All organisations hold cash on deposit to cover payments arising in the near term. There are two key treasury risks to manage here: getting access to your cash when you need it (liquidity) and receiving back the correct amount without losses (security or credit risk). Earning a return on your investment (yield) is secondary to ensuring the return of your investment.
Government guidance on local authority investments in England, Wales and Northern Ireland is very clear on this point: treasury management investments should prioritise security and liquidity above yield, where security means protecting the capital sum invested from loss.
In normal times you would expect to deposit cash and then withdraw it with added interest at a later date. But what about when interest rates are negative, and you withdraw your cash with interest deducted. Have you broken the golden rule of keeping your investment secure?
It depends on your point of view. Have you got back less than full principal and no interest? Or have you received full principal less the negative interest? I would suggest the second interpretation is the correct one to reflect the negative interest rate. The capital, or principal, sum has been protected from loss.
The alternative viewpoint, that an investment must always be worth more at the end than at the start, could force you into taking higher risks. In the Eurozone, where the central bank policy rate is minus 0.50%, only the riskier counterparties pay as high as 0% for an overnight deposit. And if you want the highest credit quality – German government bonds – you must tie your cash up for at least 30 years to earn as high as 0%.
CIPFA’s Treasury Management Code has a slightly different definition of credit risk - the failure by a counterparty to meet its contractual obligations. Scottish government guidance is worded similarly, talking about the risk of default. Your negative rate investment has met these criteria, as you have received back the contractually agreed amount, even though it is less than the sum you initially invested. Local authorities using Arlingclose’s treasury management strategy template will have explicitly adopted this definition of security since 2017/18.
This discussion around the security of the nominal sum is all very well for the cash held to meet near-term spending commitments. But where reserves are invested for the long-term, the aim should be for the principal to retain its purchasing power, i.e. to keep pace with inflation. If instead of buying 100 widgets for £10,000 each today, you deposit the £1m cash for a year at 1%, you will receive back £1,010,000. But if a year later inflation is 2% and widgets now cost £10,200 each, you can only afford to buy 99 of them. Was that really a secure investment when its real value has deteriorated?
In summary, we would advise all organisations to be wary of adopting too tight a definition of security – there’s nothing wrong with getting back slightly less than you invested in a short-term deposit in today’s market. But for the cash you are confident you will hold for the long-term, you should be considering a more ambitious target that keeps pace with inflation.