How negative interest rates will affect treasury

How negative interest rates will affect treasury

A few years ago it was deemed highly unlikely that euro interest rates would move below the perceived floor of zero. Nowadays, we encounter a sub-zero interest-rate environment that raises many challenges for a treasury department. In our opinion, the challenge of negative interest rates for treasurers can be considered as challenges for the treasury operations and challenges from an investment perspective.

Challenges in treasury operations

Let us start with the treasury operations. It is a fact that many treasury systems and financial contracts are not prepared for the possibility of negative interest rates. For example, many treasury management systems (TMS) do/did not support negative interest rates. There are work-arounds so that you end up with a negative rate (e.g. adding extra fees/mark-offs), but this is not ideal. We have seen most TMS suppliers releasing new upgrades to cope with negative interest rates. Even for the TMSs that support negative interest rates, the functionality has not always been configured to do so.

So negative interest rates could mean upgrading and re-implementing treasury management and ERP systems. The sub-zero interest rate also affects companies for which an interest rate floor of zero is included in the loan documentation, but is excluded in the interest rate swap. This impacts hedge effectiveness and could jeopardize hedge accounting. Treasurers should investigate if the interest rate hedging products they use are still effective, to avoid unexpected adverse financial results.

Challenges in investing

From an investment perspective, treasurers might explore alternative investment solutions to secure some return on capital. However the credit crisis has taught us that the primary objective should be the return of capital not the return on capital. We still believe investments should be made according to the SLY approach. The first objective is Security, which can be measured by a combination of credit ratings, CDS levels and other types of investment products. The next one is Liquidity, which is the ability to quickly sell the investment without affecting the asset’s price. Finally the treasurer should think about the yield on the investment. Optimizing yield should be based on the prerequisites as defined by security and liquidity. We feel that it would be a mistake to compromise on these two factors in order to achieve a positive yield in a sub-zero environment.

We believe treasurers should always look at the opportunity costs when investing, taking into account the SLY principle, despite the level of interest. From a strategic point of view, the low interest rate environment should not change treasury decision-making, as long as the spread between debit and credit interest remain stable, the absolute opportunity costs may change compared to different alternative investments, but the sequence will not. Treasury’s investment decision should always be aligned with the corporate strategy and shareholder expectations, therefore communication is key before engaging in, for example, significant debt repayments and dividend pay-out programs.

Psychological point of view

It is paramount to realize that, from a psychological point of view, it is difficult for people to accept a low or even negative yield on investments. This aversion to loss can result in increased risk taking. To ensure the treasury organization makes rational investment decisions, a strong treasury framework should be in place with up-to-date treasury policies. It is important that treasury’s mandate and the levels of risk it can take are clear and formally documented. To monitor risks, key risk indicators (KRIs) can be set up, so that treasury can monitor investment risks in an objective manner, for example by assessing the concentration risk and credit risk of financial counterparties.

Common investment opportunities

There are different positive actions to be taken to lessen the impact of negative interest rates. The first action is to centralize as much cash as possible. In this way only the header accounts of cash pools are affected by negative interest rates and only they need to be invested. The major banks offer a fine array of liquidity management products designed for this purpose.

A commonly used investment solution is to place excess cash on a bank time deposit. However, cash management banks (especially during times of potential liquidity crises) prefer long-term, ‘sticky’ money (operating balances) to short-term deposits and, before going down the term deposit route, it would be worth negotiating hard with the concentration bank for an enhanced yield on the header account(s). This might also prove simpler from an administration perspective.

Furthermore, there are opportunities in diversification of investments between banks. Generally speaking, one can improve the expected risk/return pay-off on an investment portfolio by using imperfect correlations between asset classes. This kind of risk/return optimization is the cornerstone of many investment mandates of asset managers. The opportunities to achieve interest optimization by diversifying deposits between banks are limited, however, because the return on bank deposits is highly correlated. Nonetheless, there are opportunities to diversify the counterparty risk.

Alternative investment opportunities

Another positive action is to ‘invest’ the cash that is available in a supplier finance project, such as invoice discounting. Advantages of using excess cash to pay your suppliers early are

(1) the potential enhanced relationship with your suppliers,
(2) the reduced risk of default of your suppliers as their working capital is reduced and
(3) the yield the corporate can earn by taking advantage of any discount.

In the longer term, excess cash can be used to pay-down debt. However, the business case for such a liability management action depends on both the long-term funding requirement and the steepness of the yield curve. If the yield curve is steep (difference between short-term and long-term interest), buying back debt with negative yielding excess cash creates a positive NPV.

Additional benefits of reducing gross debt and shortening the balance sheet are improved leverage ratios which could increase the company’s credit rating. A final positive action is to take advantage of the impact of the low interest rate on the WACC (weighted average cost of capital) or other investment hurdle rates. With a lower WACC, excess cash can be made available for acquisitions or CAPEX as the lower discounting rate increases the NPV of such investment opportunities.

Prepared for the future

John Maynard Keynes once said: “The expected never happens; it is the unexpected always”. Interest rates might move up or decrease even further, unrest in the financial markets might increase or move back towards (a new) normal after Brexit, other EU countries might follow the path of the United Kingdom, or they might not. With uncertainty about what the future will bring us, treasury should be prepared for the unexpected. With a strong treasury framework, up-to-date policies, a clear treasury mandate and fit-for-purpose treasury systems in place, the treasury organization will be future proof.