Surplus funds not needed for either operating purposes or compensating bank balances are available for investment. Prudent use of idle funds can add to income, though the treasurer must consider a range of investment strategies before selecting the appropriate investment vehicle. Well, I am not a treasurer, but I know a treasurer should develop a standard methodology for investing funds. This goes beyond the selection of a type of investment, and enters the ream of strategies that can range from being passive (and requiring no attention) to those that are quite active and call for continuing decision making.
This post describes 6 possible investment strategies that you can adopt to generate additional income. Follow on…
Strategy-1. Earnings Credit
“My firm has minimal cash balance, what investment strategy should I adopt?” you asked. Well, at the most minimal level of investment strategy, the treasurer can do nothing and leave idle balances in the corporate bank accounts. This is essentially an earnings credit strategy, since the bank uses the earnings from these idle balances to offset its service fees. If a company has minimal cash balances, then this is not an entirely bad strategy—the earnings credit can be the equivalent of a modest rate of return, and if there is not enough cash to plan for more substantive investments, leaving the cash alone is a reasonable alternative.
Strategy-2. Matching Maturity Dates With Cash Flow Availability Dates
A matching strategy simply matches the maturity date of an investment to the cash flow availability dates listed on the cash forecast.
Lie Dharma Company’s cash forecast indicates that $80,000 will be available for investment immediately, but must be used in two months for a capital project. The treasurer can invest the funds in a two – month instrument, such that its maturity date is just prior to when the funds will be needed. This is a very simple investment strategy that is more concerned with short–term liquidity than return on investment, and is most commonly used by firms having minimal excess cash.
A laddering strategy involves creating a set of investments that have a series of consecutive maturity dates.
Lie Dharma Company’s cash forecast indicates that $150,000 of excess cash will be available for the foreseeable future, and its investment policy forbids any investments having a duration of greater than three months.
The treasurer could invest the entire amount in a three – month instrument, since this takes advantage of the presumably somewhat higher interest rates that are available on longer – term investments. However, there is always a risk that some portion of the cash will be needed sooner.
In order to keep the investment more liquid while still taking advantage of the higher interest rates available through longer-term investments, the treasurer breaks the available cash into thirds, and invests $50,000 in a one – month instrument, another $50,000 in a two – month instrument, and the final $50,000 in a three – month instrument.
As each investment matures, the treasurer reinvests it into a three – month instrument. By doing so, Lie Dharma always has $50,000 of the invested amount coming due within one month or less. This improves liquidity, while still taking advantage of longer – term interest rates.
Strategy-4. Tranched Cash Flow
A tranched cash flow strategy requires the treasurer to determine what cash is available for short, medium, and long – term investment, and to then adopt different investment criteria for each of these investment tranches.
The exact investment criteria will vary based on a company’s individual needs, but here is a sample of how the tranches might be arranged:
- The short-term tranche is treated as cash that may be needed for operational requirements on a moment’s notice. This means that cash flows into and out of this tranche can be strongly positive or negative. Thus, return on investment is not a key criterion—instead, the treasurer focuses on very high levels of liquidity. The return should be the lowest of the three tranches, but should also be relatively steady.
- The medium-term tranche includes cash that may be required for use within the next 3 to 12 months, and usually only for highly predictable events, such as periodic tax or dividend payments, or capital expenditures that can be planned well in advance. Given the much higher level of predictability in this tranche, the treasurer can accept longer-term maturities with moderate levels of volatility that have somewhat higher returns on investment.
- The long-term tranche includes cash for which there is no planned operational use, and which the treasurer feels can be safely invested for at least one year. The priority for this tranche shifts more in favor of a higher return on investment, with an attendant potential for higher levels of volatility and perhaps short-term capital loss, with a reduction in the level of liquidity.
To engage in the tranched cash flow strategy, the treasurer should regularly review the cash forecast, and adjust the amounts of cash needed in each of the three tranches. Inattention to these adjustments could result in an unanticipated cash requirement when the cash in the company’s long-term tranche is tied up in excessively long-term, illiquid investments. The preceding strategies were mechanical; the treasurer analyzes cash flows and engages in investments based on cash availability. The next two strategies are more speculative, since the treasurer is guessing at the possible direction of future yields.
Strategy-5. Riding The Yield Curve
Riding the yield curve is a strategy of buying longer-term securities and selling them prior to their maturity dates. This strategy works when interest rates on short – term securities are lower than the rates on longer-term securities, which is normally the case.
Having an upward-sloping yield curve, the longer – term securities with their higher interest rates that are held by the company will increase in value over time. For example, Lie Dharma Company has $75,000 of cash available for investment for a three – month period of time. The treasurer invests in a six – month security and sells it after three months, achieving a higher-than-usual rate of return. However, if the yield curve had changed during the interim, so that short – term rates were higher than long – term rates, then the treasurer would have sold the security and earned a below – market return on the investment.
Strategy-6. Credit Rating
Under a credit – rating strategy, the treasurer buys the debt of a company that may be on the verge of having its credit rating upgraded. By doing so, the investment ends up earning a higher interest rate than would other investments with a comparable credit rating.
This strategy works best when the treasurer is very familiar with the debt issuer and has some confidence in his credit assessment. However, the company’s stated investment policy may prevent the treasurer from buying debt below a fairly high credit rating, which eliminates this strategy from consideration.
Also, it is difficult to time a possible credit-rating upgrade to be within the term of an investment. And finally, delving into lower-grade debt increases the risk of an outright default on payments by the debtor.
For all of the investment strategies noted here, the treasurer must closely monitor the credit rating of the debt issuer. A credit downgrade can result in a substantially lower return to the company if the treasurer needs to sell the debt prior to its maturity date. As a final word of caution; return is least important, do not let return on investment become the key criterion for an investment strategy, or else the attendant increase in risk could result in a significant loss of principal.