Coping with a Prolonged Low-interest Rate Environment

In the late 19th century the head of a shoe company, keen
to expand his business, sent two sales managers to Africa to assess the
market.  The first reported that there was no sales potential for shoes as all
Africans were barefoot.  The second said there was huge market opportunity to
be tapped; not only did most Africans envy his shoes but there were no
competitors!

Today corporate treasurers face a similar dilemma for
their investment decisions, due to record low interest rates, uncertainties in
financial markets and regulatory changes. The resulting eternal risk-return
trade-off and an anticipated eventual rise in interest rates provide both
challenges and opportunities to businesses, investors and banks.

The
bailouts in Greece, jitters in Spain, Italy and Portugal and the Cyprus banking
crisis with its unprecedented ‘haircut’ for major depositors have added to the
uncertainties triggered by the 2008 financial crisis.

Since the
shutdown in global credit markets, many corporate treasurers prioritised
guarding against risks of disruptions in funding. In addition, in September
2008 the market witnessed only the second case of a money market fund (MMF) –
Reserve Primary Fund in the US – ‘breaking the buck’ and investors losing their
principal. So treasuries moved large portions of their cash into conservative,
low-risk, highly liquid instruments, such as conventional deposits and
government securities. Today’s savvy chief financial officers (CFOs) are
issuing bonds to lock in finance at historically-low rates, further bolstering
their cash reserves.

With record cash holdings, especially in the US,
the strategic choices for treasurers are either to invest the surplus cash and
put it to productive use, or return it to shareholders via dividends or share
buybacks such as Apple’s
recent bond
. The cycle of cash accumulation has not yet ended and these
liquidity buffers present investment opportunities.

Key
Investment Objectives

Treasurers follow three fundamental
objectives when investing:

  • Safety:
    Maintaining principal.
  • Liquidity: Ensuring
    complete access to the invested principal at all times.
  • Yield: Maximising return on investment (ROI).

Optimising all three investment objectives simultaneously is a
difficult balancing act to find the point of equilibrium.

Liquidity Segmentation

Liquidity, having the right
amount of funds at the right time in the right place, can be segregated into
three components:

  • Operating cash (short-term horizon):
    Working capital cash for day-to-day operations, typically with an
    investment horizon of a week to three months. This requires the highest
    priority on liquidity and near immediate access to funds.
  • Core cash (medium-term horizon): Cash required
    occasionally. For example, for specific projects or significant financial
    obligations such as tax and dividend flows or unforeseen contingency events,
    with an investment horizon of three to 12 months. The investment strategy for
    this cashflow component is relatively conservative.
  • Strategic cash (long-term horizon): Cash that is
    rarely required, but used for major capital projects such as mergers and
    acquisitions (M&A), with an investment horizon of one year or more. Highest
    priority for this component is yield as the risk tolerance is higher. 

Once these cash components are established, investment decisions can
be made for each component based on corporate investment policy. 

Investment Policy

The investment policy ensures that
everyone from the board of directors to the treasury analyst has a common
understanding of their objectives and permissible investments. A disciplined
investment policy aims to address the following key issues:

  • Statement of purpose and investment objectives.
  • Investment
    instruments and currencies.
  • Limits on investments in specific
    countries, industries or with specific issuers.
  • Minimum credit rating
    of counterparties, countries and instruments.
  • Maximum maturity limits
    for specific instruments and/or portfolio.
  • Concentration limits for
    instruments, industries or currencies, individual maturities, etc.
  • Operating procedures for risk- and performance management; for review and
    benchmarking of the policy.

Traditional Investment
Products

A plethora of investment options is available for the
treasurer to select from, based on the company’s investment policy and
objectives:

Figure 1: Investment Options for
Corporate Treasurers.

DBS Bank Investment Options for Corporate Treasurers
Source: DBS Bank.

Non-traditional Investment Products

Innovative
bank account solutions are useful for companies with a stable component of
balances. They can track the stability of balances over an agreed period and
offer preferential interest on the core or stable component of the balance.
Other hybrid investment products include automated sweeps between current
accounts and term deposits.

Cross-border liquidity
management techniques, such as regional interest optimisation, enable
corporates to leverage on deposit-pools across multiple countries and multiple
currencies. Other liquidity management solutions consolidate surplus balances
across accounts and group companies, both in-country and cross-border.
Treasurers are also looking at options like dynamic discounting, whereby
suppliers are paid early with negotiated discounts, effectively investing cash
into the supply chain.

Regulation, Regulation,
Regulation

Increased regulation of the banking
sector is a given. This has indirect implications for selection of banks and
liquidity structures by corporates.

Deposit insurance
schemes:
In most countries, funds in bank accounts are covered by
such schemes, up to specified amounts. Certain schemes cover all investors
(retail and institutional), while some others provide restricted coverage to
corporates and institutions.
The expiry of the US unlimited Federal
Deposits Insurance Corporation (FDIC) programme on non-interest bearing bank
accounts last December has prompted US treasurers to review the products and
countries in which to invest their cash holdings.

Basel
III
:
It introduces new minimum liquidity
coverage ratios (LCR)
 and structural liquidity ratios prompting banks to
redefine the pricing and value of deposits, based on duration and stability of
funds as well as depth and profitability of client relationships. Basel III
proposals will affect the type of and returns on term deposits offered to
institutional investors. Further as banks focus on capturing operating account
balances, so balances in such accounts may be more valuable alternatives to
other short-term investments.

Proposed
regulatory changes for MMFs:
The changes proposed for money
market funds (MMFs) have resulted in tremendous uncertainty. Regulators are
closely evaluating proposals to reduce systemic risks by imposing variable net
asset values (VNAV) – wherein NAV fluctuates on a daily basis, redemption
restrictions and/or capital buffers on MMFs. Currently a number of MMFs use
constant net asset value (CNAV) (i.e. a fixed invested principal). These are
considered vulnerable to runs by investors under conditions of market stress
due to their constant value. A move to a floating NAV is likely to force many
depositors out of MMFs.

The End of Easy
Money

After four years of crisis in leading Western free
market-oriented economies, there are at last signs of stability. Substantial
government deficits and central bank liquidity injections have successfully
sustained aggregate demand and stabilised banking systems at the heart of the
global financial system. The private sector is returning to drive the economy
and government economic policy priorities are shifting from supporting
aggregate demand to putting public finances on a sustainable path. If economies
regain their resilience, exceptionally easy monetary policy will soon no longer
be appropriate, but this is likely to happen more quickly in the US than in
Europe.

The world’s biggest economies – the US, China, and Japan –
all are doing better than a year ago. With the housing market having turned and
private sector activity improving, US domestic aggregate demand is likely to
strengthen despite fiscal consolidation. China is rebounding after a two-year
slowdown despite efforts to address domestic imbalances and risks to financial
stability stemming from the strong investment and credit boom that helped it
become the world’s second largest economy.  Japan is taking decisive steps to
end deflation and revitalise its economy by kick-starting higher private sector
activity through expansionary fiscal and monetary policy. Global growth will
not rebound to the high rates achieved during the V-shaped recovery in 2010-11
but will improve, raising the question as to whether interest rate risk will
increase with it.

Post-2008, the US economy was exceptionally weak
and US dollar (USD) interest rates exceptionally low because there was no major
positive private sector net demand for funds, a situation referred to as a
balance sheet recession or liquidity trap. Weak balance sheets and confidence
led to depressed investment activity and so little appetite for funds from the
private sector that both short-term and long-term interest rates lost their
relevance in pacing private sector credit growth. As long as the economy is in
that situation, central banks keep interest rates at exceptionally low levels
to lower debt burdens, ease financial conditions and support the government’s
deficit spending. But when private sector demand for funds returns, it’s time
for interest rates to rise and resume their role of pacing the credit
expansion.

US Recovery

If the key
factor behind exceptionally low interest rates is weak private sector demand
for funds, the key question is whether that demand is recovering. As credit
demand is predominantly a function of investment activity, it will be
recovering with investment activity. Three factors suggest that the US
investment climate is improving and that stronger investment growth lies ahead:
confidence in the economic outlook is improving; US business sector balance
sheets are strong and businesses are in a good position to expand.
Additionally, US financial institutions have deleveraged and well positioned to
extend credit. 

The return of the private sector as the driver of
domestic aggregate demand suggests that the turning point in the US interest
rate cycle is nearing. Given the prospect of stronger private sector activity,
the Federal Reserve could hike rates as early as 2015. As a lower unemployment
rate materialises, the Fed will phase out its unconventional monetary policy
measures and the market will gradually price in interest rate risk for 2015 and
2016. As a result, the behavior of the USD yield curve will be very different
during the second term of the Obama administration than during the first. The
US Treasury yield curve ‘bull-flattened’ during fiscal expansion. Now, it
should ‘bear-steepen’ during fiscal consolidation. The current level and
steepness of the US Treasury yield curve are consistent with a persistent
deflationary environment characterised by a low level of private sector
activity and no net demand for funds, not recovery.

In short, the
markets cannot have recovery and low rates forever. Increasingly an improving
US economy means interest rate risk in the form of rising short-term rates,
which has yet to be priced into the front-end of the yield curve. If data flow
over the coming months confirms that fiscal consolidation is not premature and
aggregate demand can strengthen in spite of it, the USD rates markets cannot
ignore the implications. If the private sector is back on its feet, it won’t be
long before short-term interest rates will be back above inflation.

To be clear, short-term USD interest rates are still expected to remain low
for some time, but there will be more and more factors that suggest a US Fed
rate hike risk is increasing with investment activity. By the time the Fed
hikes rates, the USD yield curve will be significantly steeper. As the USD
yield curve is the global benchmark yield curve for the pricing of capital and
risk, its behaviour has major implications for savers and borrowers globally. A
higher cost of capital in the USD space is expected to lead to a higher cost of
capital worldwide.

Conclusions: The Way Forward

With short term interest rates near record lows, the dilemma is
whether to accept credit, liquidity or interest rate risk to earn higher yield,
or to preserve capital. Despite numerous investment options, tolerance for
volatility continues to be low: treasurers’ view is typically “Maybe I’ll gain
five basis points, but is it really worth it?”

Investing
further out on the interest rate curve is one obvious solution to enhance
yield. In general, the longer the tenor of the investment, the higher are the
returns. However rising interest rates will present challenges to treasuries
when dealing with returns from existing investments. Fixed rate bonds are
sensitive to interest rate risk compared to term deposits or bank accounts.
Such investments can suffer unrealised losses with increase in interest
rates.

Closer to steepening of the US yield curve,
treasurers may reduce the average maturity of their portfolios, to be able to
invest in progressively higher yields. Floating-rate instruments are also
effective means to benefit from pick up in rates.

In view
of the strong regulatory changes, both recent and proposed, it is important to
keep abreast of them.

Asia is increasingly an attractive
liquidity destination with two AAA-rated countries – Singapore and Hong Kong –
some of the world’s safest banks, and strong regulatory frameworks. There have
been upgrades in various other sovereign ratings in Asia.

Some
multinational corporations (MNCs) have developed a bias towards holding local
Asian currencies, which also have relatively higher interest rates. The
continuing shifts to alternative clearing currencies, especially renminbi
(RMB), are potential game-changers too. It is now time to re-visit investment
policies, in particular selection criteria for counterparties, countries and
instruments, to ensure return on investment (RoI) along with preservation of
capital.

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