Responding to rising risk: the treasurer’s options

With the Eurozone sovereign debt crisis dominating news headlines again, how should local authority treasurers respond to the rise in credit risk levels?  As I see it, there are three main options.

The first is to invest only in organisations that can’t go bust, such as the UK Government and other local authorities.  These safe havens don’t pay a lot of interest, from 0.25% in the Debt Management Account Deposit Facility to 0.85% in a five-year gilt, with local authorities paying no more than 1% higher.  But if security is your over-riding concern to the complete detriment of yield, then that might be OK.  Multilateral development banks like the European Investment Bank used to be considered safe havens too, although with their 5 year bonds trading at over 2%, some would consider them to be a riskier asset class these days.

The second strategy is to pick a number of low-risk commercial organisations to spread your money across, either those whose business model makes them less susceptible to economic conditions (utility companies and food retailers, for example), or those that are likely to be bailed out by the government in times of trouble (banks being the obvious ones).  Investing in companies is not always straightforward though, with settlement and custody expensive unless you can piggy-back on the pension fund custodian.  This leaves most local authorities looking at the fairly small number of banks with adequate credit ratings that accept sterling denominated deposits, and therefore failing to diversify adequately to hedge against the risk of government support not being available.  In trying to manage this risk, there is a tendency to stick to very short-term investments, and then the returns achieved are often no better than those available for longer periods in the very safest places.

So for many treasurers, the third way of external fund management is the winner.  Pooled funds, in particular, will give you much smaller exposures to a much wider range of counterparties, professional fund managers and credit analysts incentivised to act in your best interests, and the potential for the sponsor to step in and support the fund to prevent losses.  Banks will never pick up the phone to warn you they are going to default tomorrow and ask if you’d like to withdraw your deposit early, but money market fund managers will do everything in their power to preserve their net asset value at a constant £1 per share.  I know which one I’d prefer to be relying on.  The other great feature of money market funds is the fact that you have access to longer-term interest rates while retaining short-term notice to your cash.  This allows instant access funds to pay around 0.75% and longer dated funds to pay anywhere between 1% and 3% after fees have been deducted.  You would have to lock into gilts for 25 years to guarantee a 3% return.

As ever, no investment is guaranteed to be the perfect solution – if it was, the returns available would fall until equilibrium was reached – that’s market economics for you.  But if you apply the usual rules of keeping your eyes and ears open, and not putting all your eggs in one basket, you’ll be one step ahead of the investors sleepwalking into another crisis.

David Green is Head of Sterling Consultancy Services, a provider of treasury management advice to local authorities and other not for profit organisations.  This is the writer’s personal opinion and does not constitute investment advice.  It should not be relied upon when making investment decisions.