Pierre Paul of Royal London Asset Management (RLAM) discusses the investment options, risks and rewards, available to cell captives.
Cash is an integral and often very significant component of a cell captive's balance sheet which, like any other asset, should be looked after properly in order to get the best result.
At RLAM we have always treated cash as an asset class in its own right. This means that we employ managers, systems and tools whose exclusive focus is cash, with the aim of giving our clients an unrivalled experience in terms of service and performance.
As at 31 May 2013, RLAM had in excess of £46bn of assets under management (AuM) – of this figure over £5bn is managed by the cash team. Our cash management approach is not merely placing money on deposits with banks. We have more than 25 years' experience in managing cash and have built a sophisticated system which employs a wide range of investments.
Selecting the appropriate investment type and duration is essential to achieving long-term performance gains. Our investment managers do this with the support of the RLAM asset allocation committee, which includes our group economist and the headsof all RLAM's asset classes; comprising gilts, bonds, equities, credit, property, derivatives and of course cash. The asset allocation committee meets weekly to discuss market developments. Following a market level/RLAM forecast comparison, we often reappraise our current asset allocation and adjust our investment policy to refl ect any outlook changes. The IT platform that is used to manage our investments was designed and written in-house specifically for our cash team. It provides a real-time dealing environment and allows us to provide clients with a wide range of reports, either daily or for any specified date range. Investment types used include deposits, treasury bills, certificates of deposit, commercial paper, floating rate notes, gilts and bonds.
Deposits: A sum of money placed on deposit with a licensed deposit taker such as a bank or building society. It may be placed on a variety of terms such as instant access call, notice call, overnight or fixed deposit. Based on the currency, interest rates vary depending on the deposit's duration and size and the credit rating of the deposit taker. The rate paid by the deposit taker reflects the perceived risk being taken by the depositor. The longer the deposit's duration, the higher the interest rate, in recognition of the liquidity risk being taken.
Certificates of deposit (CD): A CD is like a fixed deposit, with a certain cash sum, an interest rate and a maturity date. However, because a CD is a negotiable financial instrument it can be sold before the maturity date. This allows the CD holder to liquidate the investment and receive cash without penalty. CDs are issued by banks and building societies. The interest rate depends on the CD's maturity date and on the issuer's credit rating. The longer the duration of the CD and the lower the borrower's rating, the higher the interest rate will be in recognition of the liquidity risk taken by the investor.
Treasury Bills (T Bills): T Bills are short-term debt instruments issued by the UK and US Treasury on behalf of their respective governments.
They are most often issued for three months but can be issued from one to six months. Cash is usually invested in T Bills for security as opposed to return as they carry the same credit rating as the issuing authority (UK or US Government). The current UK credit ratings are Aa1 (Moody's Rating Agency) and AAA (Standard & Poor's). The current US credit ratings are Aaa (Moody's Rating Agency) and AA+ (Standard & Poor's). High ratings imply an undoubted ability of the issuer to repay and, accordingly, the interest rate on T Bills is relatively low compared to other investments or deposits of a similar duration. Because T Bills are such high-quality investments, they are very liquid, meaning they can be turned into cash for same-day value. In times of financial stress, T Bills are seen as a safe haven for cash. They are issued and traded at a discount- to-face value. If an investor buys £1mnominal of a UK T Bill, they actually pay less than £1m and will only receive the full amount on maturity.
Government bonds: The majority of bonds issued by governments are fixed interest – the interest rate is fixed for the bond's lifetime. Historically, UK Government-issued bonds were known as gilt-edged stock because of the gold (gilt) edging printed around each certificate, hence they are known as Gilts. They carry the credit rating of the issuing government. The high ratings also reflect the undoubted security of these bonds, making the bonds' interest rate relatively low compared to bonds of a similar duration with an inferior rating.
Given their low interest rates, UK gilts and US bonds are not a natural investment choice unless the investor is looking for absolute security. However, they can deliver capital gains if their market value (financial market price) rises. Prices can rise for numerous reasons, for example when bank or Federal Reserve rates are cut or when investor demand increases. Prices also fall when an official rate rise takes place or is anticipated. Astute investors can take advantage of such price movements to make money.
Corporate bonds: These have similar features to government bonds but are generally less well rated and seen as less secure (dependent on actual ratings). A well rated US dollar corporate bond issued by General Electric Capital Corporation is seen as safe and secure, therefore its yield would be comparable to a US Government bond of the same duration. To achieve a higher corporate bond yield, investors would have to buy a bond issued by a lower-rated company. Such bonds are seen as less secure and less liquid, making them harder to sell in difficult financial times. Corporate bond prices rise and fall for the same reasons as government bonds. Changes bank. This process, known as a "haircut", effectively forces losses onto bond holders.
Floating rate notes (FRN): These are corporate bonds but have an interest rate which floats up or down depending on market rates. The interest rate terms on an FRN are set by the issuer. Typical terms might be that the paid interest rate will equal three month GBPLIBOR plus 0.25%. Currently three month GBP LIBOR is 0.49%, so an FRN at this rate would yield 0.74%. The actual rate is reset at given intervals, often quarterly. FRNs are particularly attractive investments in a rising rate environment as the return an investor earns will rise as market and/or official rates rise.
Commercial Paper (CP): CP is short-term company-issued debt. The maximum maturity of CP is one year but most issues are for three months' maturity. Like T Bills, CP is issued at a discount-to-face value. The attraction of investing in CP is that its yield is often higher than other investments of a similar duration, such as T Bills or fixed deposits. CP investment is also a way of increasing diversification away from the banking sector.
RLAM is a sophisticated investment management operation backed by the UK's largest mutual insurance company. Our experience in managing cash portfolios shows itself in the range of investment types described above, which are found across our client portfolios. This wealth of expertise has, over the years, helped our clients enjoy positive returns, diversification and security. Our service levels were set very high from the outset and still apply in today's fast-changing environment.
Pierre Paul is managing director of RLAM CI, a wholly owned subsidiary of Royal London Mutual Insurance Society Limited. His Guernsey-based operation manages investment portfolios on behalf of over thirty captive insurance companies based in Guernsey, Gibraltar, Malta and Bermuda as well as providing security interest agreements.
Originally published in Captive Review's Cell Company Guide 2013, July 2013.
For more information about Guernsey's finance industry please visit www.guernseyfinance.com.
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