The investment policy: Sarbanes-Oxley 'first line of defense'; A properly structured investment policy serves as a roadmap for pursuing a company's investment objectives. But, often these documents contain vague and contradictory language and do not reflect current risk tolerance and liquidity requirements. A cash management expert provides insights on updating your investment policy.
Portfolio Management Strategies
Prior to drafting the investment policy, a company must first determine which of two basic cash management strategies it wishes to pursue. This decision is largely driven by the company's overall investment objectives. Depending on those objectives, companies will typically adopt either an active or a passive portfolio management strategy.
In an actively-traded portfolio, managers often sell securities prior to maturity for various reasons. They might wish to rebalance the portfolio to take advantage of anticipated shifts in the yield curve, or they may elect to adjust the combination of securities to either mimic or diverge from a specific index. This strategy is appropriate for companies seeking above-benchmark returns through more active trading, while being in a position to tolerate capital gains and losses.
When pursuing a passive, or "buy and hold" strategy, portfolio managers generally hold securities to final maturity. While duration and security selections within the portfolio may evolve, the evolution is gradual. Sales of securities prior to maturity typically are executed only in
response to a decline in credit quality or an unanticipated liquidity requirement.
In a passive portfolio management program, every decision the portfolio manager makes must be driven by the three fundamentals of prudent cash management: safety, liquidity and yield, with safety of the cash as the first priority. (For a more comprehensive analysis of these two strategies, see "Choosing the Best Compensation Program," which appeared in the October 2004 issue of Financial Executive. The article is also online at bearcorpcash.com.)
Deficiencies within the investment policy often result in issues companies are required to address and resolve as a result of the independent audit process. These include:
Using Vague Terminology. Any language subject to interpretation may lead to audit issues. For example, while the intent behind a requirement for "immediate credit downgrade notification" may seem clear, it is difficult to quantify a time frame that will satisfy that requirement. "Best net price" is a subjective term and, due to the constantly changing supply of particular securities, it is nearly impossible to quantify. In the case of dealers, there are no universally accepted definitions of "reputable" or "principal."
Specifying Concentration Limits by Security Type. Although referencing such limits may be beneficial, including highly detailed concentration limits often requires frequent revision to the investment policy. For example, the policy might set maximum allocations of 40 percent to corporate bonds, 50 percent to commercial paper and 40 percent to auction-rate securities.
Although these allocations may appear to reduce risk, they do not necessarily achieve that objective because, while issuers may default, entire security classes typically do not. Furthermore, corporate entities may issue corporate bonds, commercial paper and auction rate securities and, consequently, a portfolio reflecting such limitations may actually have 100 percent exposure within the corporate sector.
Neglecting to Use Credit Rating Modifiers. As a means of refining their ratings grades, Moody's Investor Services uses numbers 1, 2 and 3 as modifiers; Standard and Poor's uses + and -signs. Since these modifiers effectively split single- and double-A ratings grades into three sub-categories, use of modifiers is recommended.
Tying Maturity Structures to Security Type. Although certain securities, such as Treasuries, are more liquid than others, assigning a different maximum maturity to different types of securities limits the portfolio manager's ability to purchase the most attractive securities on a relative value basis at a particular maturity point. Also, with non-subordinated debt, there is no advantage to distinguishing among different securities issued by the same company. The default risk on General Electric Co. (GE) commercial paper, for example, is the same as that on a GE bond with an equivalent maturity. Such distinctions simply serve to complicate the portfolio manager's compliance responsibilities without any corresponding decrease in risk.
Limiting Issue Size. While the intent behind limiting minimum issue size is to enhance liquidity, especially on short notice, liquidity is not always directly correlated to issue size. A company such as GE may have hundreds of different bond issues outstanding, some of which may be quite small. However, the GE name alone typically results in an active secondary market in its debt. Conversely, less-well-known companies may have only one or two debt issues outstanding. Although individual issues may be quite large, there may be a "thinner" secondary market for that security because there is little overall debt outstanding.
Specifying "Approved Countries." Investment policies often include a list of "approved" countries and specify that securities issued in "unapproved" countries are not to be included in the portfolio. These types of provisions can be problematic for two reasons. First, in today's expanding global economy, U.S. companies often issue debt through non-U.S. subsidiaries and vice versa.
For example, American International Group (AIG), which is headquartered in New York City, issues some of its debt through a Cayman Islands subsidiary; Japanese auto maker, Toyota Motor Corp., has significant outstanding U.S. dollar-denominated paper issued under Toyota Motor Credit, which is based in Los Angeles.
Second, the criteria that govern the assignment of ratings do not differ from country to country. The financial metrics of a double-A rated British or Canadian company, for example, will be the same as those of a U.S. company. Consequently, risk assessment should be performed on the issuer, not the country of issue.
Although the rationale behind including an "approved countries" list may be to safeguard the portfolio from investment in countries with poor investor safeguards and heightened social and political risks, the types of high-grade issuers in a position to access the U.S. capital markets are not typically headquartered in such countries. Moreover, portfolio managers typically avoid issuers in countries with such risks.
Investment Policy 'Essentials'
Properly drafted investment policies generally comprise four main sections: Authorized Securities, Concentration Limits, Maturity Structures and Credit Ratings.
* Authorized Securities. Specifies the types of investments authorized for inclusion in the investment portfolio. It is generally recommended that both taxable and tax-free securities be included, regardless of a company's tax status. Making provision for both eliminates the necessity to revise the investment policy in the event of a change in tax status. It is also recommended that the list not preclude any of the various structures within the authorized asset classes.
* Concentration Limits. Specifies the maximum acceptable exposure to any single issuer. This is an especially important provision; it governs the degree of issuer "event risk" in the portfolio--i.e., the degree to which the portfolio can be affected by a decline in the credit quality of an issuer. Concentration limits generally restrict the amount invested in the securities of any single issuer to no more than 10 percent of the total portfolio. Depending on portfolio size and other considerations, managers generally maintain concentration limits at levels significantly lower than the specified maximums.
In the past, Treasuries, money-market funds and government-sponsored enterprises ("agencies") generally have not been subject to this limit. However, recent publicity surrounding the risk associated with agencies has prompted some companies to limit the amount that can be invested in the securities of any single government-sponsored enterprise.
* Maturity Structure. Typically specifies three separate but related components:
Maximum Maturity: Maximum days to maturity of any single security in the portfolio.
Maximum Weighted Average Maturity (WAM): Overall days to maturity of the portfolio as a whole. This provision addresses interest rate sensitivity or portfolio volatility.
Minimum Liquidity Percentage: Percentage of the portfolio or hard dollar amount that is to be retained in very short-term investments or overnight maturities. This enables the company to specify the amount of cash that must be available for withdrawal at any given point in time without the necessity to liquidate longer-term investments.
Acquisitive companies or those requiring cash to meet burn rates or capital expenditures typically specify short maximum and weighted average maturities and greater amounts of liquidity. Companies with larger cash balances and positive cash flow generally specify longer final and weighted average maturities and lower liquidity levels. Companies pursuing an active management strategy and benchmarking performance to a specific index, generally specify maturity structures that mimic the index in question.
* Credit Ratings. Governs the minimum acceptable short- and long-term ratings in the portfolio. Because different types of securities have different risk profiles, ratings may vary by security class. (It is important to note that different security types have different ratings.)
In the context of the current Sarbanes-Oxley environment and as stated previously, the investment policy statement represents a company's most crucial internal control structure. Although creating the investment policy in accordance with the parameters outlined above is a relatively straightforward process, ongoing monitoring of the portfolio for investment policy compliance often proves quite challenging.
However, new reporting systems are now under development, and portfolio managers who embrace them will be in a position to offer a truly innovative client service that includes interactive, Web-based reporting in real time. Such technology undoubtedly will prove extremely valuable to corporate cash managers and their independent auditors in adhering to Sarbanes-Oxley requirements.
Richard Saperstein is a Senior Managing Director at Bear, Stearns & Co Inc., where, as head of the Corporate Cash Management Group, he and his team currently oversee more than $8 billion in client assets. With nearly 25 years experience on Wall Street, he is consistently ranked among the country's leading financial advisors. He can be reached at firstname.lastname@example.org or 212.272.0800.
RELATED ARTICLE: takeaways
* A company's formal investment policy should define, in precise terms, how cash is to be managed.
* The two basic cash management strategies are "active" or "passive." An actively-traded portfolio is appropriate for companies seeking above benchmark returns while being in a position to tolerate capital gains and losses. Using a passive "buy-and-hold" strategy, securities are generally held to final maturity.
* Properly drafted investment policies comprise four sections: Authorized Securities, Concentration Limits, Maturity Structures and Credit Ratings.
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|Date:||Apr 1, 2006|
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