Banking: finding hidden value

One of the main challenges facing captives in a low interest rate environment is keeping up with various cash management options. In the best of times most captive managers will only place funds on deposit for less than 12 months, due to the specialised nature of captives. Such entities must have funds available to pay insurance claims as they arise and be able to match the captive’s risk profile, while seeking the best rate of return.

While certificates of deposit (CDs) offer fixed terms and a better return than the normal savings account, other options such as fixed income funds can provide a good alternative to CDs, providing a better rate of return, together with daily liquidity if needed. This can prove very attractive for captive owners. HSBC’s Short Duration Fixed Income Fund offers these advantages and this article examines how.

Interest rates outlook

The minutes of the Federal Open Market Committee meeting in August 2011 show that economic growth remains slow. There is continued weakness in the labour market, and the unemployment rate remains elevated. Although inflation appears to have moderated since earlier in 2011, as prices of energy and some commodities have declined from their peaks, longer-term inflation expectations remain difficult to quantify. Against this economic backdrop the Fed has decided to keep the target range for the federal funds rate at 0 to 25 basis points (or 0.25 percent), a range it forecasts will remain unchanged at least through to mid-2013.

A direct consequence of such a low interest rate environment is the near zero rate available on cash deposits or money market funds. Low interest rates reduce captives’ ability to meet their financial goals. And although inflation risk is not currently manifesting itself, captives must be vigilant and continue to pay close attention to the evolution of inflation and inflation expectations.

Given this market context, corporate treasurers were among the first to question how they should attain a higher return on their cash, while still preserving capital. Treasurers have had to assess their traditional view of cash and examine how complementary investment strategies for operational and strategic cash could optimise the portfolio’s risk-return profile.

Evaluating the nature of cash

It is vital that treasury understands the nature of any surplus cash before an investment decision is made.

Short-term cash surpluses will typically be required by group entities to finance ongoing activities. This cash cannot usually be invested for more than a few days. However, other surplus funds may be available for investment for a longer period.

By identifying the importance of cash to the company’s daily business, treasury can decide how much risk the company can assume. This will determine what type of instruments would be appropriate for operational and strategic cash. One way to do this is to try to classify the cash to be invested by looking at its different levels on the balance sheet (see Chart 1). Cash can be classified in three ways:

• Working capital (operating cash)

• Short-term predictable cash (core cash)

• Long-term cash (strategic cash)

Determining investment options

Whether or not treasury decides to classify cash in this manner, before an investment decision can be taken, three factors need to be determined:

• The currency in which cash is denominated

• The amount of cash to be invested

]• The date when the cash will again be required by the business.

Currency

Treasury should also know the currency in which the significant bank accounts are denominated. For example, international companies often establish cross-border pools for the major operating currencies (typically the dollar and the euro). At the same time, they will maintain local currency pooling arrangements in countries where it is sensible to do so.

Treasury will then need to decide whether it is possible and realistic to physically convert cash into another currency for investment purposes. In practice, cash would have to be available for investment for a number of days to make this worthwhile.

Quantity

For every significant bank account, treasury will have a daily balance forecast. Cash flow forecasts usually become more detailed as the forecast date comes closer.

Each day, treasury will need to update and confirm the cash flow forecast before selecting the investment instrument. For example, sweeps into deposit accounts require the funds to be available at the time of the sweep. A bond purchase will require funds only on settlement date.

Maximum investment period

A forecast of future balances over the next few days and weeks will provide treasury with the opportunity to invest in longer-dated instruments. It will also remove the need for treasury to reinvest all surplus cash on a daily basis. Not having a requirement to reinvest funds will reduce the operational risk associated with investing.

Cash is not always ‘cash’

In a typical liquidity portfolio there are many components that are very different from cash.

There are times when the premiums to include longer components in a treasury portfolio do not compensate for the lack of liquidity and/or market risk. For example, assuming a market where the overnight rate is around 4 percent and the six-month rate is 4.6 percent, the premium to increase the term to six months is 0.6 percent.

In contrast, in times such as these when the overnight is 0-0.25 percent, if you can get 0.55 percent in six months, the premium to go longer will be +0.30 percent. So although the nominal figure is lower, it is more relevant as it represents double the return on the investment.

Therefore, adding longer-dated instruments into the cash management tools enables the returns to be improved without compromising liquidity and security objectives.

"Treasurers have had to assess their traditional view of cash and examine how complementary investment strategies for operational and strategic cash could optimise the portfolio's risk-return profile."

To provide an effective and efficient solution to implement this growing interest in short duration fixed income, HSBC has launched the Short Duration Fixed Income Fund. The fund* comprises a diversified portfolio of high grade, short-term fixed income instruments and offers daily dealing to satisfy clients’ liquidity requirements. With an investment approach that balances income needs, maintains liquidity and reduces the risk of capital deterioration through a robust credit analysis and risk management process, the fund has become a welcome addition to clients’ investment portfolios, in particular among insurance companies.

The fund obtained an ‘Aa’/‘MR2’ rating by Moody’s, reflecting the high quality of the fund portfolio, which is invested in corporate and government securities with an average rating ‘AA’. It also reflects the rating agency’s expectation that the fund will exhibit low sensitivity to interest rates and other market conditions. It is expected that the fund will maintain a buy and hold strategy rather than seek to earn excess returns. The fund’s duration profile will typically be between one and three years, currently 0.74 years as of September 2011.

An important consideration for investors such as captives and reinsurance companies is how effectively the portfolio can be used as collateral for their letters of credit. In this case, a collateral value of 95 percent has been established for letters of credit issued by HSBC.

As we move into 2012, review of internal rates of return versus asset management yields will continue to be a vital balancing act until there is an upswing in interest rates. As the rate environment changes, clients will continue to focus on their investment objectives and risk-adjusted returns. We will continue to work with our clients to ensure that they are employing the best strategies throughout the market cycle.

Dwight Merren is relationship manager, Captive Insurance at HSBC Corporate Banking (Cayman). He can be contacted at: dwight.l.merren@ky.hsbc.com

Claudio Lede is the head of product development and marketing at HSBC Global Asset Management (Bermuda) Limited. He can be contacted at: claudio.lede@hsbc.bm

Louise Twiss West is the head of business development at HSBC Global Asset Management (Bermuda) Limited. She can be contacted at: louise.twiss-west@hsbc.bm

As of June 2011, HSBC Global Asset Management had $453.4 billion in assets under management globally, including $189.5 billion in liquidity and $94.8 billion in fixed income. HSBC Global Asset Management Bermuda manages more than $4 billion in insurance assets from over 500 clients.

*The Short Duration Fixed Income Fund is a class of HSBC Specialist Funds Limited, which is managed by HSBC Global Asset Management (Bermuda) Limited.

Issued by HSBC Bank Bermuda Limited, 6 Front Street, Hamilton HM 11, Bermuda (HSBC), which is licensed to conduct Banking and Investment Business by the Bermuda Monetary Authority. HSBC Global Asset Management (Bermuda) Limited is a wholly owned subsidiary of HSBC and is licensed to conduct Investment Business by the Bermuda Monetary Authority. Expressions of opinion are subject to change without notice.