (2) suitable as part of an overall currency hedging strategy (which may include having future payment obligations in that currency).
- Investment Requirements
- Instrument Selection
- Allocating by asset type (e.g., bank deposits, commercial paper, and government securities) or among a variety of investment management firms (e.g., 25% with Company A and 75% with Company B)
- Holding a certain percentage of foreign instruments so the company can minimize the impact that movements in a specific currency may have on the portfolio (e.g., the US dollar weakens by 5% against the euro)
- Limiting investments in issues from the same organization to a certain percentage of the total portfolio (e.g., 10% of the portfolio)
- Limiting investments from specific issuers and/or instruments in order to limit concentration risk (e.g., can invest up to $10 million in ABC Company commercial paper, or can invest up to 10% of the portfolio in a single currency or country)
- List financial and/or minimum credit rating requirements for financial institutions and other companies in which investments are made.
- Define any special credit requirements and guidelines if foreign investments are allowed in the policy (e.g., direct investment in foreign companies or indirect investment through brokers/funds).
- Specify whether and how MMFs and other mutual funds may be used. When using an MMF or mutual fund, it will not always be possible to completely align the investment policy with the fund. Given the wide variety of funds, the investment manager should be able to find one that is fairly close in terms of investment objectives and policies. If funds are permitted investments, the policy should state this and clearly state the rules governing their use, including how the funds are to be selected, if they must be rated by one or more rating agencies, whether their composition must adhere to the overall guidelines established in the investment policy, and whether (and how) they are regulated (e.g., 2a-7 MMFs in the United States or EU short-term MMFs).
- Investment Strategies
- Buy-and-hold-to-maturity strategy
- Actively managed portfolio strategy
- Tax-based strategy
A firm must decide which securities/instruments are suitable for investment and develop an approved list of permitted investments (or, for those companies that tier their cash, one list for each bucket of cash). Some companies also have a list of approved counterparties and/or a list of prohibited investments. Many firms include, or refer to, the approved list or lists in their investment policies. The list may name specific securities approved for investment (e.g., ABC Company commercial paper) or it may simply specify categories of qualified investment instruments (e.g., commercial paper). Lists are sometimes based on minimum credit ratings (e.g., commercial paper with a minimum rating of A-1/P-1). For global companies, the approved list may further specify acceptable issuer countries and in some cases specific industries within countries. As an example, investment in South African mining companies may be approved, but not African mining companies generally, due to concerns about conflict diamonds.
Regardless of the approach taken to establish the list, it is important to review each approved instrument periodically to ensure that it remains compatible with the stated investment objectives.
On each occasion that cash is invested, the treasury professional will select an appropriate instrument from the lists of approved instruments and approved counterparties. For a discussion of the different types of money market investment instruments, refer to Chapter 5, Money Markets.
Short-term investment policies lay out the guidelines that must be followed when building and managing a short-term investment portfolio. Specifically, the short-term investment policy should regulate risk taking to ensure that the investment portfolio is aligned with the firm’s desired risk tolerance. Further, the short-term investment portfolio should be constructed and regulated in a manner that is faithful to the goals of principal preservation and liquidity optimization. Each individual investment decision should be evaluated in this context.
The short-term investment policy (whether it is a stand-alone document or part of a general investment policy) should set clear guidelines for the structure of the portfolio. These should include rules regarding diversification requirements, investment or exposure horizon, other limitations on investments, and legal/regulatory restrictions.
Diversification is one of the most important tools an investment manager possesses to protect the organization from the risks to which it is exposed. Diversification approaches include:
Whatever approach is used, the diversification strategy should be defined clearly in the investment policy.
The investment horizon is the total length of time that an investment will be held before the investment matures or is sold. The longer the average time to maturity (i.e., duration) of investments in the portfolio, the greater the exposure to interest rate risk. An investment policy should specify any limitations that a firm may have regarding the maximum and average duration of the investments in its portfolio. This exposure horizon is a function of both the organization’s risk philosophy and the total interest rate exposure already present in other areas of the organization. Short- and medium-term investment portfolios often consist of fixed-income securities and money market funds (MMFs). Since the price and/or return on those securities and MMFs is largely a function of the market interest rate, the portfolios are subject to significant interest rate exposure.
In addition to decisions regarding diversification and investment/exposure horizons, organizations must consider several other investment-related issues and outline decisions regarding these issues in their short-term investment policies. For example, an investment policy should:
Regulatory or legal restrictions that may impact investment practices should be clearly described in the investment policy. Certain regulated entities (e.g., insurance companies, government agencies, and public utilities) may have specific investment constraints. For example, an insurance company may be required by NAIC (National Association of Insurance Commissioners) guidelines to limit investment activities to specific types of investments or apply concentration limits on permitted investments. Similarly, depending upon their legal structure and prevailing regulations, insurance companies, regulated entities, or state-sponsored institutions (e.g., universities and hospitals) may need to segregate their investments in separate accounts to comply with statutory commingling guidelines. The investment policy should clearly define all restrictions that affect the investment practices of the organization.
Debt covenants may also place specific limitations on how a company manages investments. Restrictions may require the debt issuer to pay down the debt with any available cash, effectively prohibiting the company from making any short-term investments until the debt is retired.
An investment decision will be part of a broader investment strategy, reflecting the company’s appetite for risk. A variety of short-term investment strategies are available to an organization, including a(n):
These strategies may be used individually or in combination, depending on the organization’s investment needs and strategic objectives for each tier of cash. Each strategy is described below.
A traditional strategy for investing excess cash and preserving capital is to (1) invest only in securities whose maturities can be expected to sufficiently fund any potential cash needs, (2) hold those securities to maturity, and (3) reinvest only if maturity proceeds are not needed for expenditures. This approach is referred to as a buy-and-hold-to-maturity strategy, which is a passive investment approach6 that might be favorable to conservative investors, including those investing working capital (or operating) cash.
The main advantages of the buy-and-hold strategy are that funding needs are always met, as long as securities are structured or laddered properly to meet cash needs, and interim price fluctuations can largely be ignored since the maturity will always fulfill the investment’s initial return expectation. The disadvantage of this investment strategy is that the firm may forgo potentially lucrative alternative investments.
The buy-and-hold strategy is also referred to as a matching strategy. This stems from the fact that cash flows from maturing investments can be matched to future expenditures. This matching of cash flows generally allows for investing over extended periods (i.e., longer maturities), which may lead to increased yields. For this strategy to be effective, however, it requires careful forecasting of future cash flows and capital requirements. If cash is needed sooner than expected, the securities purchased to correspond with a specific cash outflow may have to be sold prematurely, perhaps at a loss. Firms that apply a matching strategy often will do so in a conservative manner, covering only a portion of the expected capital need.
An active investment strategy (or a total-return strategy) is contrasted with the buy-and-hold strategy in that an active approach pursues enhanced returns by capturing capital gains that may arise on relatively longer-dated instruments. This strategy requires that an investor be prepared to sell holdings when their prices rise, and is dependent on interest rates falling or on the relative creditworthiness of an issue improving. An actively managed investment strategy is typically used by investors to meet specific needs or to earn higher returns. It is generally more suitable for medium- and long-term cash, rather than working capital investment.
One advantage of an active investment approach is that for as long as the yield curve is positively sloped (i.e., short-term interest rates are lower than long-term interest rates), capital gains are possible. The yield curve, discussed in more detail later in this chapter, is the interest rate trend line that spans the full spectrum of maturities for a certain instrument. As time passes and longer-dated purchases approach maturity, their value in the secondary market increases because while their maturities are shortening, their stated interest rates remain at levels associated with longer-dated instruments. When this increase in value occurs, such securities can be sold for a premium because they now pay above the market rates for short-term investment instruments of identical maturity.7
The threats to cash assets from this strategy arise when time passes but prices do not rise—capital gains therefore do not materialize, and the investor’s portfolio has a longer duration than intended due to the lack of capital gains. Investing in an actively managed portfolio, or using a total-return approach, is only appropriate for amounts of cash that are likely to be required no earlier than the longest-maturity security that might be purchased with such a strategy. An active short-term investment strategy requires that the investment manager forecast the course of interest rates over the very short term.
Corporate investors in high tax brackets may favor tax-based strategies that are designed to minimize income taxes on investment return. The success of tax-based strategies depends on the investor’s location and applicable tax regulations. Where tax-advantaged investments exist, potentially higher returns may be available to certain investors. In most cases, the yield benefit of a tax-advantaged investment is related directly to an investor’s marginal tax rate (see details in the yield calculation discussion in Section III.A.2 of this chapter). The use of such tax-advantaged investments can be employed in both passive and active strategies.
For global organizations, there may be advantages related to developing a globally based investment strategy. There are often tax advantages related to investing in one location or currency versus another, and an organization operating in many different currencies and countries must often maintain liquidity in many currencies and locations.
In India, for example, companies can earn higher yields by investing in tax-free infrastructure bonds. In the United States, there are several tax-advantaged investment strategies. Besides investing in specific federally tax-exempt municipal securities, investors may buy shares in tax-advantaged mutual funds tailored to their state of domicile. Further, for firms with a mix of income from multiple US states, portfolios of municipal securities and/or bond funds can be used to match this income mix closely, thereby minimizing overall state taxation.
Dividend capture is another tax-motivated, short-term investment strategy also available to corporations that pay taxes in the United States. A firm may exclude from its taxable income 70–80% of the dividends received from stock owned in another corporation,8 as long as it owns the stock for at least 46 days of the 91-day period starting 45 days prior to the ex-dividend date.9 Even though dividend capture requires an equity investment, the strategy is considered a short-term investment because the stock is held only long enough to capture the dividend and qualify for the dividend exclusion. However, the risk to principal that is associated with an investment in stock means a dividend capture strategy is more appropriate when investing longer-term cash rather than working capital.
As an example of dividend capture, assume that a firm purchases common stock in another firm after the dividend announcement, then sells it after the ex-dividend date, ensuring that at least 46 days of ownership elapse. The investing firm has then captured the dividend and will receive it on the payment date. There is little risk that the dividend will not be paid because only stock in large, reputable firms is purchased for this purpose. However, there is a risk that the stock may have to be sold at a loss, but firms using this strategy employ it frequently so that gains and losses offset one another over many transactions. The strategy should be avoided when the market is in a secular downtrend or if there is a sense that the market may be impacted adversely in the near future by a macroeconomic shock or political event.
When implementing a short-term investment portfolio, treasury professionals have three choices: (1) manage all investment in-house, (2) outsource all investment management, or (3) combine the two approaches. Each approach offers advantages and disadvantages, some of which are described below.
- In-House Management
- Methods of monitoring compliance with policies, procedures, and internal controls
- Provisions for performance measurement, evaluation, and reporting
- Exception management and related approval processes
- Outsourced Management
- Combination of In-House and Outsourced Management
When using in-house management of short-term investments, an organization assumes responsibility for directly managing its own portfolio. Although investment decisions are guided by the organization’s investment policy, management must be prepared to make specific decisions at all times based on current market conditions.
In-house (or internal) management is generally appropriate only to the extent that the individuals charged with this responsibility have the training and experience required to effectively manage the portfolio. The company’s investment policy may reference a document that lists specific responsibilities, either by organizational title or by name. This document should be reviewed and updated after any change in personnel.
The use of in-house management also requires that appropriate controls be in place to approve and monitor investment activity. These controls should include:
The primary advantage of in-house management is that the firm maintains control over the investment process. However, a key disadvantage of in-house management is that it is costly to hire, train, and retain employees with the skills needed to execute the short-term investment strategy.
In-house management may be particularly appropriate for entities that only have small cash surpluses to invest for very short periods of time (i.e., overnight or a few days at a time). In these circumstances, it may be sufficient, for example, to automate sweeps to money market deposit accounts held with designated banks or into certain money market funds, thereby reducing the need for investment staff.
With outsourced management (or external management), the short-term investment portfolio duties are assigned to a third-party provider, such as an asset manager or an outside money manager (e.g., an investment bank or registered investment advisor). While management costs or fees will be incurred (e.g., 10 to 100 basis points), these fees should be balanced against the cost needed to hire and maintain appropriate internal expertise. The use of external managers may also be dictated by the size and complexity of the organization’s portfolio. External fund and money managers will typically have greater resources and experience than those usually found within an organization’s treasury department. One of the most important of these resources is ready access to securities research. While in-house treasury managers can usually get access to research information from their broker-dealers, they must ask for it and in some cases may be required to pay for it, especially in the European Union under MiFID II (Markets in Financial Instruments Directive II) requirements.
A potential disadvantage of outsourcing is that investment policies and guidelines must be communicated clearly to the outside manager, who must be able to make individual, tactical investment decisions within a portfolio independent of the investor client and within the policy guidelines (or its exception provisions). This may become an issue when using MMFs, as the manager’s investment choices may not be completely aligned with the client’s preferences, although this can be overcome via the use of a separately managed account (SMA) in which the asset manager creates an investment portfolio tailored to the investor’s requirements. Other issues can include compliance monitoring and general due diligence with regard to the safety and soundness of the outside management firm.
Another potential disadvantage of outsourcing is that the incentive structure faced by the outside investment manager may not align with the client firm’s goals. For example, if a broker-dealer is hired to manage a firm’s short-term investment portfolio, then the firm’s management must recognize that the broker-dealer does not have a fiduciary duty to always act in its client’s financial interest. Since a broker-dealer trades securities for its own account and on behalf of its customers, its investment recommendations may arise from securities that the broker-dealer has available for sale, which may not address the client’s needs.10 As an alternative to a broker-dealer arrangement, a firm’s management may hire a registered investment advisor to manage an SMA based on the firm’s short-term investment policy. An investment advisor has a fiduciary duty to its clients that a broker-dealer does not. Still, it is best practice for management to periodically review the portfolio with the outside manager to verify compliance with the short-term investment policy.
It may be possible to allocate funds to more than one managing party, depending on the funds available to invest. This strategy allows the firm’s management to compare the cost and performance of the portfolio managers over time. If one portfolio manager is significantly better or worse than the other, then the firm’s management has an effective benchmark to use in renegotiating fees or reallocating the portfolio between portfolio managers. The downside of this approach is that the added cost of multiple managers may exceed the expected value of comparing the various managers. One alternative is to benchmark fund managers against industry indices, such as the BofA Merrill Lynch 3-Month US Treasury Bill Index or the Bloomberg Barclays Global Treasury ex-US Capped Total Return Index, depending on the nature of the cash being invested. This approach is also helpful if the funds are allocated to various managers based on investment type or duration, making it difficult to directly compare the managers.
Depending on the size of the investment portfolio, some cash may be managed in-house and the remainder outsourced to a specialist manager. This can be appropriate for organizations that tier their cash, with working capital (operating) cash managed in-house and longer-term cash managed by an external portfolio manager. In this scenario, short-term cash is placed in relatively low-risk instruments by the in-house treasury team to preserve principal and ensure liquidity. Medium- and long-term cash can either be managed in an SMA by an external manager according to a pre-agreed mandate or placed in mutual funds that reflect the company’s risk appetite for its longer-term cash.
In addition to the basic short-term investment policy, firms should have two other policies to round out the guidelines for the management of the short-term portfolio: a short-term investment valuation policy and a short-term investment impairment policy. While it is possible to include these in a master investment policy, it often makes sense to leave them as separate policies due to their different purposes and potentially different owners (i.e., the valuation and impairment policies may be accounting policies rather than treasury policies). These policies are more relevant to cash investments that have a slightly longer term and are therefore not accounted for as cash or cash equivalents. Further information on each of these policies is provided below:
- The short-term investment valuation policy lays out the methodology that will be used to establish the fair market value of the various securities in the portfolio. While this is a rather routine process for the actively traded securities in the portfolio that have publicly quoted prices, the methodology used may not be as clear for securities that are not actively traded (i.e., those that do not have a publicly quoted market price). Although these other securities may represent only a small fraction of a given portfolio, the methodology that will be used to establish their fair value should be documented before questions are raised by auditors or other outsiders.
- The short-term investment impairment policy documents the actions that will be taken when a particular investment may be impaired, as discussed below in the section on reporting. The policy should clearly define the severity and duration of an unrealized loss that will cause an impairment review and identify the specific securities that need to be reviewed. An impairment review does not necessarily require a write-down, but leads to a quantitative analysis of the securities involved. There are always alternatives to be evaluated, and having a well-written and documented impairment policy can help avoid unnecessary write-downs of securities that might otherwise be classified by the auditors as impaired.
Once a security is purchased, it must be warehoused and tracked to ensure that any interest income, dividends, or other proceeds are credited properly to its owner. The common method for this is for securities to be registered in the name of an institution that holds securities on behalf of investors (sometimes referred to as the nominee or street name ). In turn, these institutions are required to maintain separate books and records that evidence the specific, underlying ownership of the securities. The essential purpose of these processes is to facilitate fast and efficient transfers of securities from one broker to another.
Effective custody of securities can be accomplished by one of two basic means. The first choice is to engage a third party to provide custodial services for an investor. In this situation, the corporate trust department of a commercial bank serves as custodian of the securities, and collects income from the securities, redemption monies, and other cash flows associated with a particular investment on behalf of individual investor clients (including corporations). A custodian bank also serves as a conduit to the underlying investor for any notices, official information, or other actions regarding the securities it holds.
An alternative to fee-based, third-party custodians is to keep securities at the institution (usually a brokerage firm) from which they were purchased. This method affords all the same support as with a custodian bank, but such custody services are normally offered at no charge, which may be attractive to smaller organizations. This second approach is considered somewhat more risky than the first because there may be a potential for fraud, as the custodian is supposed to be the third-party control in the process.
The primary advantage of using a fee-based third party for securities custody is that reporting is consolidated and control over the investor’s entire group of holdings is established. This is especially important when an organization uses multiple investment managers, who otherwise might execute trades through their own brokerages. Since all of the portfolio’s trades are handled by a single custodian, it is much easier to monitor compliance with policy and operating guidelines, and identify any irregularities in trading or undue concentration. Further, since this process requires managers (internal or external) to trade through a particular custodian rather than using their own facilities, it can be an important separation-of-duties control feature. While some firms may be able to take advantage of complimentary custody services extended by brokerage firms to reduce expenses, third-party custodians are often required for investors using outsourced investment management.
Regulation may also require organizations, such as government institutions, to hold securities in a particular way. Any investment in mutual funds, including money market funds, effectively outsources custody selection to the asset manager.
Reliable investment reporting is important in order to ensure that performance and risk management goals are met, as well as to satisfy any external reporting requirements. An investment report should clearly illustrate the composition of a portfolio according to maturity distribution, quality ratings, and security classes. This presentation furnishes a simplified means for assessing investment policy compliance and affords the reader a concise overview of the investment pool and its risk exposure.11 If multiple fund managers are used, then each manager should provide a separate report for its portion of the overall portfolio.
Reporting is especially critical for publicly traded firms, due to regulatory and exchange requirements. In periodic filings, a firm must account for investment returns as allocated to a specific reporting period.12 For money market and other fixed-income investment portfolios, this means reporting interest income on an accrual basis rather than a cash basis. For investment vehicles that pay interest on dates that do not coincide with a reporting period’s beginning or ending dates, interest accrual reports must be prepared by the firm, and by its investment managers or brokers, that accurately show interest earned (even if unpaid) for any relevant reporting period.
An added component of investment reporting requires that unrealized gains or losses be shown. Because market values for money market and other fixed-income instruments may fluctuate during their lives until maturity, any difference between the current market value of a holding and its adjusted cost basis must be reported. This is referred to as mark-to-market accounting.
Under rules created by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), a security is deemed to be impaired when its fair market value is less than its adjusted cost basis.13 This difference is an unrealized loss unless the security is liquidated at that current price, whereupon it becomes a realized loss. However, under certain circumstances and according to IASB and FASB requirements, unrealized losses must be reported in the same manner as realized losses.
If a security is deemed to be impaired and this impairment is not or cannot be expected to be cured in the foreseeable future, then it must be further classified as other-than-temporary impairment (OTTI). As such, the investment’s carrying value must be reduced by the amount of the unrealized loss, and this loss amount must be subtracted from net earnings.14 As discussed above, firms should have both valuation and impairment policies in place that spell out the actions that need to be taken to determine if specific securities are impaired and when or if a write-down is appropriate.
Portfolio performance should be evaluated against established benchmarks to measure and validate the success of the investment policy’s objectives. The benchmarks selected should be consistent with the company’s agreed-upon goals and should be based on investment vehicles permitted by the investment policy. Common benchmarks for USD-denominated investments include reference interest rates (likely to be the Secured Overnight Financing Rate [SOFR] in the United States) and yields on US Treasury securities and 30-day commercial paper. Indices of particular segments of the market may also be used as benchmarks. There are a number of indices available, including the Lipper Money Market Funds Index, the BofA Merrill Lynch 1–3 Year US Corporate/Government Bond Index, and the Bloomberg Barclays US Aggregate Bond Index. Depending on the composition of the portfolio, a customized or blended benchmark, such as a weighted average of the 30-day US Treasury bill (T-bill) yield and the two-year Treasury note yield, may be best.
Firms that authorize the use of non-USD investment instruments should also select benchmarks that reflect their global market exposure. These might include reference rates such as the euro short-term rate (abbreviated as ESTER or €STR,15 and indicated as the ECB’s chosen replacement for EONIA, the Euro Overnight Index Average), the London Interbank Offered Rate (LIBOR), and the Sterling Overnight Index Average (SONIA), as well as specific international bond rates (e.g., Eurobonds). The impact of currency movements on the portfolio should also be reported.
As with all policies, an investment policy should incorporate the need for regular policy compliance review and evaluation. Furthermore, it should identify the parties responsible for fulfilling this role. This may be a responsibility of internal or external auditors, or a specific person or area outside the policy-related functional area, such as the compliance department. In certain firms, the internal or external auditors include investment policy compliance testing in their audits. When this is the case, the internal or external auditors should evaluate and review procedures, test individual transactions for compliance with the policy, confirm the effectiveness and validity of selected investment reports, and make any appropriate recommendations to amend the policy or procedures. At the very least, auditors should test compliance and policy effectiveness annually, as well as immediately following periods of significant change in the company or following periods of major economic upheaval.
If internal or external auditors do not review investments for compliance with the policy, the responsibility for investment policy compliance measurement should be assigned to a specific person or unit outside the policy-related functional area. This approach clearly represents a best practice, as it ensures objectivity in the review process and does not rely on internal or external audit resources that may have other responsibilities that take precedence over compliance testing.
Controls should be established to ensure that assets and market-sensitive inside information are protected from loss, theft, or misuse. These controls should be described clearly in the investment policy. Segregation of duties is critical to ensuring sound internal controls. The separation of transaction authority from accounting and record keeping is essential to enforcing the checks and balances of the treasury department. Investment-related accounting activities should be segregated from the person and/or area responsible for managing investments. In addition, sound internal controls over the wire transfer process must be established and maintained. Again, these activities should be performed by someone outside the investment management process in accordance with standard treasury department policies around separation of duties.
The monthly reconciliation of investment statements and records to an organization’s internal general ledger accounts is considered a best practice and another significant safeguard in maintaining strong internal control. In addition to establishing internal safeguards against fraud and/or negligence, it is also important to understand the controls that third-party service providers have in place. Another recommended best practice is to conduct periodic audits of service providers to evaluate not only their service capabilities but also their internal controls. One approach for monitoring internal controls for providers is to require Statement on Standards for Attestation Engagements (SSAE) 18 audits of the providers' relevant operational controls.
1 Chapter 18, Treasury Policies and Procedures, provides additional information on policy development, as well as an example of a short-term investment policy.
2 The investment of longer-term cash discussed in this chapter should be distinguished from the long-term investments discussed in Chapter 19, Long-Term Investments. Longer-term cash is still a short-term investment—it just falls on the far end of the short-term investment range. An example of longer-term cash might be if a company holds cash for a year or so following a divestment, while awaiting another opportunity.
3 Static liquidity is measured at a particular point in time while dynamic liquidity is a measure of liquidity over a future period of time.
4 In the United States, these are more generally known as nationally recognized statistical rating organizations (NRSROs).
5 From “Default and Recovery Rates of Corporate Commercial Paper Issuers, 1972–2017 H1,” published by Moody’s Investors Service, April 2018.
6 Investing in MMFs represents another type of passive investment strategy.
7 This would not be the case if the yield curve were inverted (i.e., short-term interest rates are higher than long-term interest rates).
8 For a 70% exclusion, the stock must be less than 20% owned by the corporation receiving the dividend. If a corporation owns more than 20% but less than 80%, then the exclusion is 80% of the dividend.
9 The ex-dividend date is the first date on which the stock is sold without entitlement to an upcoming dividend.
10 FINRA (Financial Industry Regulatory Authority) Rule 2111: Suitability holds US broker-dealers responsible for assessing the suitability of a given investment before recommending it to a customer, but this regulation says nothing about complying with a customer’s investment policy.
11 In the United States, this reporting is covered under Accounting Standards Codification (ASC) Topic 820: Fair Value Measurement. For organizations following International Financial Reporting Standards (IFRS), the relevant guidance is IFRS 13: Fair Value Measurement.
12 The relevant US guidelines in this area are ASC Topics 320, 820, and 825.
13 In the United States, the FASB reporting is covered in ASC Topic 320: Investments – Debt and Equity Securities. The IASB rules are covered in IFRS 9: Financial Instruments.
14 For securities deemed to be temporarily impaired, this unrealized loss amount must be accounted for on the firm’s balance sheet rather than on its income statement.
15 At the time of writing, the European Central Bank (ECB) had promised that ESTER would be first produced by October 2019.