To boldly go…

Don’t get me wrong, I am not a Trekkie, so as much as some of you may like the idea of this blog being about Spock and co., you may have to look elsewhere. But I would like to talk about frontiers; not the final one but some frontiers that colleagues and I have been working on to raise some interesting concepts about treasury investment performance.  I’d like to share some thoughts with you about efficient frontiers – a reflection of the best returns that can be achieved for various levels of risk, and the role that these could play in a risk-based treasury management strategy.

Before I get going, caveats do apply.  I am not an investment manager, but I am someone who has a keen interest in assisting authorities in squeezing slightly better returns out of their cash without being at the expense of risk.  Everyone needs their assets to sweat harder, and I worry that this increased desperation for higher yield may be pushing the boundaries a little too far out of traditional treasury management in some cases – so I’d like to take a step back and think of more conventional ways in which higher returns can be achieved in a framework which you should be comfortable with and demonstrate how your risk appetite can assist in governing the kind of returns you could be expected to achieve.

I would strongly argue that, for authorities with debt, the starting point for determining your investment strategy should be to quantify the impact of debt repayment; you need to know the impact of putting your surplus funds to use in this risk-free way before you can ascertain how the risks and rewards of various investment strategies can provide opportunities.  Perhaps the IRR is the starting point for this, and targeting loans that get you closer to your liability benchmark. This can effectively provide a rate representing the benefit of investing in buying back your own debt.  Only then should alternative uses for surplus cash be considered; effectively using this IRR as a benchmark.

So, once you have this, the next step is to ascertain whether this target investment rate is likely to be achievable – and with that, it is necessary to think about risk.  The two main investment risks to a local authority treasurer are credit and interest rate risk.  And, as I have blogged about previously, just because the mantra of Security, Liquidity and Yield leads us to focus on the former ahead of yield, this does not mean that the impact of interest rate risk should be a lesser concern.  In fact, in terms of quantum, based on current LA behaviour, it can dwarf credit risk exposures.  Exceptionally low credit risk is being achieved at the expense of protection against adverse interest rates, and over time this has been very costly and is likely to continue to be unless there is a change in the way we approach this dichotomy.  There needs to be an effective balance between the two.

This is where the efficient frontier can comes into play. Those of you involved in pensions are probably familiar with the concept; and it can equally be applied to your treasury investment portfolios, with risk in the treasury context could be taken as a combination of credit and interest rate risk. Of course the methodology of combining these two factors carries with it a fair degree of subjectivity but this alone should not be a reason for starting to look at more holistic approaches.

The chart below illustrates this with an example of two efficient frontiers measured over a ten year duration.  The red line shows a strategy allowing investments in A rated financial institutions for periods up to 5 years.  There is a restriction that no more than 10% of the portfolio can be with any single counterparty, with the exception of gilts and cash (e.g. liquidity funds).  The blue line shows the frontier for the same strategy except allowing up to 10 year duration of individual instruments.

This shows that the longer duration strategy is able to achieve higher expected returns over the 10 years shown here, than is possible under a strategy with more restricted duration. All this without increasing total portfolio risk.  Rather interesting, when we have all been conditioned to think that short duration = lower risk.

So, going back to my starting point, knowing the return I have to achieve to justify not repaying debt, is this possible? And if so, what kind if strategy should be presumed in order to provide me with these expected returns and what risk profile is required?

What I haven’t mentioned so far of course is alpha.  There is value to be added by tactical and executional decisions which may enable returns to considerably exceed the expectations implied by the markets, and the ability for this to be generated should not be underestimated whether that is by the use of external fund managers, or internally with support of consultants or brokers.

So in a nutshell, using a framework such as this to ascertain the returns that could be achieved for a given level of risk, and removing the arbitrary duration constraints can provide significant benefit in the medium term.  So perhaps consider boldly going into longer instruments in a managed credit framework.  Lend long and prosper!

The writer wishes to apologise unreservedly to all Star Trek fans who may have been offended by the inappropriate references in this article.

Jackie Shute is the Co-founder of Public Sector Live a company specialising in local authority treasury risk analytics and the TreasuryLive treasury platform.