The Bonds That Tie Investment Goals Together.

The tapestry of a corporate balance sheet reflects the craftsmanship of the organization's financial artisans. Illuminating the balance of equity vs. debt financing and the blend of fixed and financial assets, the balance sheet weaves together the critical elements of a company's story. The flow from the balance sheet to the income statement highlights the successes and failures of the financial and business plans. On close examination, fixed-income securities appear to be a recurring and important thread.

Fixed-income securities are prominent on both the asset and liability sides of the balance sheet. But the investment of balance sheet cash involves some variables, and there's a way to maximize return with minimal additional risk. While borrowing is important to financial flexibility, the art and science of managing debt issuance is another story. Let's look at the investing aspects of fixed income.

Common to all investing, whether balance sheet cash or pension assets, is the need for a disciplined, controlled investment process. The first and most important step is to thoroughly understand the return objectives, risk profiles and any special circumstances that might affect the management of the portfolio. Committed to paper, this makes up the investment policy statement, which becomes a road map. Be sure to have one in place before beginning your investment program.

Balance Sheet Cash

The dynamic nature of the corporate engine necessitates that some cash generally be available to cover anticipated operating expenses. Cash functions as a lubricant to operate efficiently and, in some instances, as a war chest for maximum acquisition flexibility. As a result, safety of principal is generally more important than return for this balance sheet item, leaving the other assets to reflect the general business risk. While such safety should be the primary objective of the investment policy statement, it need not be mutually exclusive of competitive returns.

The mathematics of fixed-income securities require that investment of balance sheet cash be kept short so any increase in interest rates won't erode principal appreciably, consistent with the primary objective. The obvious choices -- bank sweep vehicles, money market funds or discrete money market instruments -- have varying advantages. But all maximize liquidity and safety in one way or another. Bank sweep vehicles are typically the lowest-yielding, but are the most convenient. With time at a premium for senior financial officers this convenience often wins out over chasing higher-yielding money market funds or rolling 60-day commercial paper, especially for smaller cash balances.

As cash balances grow, the cost of convenience becomes significant, so consider alternatives. By reviewing cash flow projections for the next several months, you can identify a minimum projected cash balance. This minimum projected balance can go in a higher-yielding money market fund or, better still, be invested in discrete commercial paper issues. The minimum size for a stand-alone commercial paper portfolio should be $10 million -- a sufficient size to diversify credit risk.

With a detailed investment policy statement in place, a junior financial officer or professional cash manager can handle this responsibility. An experienced professional should easily add value, after fees, to a bank sweep vehicle or money market fund. Balance sheet cash management is a competitive service, with fees generally below 25 basis points -- well under the fees for an inexpensive money fund.

The Next Step

For most established companies, there's an even greater opportunity to augment returns on cash balances with minimal, albeit some, additional risk. Cash-flow-positive corporations continuously overestimate their cash needs with too conservative an investment policy statement. A trip to the equity or debt market for financing, or seasonal timing of internally generated funds, usually prevents the company from depleting balances below a certain minimum. It's this cash, well above the high-water mark for quarterly in/out flows, which can be worked much harder. By moving this structural cash balance farther out the yield curve, to an average maturity of two years and a maximum maturity of three years for any single issue, the benefit of an upward-sloping yield curve and wider credit spreads will accrue.

Looking at the yield curve benefit first, the average spread between the three-month Treasury bill and two-year Treasury note (weekly) for the 10 years ending December 1999 has been 81 basis points. By picking up the yield curve only, the average additional annual income on $10 million would have been $81,000. On several occasions during the past 10 years, however, the yield curve inverted at the short end, and three-month Treasury bills actually yielded more than the two-year note for brief periods in 1990, 1995, 1996 and 1998. Nevertheless the average spread for these years was 42 bp, 49 bp, 69 bp and 24 bp, respectively.

While the steepness of the yield curve gives some indication of the benefit of extending, it's important to examine the attendant risks to decide if the tradeoff is prudent. As we know, within the bond market, longer maturities exhibit greater price volatility than shorter maturities with a given change in interest rates.

The table below provides useful guidance for corporate cash managers. The right-hand column, Treasury Master, identifies the annualized rate of return of the U.S. Treasury market over the past 10 years. Immediately below the 7.46 percent return is the risk of 2.52. Using this as a benchmark for comparison, the other columns compare the return and risk of a particular maturity bucket against the Treasury Master.

Focus on the one-year to three-year maturity bucket. An annualized return of 6.59 percent represents 88.3 percent of the return provided by the entire U.S. Treasury market over this period. Most interestingly, this return was provided at less than half the risk, 44%. While not as low-risk as three-month Treasury bills, the risk is manageable and the return advantage significant.

During the 40 calendar quarters the table covers, there was only one instance of negative quarterly total returns for one-year to three-year year Treasuries (Q1-1994, as the two-year Treasury rose in yield from 4.23 percent to 5.18 percent and the Fed tightened by 50 bp), and no negative yearly total returns. The lowest annual total return was 0.57 percent in 1994; the highest was 11.68 in 1991. The average annualized total return was 6.59 percent.

Remember, these are total returns, or coupon yield plus any principal appreciation or depreciation during the quarter -- not yield. Only if the bonds were marked to market through the income statement would these total returns have been realized. Holding to maturity results in a higher yield and greater income.

Substituting a broad portfolio of corporate bonds in the one- to three-year maturity range for Treasuries over the same 10-year period, there was only one quarter of negative total return (Q1-1994) and no annual negative total return. The lowest annual total return was 1.18 percent in 1994, while the highest was 13 percent in 1991. The average annualized total return was 7.33 percent, a full 74 basis points over one- to three-year Treasuries. The additional yield of corporate bonds over Treasury instruments cushions the principal erosion in bad market years and augments the return in good years.

Thus, by extending the yield curve with the portion of the corporation's cash that serves as core, you can garner a meaningful total return and yield enhancement over conventional 90-day money market instruments. Further, by utilizing corporate debt alone or in combination with Treasuries, you can harvest significant additional returns. This strategy increases portfolio risk minimally, particularly as it's applied to only a small percentage of the total cash balance.

Since fixed-income securities thread throughout (on and off) the corporate balance sheet, you must understand their many roles. Just as the elegance and value of a fine tapestry lies in the detail of the embroidery, the precision of the stitch and organization of the motif, successful implementation of a fixed-income program lies in detailed preparation, skilled execution and congruence with overall corporate goals.

Todd A. Finkelstein, CFA, is senior vice president and director of fixed income at Boston Advisors Inc. in Boston. He can be reached at [phone].