For companies that are fortunate enough to have or generate excess cash, it is simpler and more profitable to invest their cash in short-term instruments since interest rates are rising sharply and rapidly. However, it is important to remember the advantages and disadvantages of the different products available to treasurers, keeping in mind the notion of "cash & cash equivalent".
Many companies have remained or are becoming "cash rich" again. This is a godsend at a time of rising interest rates. But treasurers sometimes wonder how to optimize this excess liquidity. The first recommendation, even if it remains very theoretical and little applied in practice, is to segment its excess cash into groups or tranches, depending on the allocation or destination of the funds. The idea is to use this segmentation to allocate each portion to one or more products that are better suited to the risk and the duration of the holding. We can see that the categories can be declined differently. At least three main ones can be envisaged: (1) Operating Cash (needs to be invested in short term, liquid, secured vehicles: very short-term deposits, Repo's or Money Market Funds best suited); (2) Stable Cash (can be invested in low risk and slightly longer maturities up to 12 months) and eventually (3) Strategic Cash (more risky solutions with higher expected return can be envisaged).
However, further refinement is possible by identifying other categories or subcategories, including "trapped cash" or "restricted cash" (cash that is inaccessible, for various reasons, and therefore "unusable" by the treasury center).
Segmentation of excess liquidities per category
The range of products that can be used by a treasurer (even more so if he/she has to keep all or part of the liquidity in "cash & cash equivalent" - i.e. IAS7), is relatively limited. However, the risk/return ratio can vary. We can think that money market funds of the ultra-short type, IMMFA, with an "AAAm" rating are the safest without being the least profitable. They allow to reduce the risk by diversification, which itself allows the maximum rating (which is obviously not an absolute guarantee). The return is stable, the interest compounded and the exit immediate and in day value. Who says better? If you segment your liquidities properly, you can allocate the instruments to the pockets thus defined according to their nature and potential duration. You should always avoid volatile instruments and stop thinking that a bond or a bond fund would be less volatile. Of course, it is not at all. We must stop thinking that a bank deposit is risk-free when the Over-Night yields vary greatly (depending on the bank own needs and positions). Finally, we must stop saying that a money market fund is complicated to use, track, or buy. There are platforms for this purpose, much less risky and more secure than calling your banker to entrust him with a term deposit. Some other attractive products, such as tri-party repos are interesting but with a somewhat particular and different management. It is important to make sure that you are always able to process, manage and record in the TMS the transactions made.
It is obvious that each investment product offers "pluses" and "minuses", is stronger/weaker in one respect or another. Obviously, we would all look for the ideal, namely: maximum diversification, immediate liquidity assured, the most flexible and easy operational processing, the highest net return, the lowest counterparty risk, the lowest sensitivity to rising interest rates and the most transparent and complete reporting.
It remains difficult to determine the best strategy, since it depends so much on the culture of the company, its appetite for risk or not, its internal policies in terms of investment and the objectives pursued. As a financial risk manager, the treasurer must find the best alchemy between the different instruments to optimize the return without compromising the preservation of the principal and the correct accounting treatment. Diversification remains one of the best ways to mitigate counterparty risk. Automation is a factor to be considered. We forget that return is essential, but the risks are also operational. A deposit made over the phone is still a somewhat old-fashioned way of working, isn't it?
The right strategy is to segment the liquidity if the C-Level agrees to do so. Often CFOs want 100% of the cash in the short term to cover the eventuality. Reporting is important to measure performance (ex-post) and to reassure management. Performance analysis must be done globally. Sometimes, a long-term pocket can allow the use of more adapted products with a longer horizon and better yield. The overall return can thus be boosted and give an outperformance compared to its benchmark (i.e., often ESTER / Over-night rate). One should also never forget the accounting rules (i.e., IFRS) and the regulations such as the one under review for Money Market Funds. As we can see, managing excess cash is perhaps less stressful than managing debt. Nevertheless, it is sometimes complex and needs to be reviewed, especially after a crisis like the one we have just experienced.
François Masquelier, CEO of Simply Treasury – Luxembourg
Disclaimer: This article was prepared by François Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).