Is Portfolio Risk Safe Again?

By Barbara Shegog, CPA, CFA

The investment environment looks and feels good. But one may still wonder: Is now the time to increase the risk in your investment portfolio? 

Like the oft-asked question by restless kids in the back seat, “Are we there yet?” the question on the lips of many a treasury investment manager is: Is now the time to increase the risk in your investment portfolio?

The answer is a definite no, maybe and yes. How can this be the answer? After all, interest rates appear stable, corporate fundamentals are improving, and time has allowed many of us to feel that the dark days of the credit crisis are behind us. One would think the answer would be quick affirmation. But the true answer and the reason it’s not a quick “yes” is that it depends on the reasons.

So, if the reason is, “I am really sick and tired of these yield levels, so maybe if I add risk, I can pick up some incremental yield,” then the answer is no. Or if the thinking is, “We have the ability to take on more risk per our guidelines, we are a little nervous about adding credit, but we are concerned about interest rate increases,” then the answer is maybe. However, if the reason is, “We shifted to cash during the credit crisis, we do not require immediate liquidity and have been waiting to jump back in,” then the answer is an absolute yes.

At this point in the recovery if you fall into any bucket, it is most likely a toss up between “maybe” and “yes.” However, given some of the fundamentals, you should be biased if not heavily leaning toward “yes.” That’s because most economist predictions say rates are not projected to move drastically higher, the aforementioned improving corporate fundamentals—profits at US corporations grew 36.8 percent in 2010 and 2011 is looking good, too—and last but not least, those higher teaser bank deposit rates are ancient history.

Finally, in some cases, management may have “low-yield” fatigue and pressuring investment managers to eke out better returns.

Of course the best recommendation is to stay true to your investment policy. You worked hard on this document and it should be aligned with the spirit and goals of the company. During the crisis, many investors removed credit or fled to money-market instruments but still maintained the same investment policy.

But now is the time to explore removing those temporary bans. And to update the investment policy if you feel it no longer accurately reflects the goals and objectives of the corporation.

After the policy is spruced up, meet with your investment manager and ask them a lot of questions (see, “Questions to Ask Your External Cash Manager,” iTreasurer, October 2010).

Question time

A good investment manager should be able help you with all of the answers. Keep in mind that the manager takes cues from you (and your questions). Therefore, it’s important to give them the opportunity to walk you through the pros and cons of any approach; otherwise you risk leaving money on the table. With that last suggestion in mind, here are some questions to pose to your investment managers and some guidance on why you are asking:

• Given that rates have been so low for so long, is now the time to increase my interest-rate exposure? Whenever you are looking at a positively sloped yield curve, you must always ask this question. Identify your company’s needs. Can you bifurcate a portion of the investment portfolio to take on more interest-rate exposure? Do you need so much liquidity?

An informal poll of corporate cash managers found that almost all the managers had a very similar interest-rate outlook. They believe the Federal Reserve will hold rates steady until 2012. All believe the economy to be showing few signs of inflation with both housing and unemployment remaining a big concern. Now might be the time to consider shifting out of money funds (particularly considering they are at their lowest rate in almost a year) or bank deposits, or wherever you have cash sitting.

Another benefit of increasing duration in the investment portfolio is diversification. The investment manager will have an expanded universe that is not money-market eligible. With less demand comes an increase in yield. If you are nervous still about an increase in rates, then ask your manager to provide you with a stress test. This will provide you a scenario to guide decision making should interest rates suddenly shift.

But with the Federal Reserve projected to be on hold for at least the balance of 2011, combined with a positive carry, if you have the risk appetite it makes sense to consider moving cash slightly further out on the curve. However, if you’re an outlier who expects rates to increase a good hedge against rising rates is corporate credit. This leads to the next question.

• Should we increase our corporate credit exposure? Yes, a case can be made for adding or increasing a weight to corporate credits. Again, another informal poll of corporate cash managers showed most managers with the ability to use corporate credit in portfolios are using their maximum allowed exposure. All feel that corporations have healthier balance sheets, most are building cash and in general are poised to perform well. All of these factors are positive for the corporate bond buyer. You might even want to consider adding BBB credits.

In addition to a yield advantage, the sector diversification improves. For example the portfolio with an A or better restriction would have a higher percentage in the bank and finance sectors than a portfolio that could purchase BBB issues.This portfolio has more opportunity to expand into the utility or industrial sectors for example. To make this move you do need to feel confident that your investment manager has the expertise to manage the default risk.

• Finally, is now the time to jump back into the ABS market? This is perhaps the scariest option. Most corporate cash portfolios have banned any form of asset-backed securities. Who could blame corporations for taking this position? But a case can be made for adding non-mortgage ABS issues, such as credit-card ABS. But again, here you need to be comfortable that the manager has the proper due-diligence process in place.

Get exposure

So, the short answer to what appears to be a simple question is actually a yes but a “qualified” one. Yes the fundamentals and current opinion do support adding some interest-rate exposure, continuing purchases of high-quality corporate issues, and even considering the dreaded ABS issues. And yes, there is generally a stable feel to the environment, be it for rates, corporate profits and other areas of the economy.

However, there remains much uncertainty—European sovereign debt problems, natural disasters and civil unrest in the Middle East and North Africa—so perhaps taking baby steps toward adding risk is best.

But remember the most important thing is to stick to your investment policy; don’t reinvent something simply because yields are low. If need be, think about changing your investment policy. Decide the best way to use your risk budget; there are several great options.

For more information contact Barbara at Harrison Fiduciary Group, LLC; +1-617-830-5773 or [email protected].