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CHAPTER THIRTY-FOUR

Corporate Investments in Securities

THIS CHAPTER COVERS how to manage a company’s surplus liquidity funds. A firm’s surplus funds or idle cash is usually considered only temporary. The funds should be made available to cover a shortfall in cash flow or working capital or to serve as a reservoir for capital spending and acquisition. Many companies flush with cash have been redeploying surplus cash—not only in increased dividends and mergers and acquisitions (M&A) activity but also in share buybacks, debt payouts, and in some capital expenditures.

CASH AND LIQUIDITY MANAGEMENT

Cash is king in businesses. Without cash and liquidity management, businesses will not survive one day. Most CFOs are conservative (not speculative) when considering investing idle cash in financial securities since they believe the money should be on hand without loss in value of the funds when needed.

How is this surplus cash used?

Generally, there are five choices:

What are the investment practices?

Here are some new insights on the investment tendencies of corporate investment officers, based on the Fortune 1000 list of large industrial firms. Respondents were asked to describe their own approach to cash management as aggressive, moderate, or passive. We focus on two types—aggressive and moderate. Respondents were asked to identify the percentage of their short-term portfolios invested in the typical marketable securities. The five most popular vehicles and the respective percentages are presented in Exhibit 34.1.

EXHIBIT 34.1 Investment Practices by Cash Managers

Type of Security	Aggressive Manager	Moderate Manager
Treasury securities	5.55%	8.82%
Commercial paper	18.16	17.53
Domestic certificates of deposit (CDs)	11.45	6.87
Eurodollar CDs	36.77	24.28
Repurchase agreements (repos)	11.27	18.99
Source: A. W. Frankle and J. M. Collins, “Investment Practices of the Domestic Cash Managers,” Journal of Cash Management (May 1987).

The survey indicates that Eurodollar CDs are preferred by aggressive cash managers, with commercial paper being ranked second and domestic CDs ranked third.

The moderate cash managers also preferred Eurodollar CDs, with repos ranked second and commercial paper third.

As for the question on which investment attributes shaped their ultimate investment decisions, the aggressive cash managers ranked yield first, risk of default second, and maturity third, while the moderate managers ranked risk of default first, yield second, and maturity third.

What are the types of securities?

Securities cover a broad range of investment instruments, including common stocks, preferred stocks, bonds, and options. Two broad categories of securities are available to corporate investors: equity securities, which represent ownership of a company, and debt (or fixed income) securities, which represent a loan from the investor to a company or government. Fixed income securities generally stress current fixed income and offer little or no opportunity for appreciation in value. They are usually liquid and bear less market risk than other types of investments. This type of investment performs well during stable economic conditions and lower inflation. Examples of fixed income securities include corporate bonds, government securities, mortgage-backed securities, preferred stocks, and short-term debt securities.

Each type of security has not only distinct characteristics but also advantages and disadvantages. This chapter focuses on investing in fixed income (debt) securities—especially those with short- and intermediate-term maturity—normally utilized by corporate investors.

What are the factors to be considered in investment decisions?

Consideration should be given to safety of principal, yield and risk, stability of income, and marketability and liquidity.

• Security of principal. This is the degree of risk involved in a particular investment. The company will not want to lose part or all of the initial investment.
• Yield and risk. The primary purpose of investing is to earn a return on invested money in the form of interest, dividends, rental income, and capital appreciation. However, increasing total returns would entail greater investment risks. Thus, yield and degree of risk are directly related. Greater risk also means sacrificing security of principal. A CFO has to choose the priority that fits the corporation’s financial circumstances and objectives.
• Stability of income. When steady income is the most important consideration, bond interest or preferred stock dividends should be emphasized. This might be the situation if the company needs to supplement its earned income on a regular basis with income from its outside investment.
• Marketability and liquidity. This is the ability to find a ready market to dispose of the investment at the right price.
• Tax factors. Corporate investors in high tax brackets will have different investment objectives from those in lower brackets. If the company is in a high tax bracket, it may prefer municipal bonds (interest is not taxable) or investments that provide tax credits or tax shelters, such as those in oil and gas.

In addition, many other factors need to be considered, including:

• Current and future income needs
• Hedging against inflation
• Ability to withstand financial losses
• Ease of management
• Amount of investment
• Diversification
• Long-term versus short-term potential

What are the questions to be asked?

In developing the corporation’s investment strategy, it will be advisable to ask these questions:

• What proportions of funds does the company want safe and liquid?
• Is the company willing to invest for higher return but greater risk?
• How long of a maturity period is the company willing to take on its investment?
• What should be the mix of its investments for diversification?
• Does the company need to invest in tax-free securities?

What are the types of fixed income investment instruments?

A CFO can choose from many fixed income securities. They can be categorized into short-term and long-term investments:

Short-Term Vehicles

• U.S. Treasury bills
• CDs
• Banker’s acceptances (BAs)
• Commercial paper
• Repos
• Money market funds
• Eurodollar time deposits

Long-Term Vehicles

• U.S. Treasury notes and bonds
• Corporate bonds
• Mortgage-backed securities
• Municipal bonds
• Preferred stock, fixed or adjustable
• Bond funds
• Unit investment trusts

What are the advantages and disadvantages of owning bonds?

A bond is a certificate or security showing the corporate investor lent funds to an issuing company or to a government in return for fixed future interest and repayment of principal. Bonds have these advantages:

• There is fixed interest income each year.
• Bonds are safer than equity securities such as common stock. This is because bondholders come before common stockholders in the event of corporate bankruptcy.

Bonds suffer from these disadvantages:

• They do not participate in incremental profitability.
• There are no voting rights associated with them.

TERMS AND FEATURES OF BONDS

A corporate investment officer should be familiar with certain terms and features of bonds, including:

• Par value. The par value of a bond is the face value, usually $1,000.
• Coupon rate. The coupon rate is the nominal interest rate that determines the actual interest to be received on a bond. It is an annual interest per par value. For example, if a corporate investor owns an $11 million bond having a coupon rate of 10 percent, the annual interest to be received will be $100,000.
• Maturity date. It is the final date on which repayment of the bond principal is due.
• Indenture. The bond indenture is the lengthy, legal agreement detailing the issuer’s obligations pertaining to a bond issue. It contains the terms and conditions of the bond issue as well as any restrictive provisions placed on the firm, known as restrictive covenants. The indenture is administered by an independent trustee. A restrictive covenant includes maintenance of (1) required levels of working capital, (2) a particular current ratio, and (3) a specified debt ratio.
• Trustee. The trustee is the third party with whom the indenture is made. The trustee’s job is to see that the terms of the indenture are actually carried out.
• Yield. The yield is different from the coupon interest rate. It is the effective interest rate the corporate investor earns on the bond investment. If a bond is bought below its face value (i.e., purchased at a discount), the yield is higher than the coupon rate. If a bond is acquired above its face value (i.e., bought at a premium), the yield is below the coupon rate.
• Call provision. A call provision entitles the issuing corporation to repurchase, or “call,” the bond from holders at stated prices over specified periods.
• Sinking fund. In a sinking fund bond, money is put aside by the issuing company periodically for the repayment of debt, thus reducing the total amount of debt outstanding. This particular provision may be included in the bond indenture to protect investors.

What are the types of bonds?

Among the types of bonds available for investment are:

• Mortgage bonds. Mortgage bonds are secured by physical property. In case of default, bondholders may foreclose on the secured property and sell it to satisfy their claims.
• Debentures. Debentures are unsecured bonds. They are protected by the general credit of the issuing corporation. Credit ratings are very important for this type of bond. Federal, state, and municipal government issues are debentures. Subordinated debentures are junior issues ranking after other unsecured debt as a result of explicit provisions in the indenture. Finance companies have made extensive use of these types of bonds.
• Convertible bonds. Convertible bonds are subordinated debentures that may be converted, at the investor’s option, into a specified amount of other securities (usually common stock) at a fixed price. They are hybrid securities having characteristics of both bonds and common stock in that they provide fixed interest income and potential appreciation through participation in future price increases of the underlying common stock.
• Income bonds. In income bonds, interest is paid only if earned. Such bonds are often called reorganization bonds.
• Tax-exempt bonds. Tax-exempt bonds are usually municipal bonds where interest income is not subject to federal tax, although the Tax Reform Act of 1986 imposed restrictions on the issuance of tax-exempt municipal bonds. Municipal bonds may carry a lower interest rate than taxable bonds of similar quality and safety. However, after-tax yield from these bonds are usually more than of bonds with a higher rate of taxable interest. Note that municipal bonds are subject to two principal risks: interest rate and default.
• U.S. government and agency securities. They include Treasury bills, notes, bonds, and mortgage-backed securities, such as Ginnie Maes. Treasury bills represent short-term government financing and mature in 12 months or less. U.S. Treasury notes have a maturity of 1 to 10 years, whereas U.S. Treasury bonds have a maturity of 10 to 25 years and can be purchased in denominations as low as $1,000. All these types of U.S. government securities are subject to federal income taxes but not subject to state and local income taxes. “Ginnie Maes” represent pools of 25- to 30-year Federal Housing Administration or Veterans Administration mortgages guaranteed by the Government National Mortgage Association.
• Zero coupon bonds. With zero coupon bonds, instead of being paid out directly, the interest is added to the principal semiannually, and both the principal and accumulated interest are paid at maturity. Tip: This compounding factor results in the investor receiving higher returns on the original investment at maturity. Zero coupon bonds are not fixed income securities in the historical sense, because they provide no periodic income. The interest on the bond is paid at maturity. However, accrued interest, though not received, is taxable yearly as ordinary income. Zero coupon bonds have two basic advantages over regular coupon-bearing bonds: (1) A relatively small investment is required to buy these bonds; and (2) the investor is assured of a specific yield throughout the term of the investment.
• Junk bonds. Junk bonds, or high-yield bonds, are bonds with a speculative credit rating of Baa or lower by Moody’s and BBB or lower by Standard & Poor’s rating systems. Coupon rates on junk bonds are considerably higher than those of better-quality issues. Note that junk bonds are issued by companies without track records of sales and earnings, and therefore are subject to high default risk. Today, many non–mortgage-backed bonds issued by corporations are junk. Often a large number of junk bonds are used as part of corporate mergers or takeovers. Junk bonds are known for their high yields and high risk. Many risk-oriented corporate investors, including banks, specialize in trading them. However, the bonds may be defaulted on. During the periods of recession and high interest rates, where servicing debts is very difficult, junk bonds can pose a serious default risk to corporate investors.

How do you select a bond?

When selecting a bond, corporate investors should consider five basic factors:

These factors are further described next.

• Investment quality—bond ratings. The investment quality of a bond is measured by its bond rating, which reflects the probability that a bond issue will go into default. The rating should influence the investor’s perception of risk and therefore have an impact on the interest rate the investor is willing to accept, the price the investor is willing to pay, and the maturity period of the bond the investor is willing to accept. Bond investors tend to place more emphasis on independent analysis of quality than do common stock investors. Bond analysis and ratings are done, among others, by Standard & Poor’s and Moody’s. Exhibit 34.2 is a listing of the designations used by these well-known independent agencies. Descriptions on ratings are summarized. For original versions of descriptions, see Moody’s Bond Record and Standard & Poor’s Bond Guide.

EXHIBIT 34.2 Description of Bond Ratingsa

Quality Indication	Moody’s	Standard & Poor’s
Highest quality	Aaa	AAA
High quality	Aa	AA
Upper medium grade	A	A
Medium grade	Baa	BBB
Contains speculative elements	Ba	BB
Outright speculative	B	B
Default definitely possible	Caa	CCC and CC
Default, only partial recovery likely	Ca	C
Default, little recovery likely	C	D
a Ratings may also have + or – signs to show relative standings in each class.

Corporate investors should pay careful attention to ratings because they can affect not only potential market behavior but relative yields as well. Specifically, the higher the rating, the lower the yield of a bond, other things being equal. It should be noted that the ratings do change over time, and the rating agencies have “credit watch lists” of various types. Corporate investment policy should specify this point: For example, the company is allowed to invest in only those bonds rated Baa or above by Moody’s or BBB or above by Standard & Poor’s, even though doing so means giving up about three quarters of a percentage point in yield.

• Length of maturity. In addition to the ratings, an investment officer can control the risk element through maturities. The maturity indicates how much the company stands to lose if interest rates rise. The longer a bond’s maturity, the more volatile its price. There is a trade-off: Shorter maturities usually mean lower yields. A conservative corporate investor, which is typical, may select bonds with shorter maturities.
• Features of bonds. Check to see whether a bond has a call provision, which allows the issuing company to redeem its bonds after a certain date if it chooses to, rather than at maturity. The investor is generally paid a small premium over par if an issue is called, but not as much as the investor would have received if the bond was held until maturity. That is because bonds are usually called only if their interest rates are higher than the going market rate. Try to avoid bonds of companies that have a call provision and may be involved in event risk (M&A, leveraged buyouts, etc.). Also check to see if a bond has a convertible feature. Convertible bonds can be converted into common stock at a later date. They provide fixed income in the form of interest. The corporate investor also can benefit from the appreciation value of common stock.
• Tax status. If the investing company is in a high-tax bracket, it may want to consider tax-exempt bonds. Most municipal bonds are rated A or above, making them a good grade risk. They can also be bought in mutual funds.
• Yield to maturity. Yield has a lot to do with the rating of a bond. How to calculate various yield measures is discussed next.

How do you calculate yield (effective rate of return) on a bond?

Bonds are evaluated on many different types of returns, including current yield, yield to maturity, yield to call (YTC), and realized yield.

• Current yield. The current yield is the annual interest payment divided by the current price of the bond. This is reported in the Wall Street Journal, among others. The current yield is:

• Yield to maturity (YTM). The YTM takes into account the maturity date of the bond. It is the real return the investor would receive from interest income plus capital gain assuming the bond is held to maturity. The exact way of calculating this measure is somewhat complicated and not presented here. But the approximate method is:

where
I = dollars of interest paid per year
V = market value of the bond
n = number of years to maturity

• Yield to call. Not all bonds are held to maturity. If the bond can be called prior to maturity, the YTM formula will have the call price in place of the par value of $1,000.

• Realized yield. The investor may trade in and out of a bond long before it matures. The investor obviously needs a measure of return to evaluate the investment appeal of any bonds that are intended to be bought and quickly sold. Realized yield is used for this purpose. This measure is simply a variation of YTM, as only two variables are changed in the YTM formula. Future price is used in place of par value ($1,000), and the length of the holding period is substituted for the number of years to maturity.

• Equivalent before-tax yield. Yield on a municipal bond needs to be looked at on an equivalent before-tax yield basis because the interest received is not subject to federal income taxes. The formula used to equate interest on municipals to other investments is:

How is interest rate risk determined?

Interest rate risk can be determined in two ways. One way is to look at the term structure of a debt security by measuring its average term to maturity—a duration. The other way is to measure the sensitivity of changes in a debt security’s price associated with changes in its YTM. We discuss two measurement approaches: Macaulay’s duration coefficient and interest rate elasticity.

• Macaulay’s duration coefficient. Macaulay’s duration (MD) is an attempt to measure risk in a bond. It is defined as the weighted average number of years required to recover principal and all interest payments. Example 34.6 illustrates the duration calculations.

• Interest rate elasticity. A bond’s interest rate elasticity (E) is defined as

Since bond prices and YTMs always move inversely, elasticity will always be a negative number. Any bond’s elasticity can be determined directly with the formula just given. Knowing the duration coefficient (MD), we can calculate the E using this simple formula:

How do you invest in a bond fund?

A corporate investor may decide to invest in a bond fund. Three key facts about the bonds in any portfolio follow.

Corporate investors must keep in mind these guidelines:

• Rising interest rates drive down the value of all bond funds. For this reason, rather than focusing only on current yield, the investor should look primarily at total return (yield plus capital gains from falling interest rates or minus capital losses if rates climb).
• All bond funds do not benefit equally from tumbling interest rates. If corporate investment officers think interest rates will decline and they want to increase total return, they should buy funds that invest in U.S. Treasuries or top-rated corporate bonds. Investment officers should consider high-yield corporate bonds (junk bonds) if they believe interest rates are stabilizing and are willing to take risk.
• Unlike bonds, bond funds do not allow the corporate investor to lock in a yield. A mutual fund with a constantly changing portfolio is not like an individual bond, which can be kept to maturity. If the investor wants steady, secure income over several years or more, he or she should consider, as alternatives to funds, buying individual top-quality bonds or investing in a municipal bond unit trust, which maintains a fixed portfolio.

Should you consider unit investment trusts?

Like a mutual fund, a unit investment trust offers investors the advantages of a large, professionally selected and diversified portfolio. Unlike a mutual fund, however, its portfolio is fixed; once structured, it is not actively managed. Unit investment trusts are available of tax-exempt bonds, money market securities, corporate bonds of different grades, mortgage-backed securities, preferred stocks, utility common stocks, and other investments. Unit trusts are most suitable for corporate investors who need a fixed income and a guaranteed return of capital. They disband and pay off investors after the majority of their investments have been redeemed.

Collateralized mortgage obligations (CMOs) are mortgage-backed securities that separate mortgage pools into short-, medium-, and long-term portions. Corporate investors can choose between short-term pools (such as 5-year pools) and long-term pools (such as 20-year pools).

Mortgage-backed securities enjoy liquidity and a high degree of safety because they are either government-sponsored or otherwise insured.

OTHER FIXED INCOME INVESTMENTS

What are other short-term fixed income securities?

Besides bonds and mortgage-backed securities, there are other significant forms of debt instruments from which corporate investors can choose that are primarily short term in nature.

• CDs. These safe instruments are issued by commercial banks and thrift institutions and have traditionally been in amounts of $10,000 or $100,000 (jumbo CDs). CDs have a fixed maturity period varying from several months to many years. However, there is a penalty for cashing in the certificate prior to the maturity date.
• Repos. The repurchase agreement is a form of loan in which the borrower sells securities (such as government securities and other marketable securities) to the lender but simultaneously contracts to repurchase the same securities either on call or on a specified date at a price that will produce an agreed yield. For example, a corporate investment officer agrees to buy a 90-day Treasury bill from a bank at a price to yield 7 percent with a contract to buy the bills back one day later. Repos are attractive to corporate investors because, unlike demand deposits, repos pay explicit interest, and it may be difficult to locate a one-day-maturity government security. Although repos can be a sound investment, it will cost to buy them (for bank safekeeping fees, legal fees, and paperwork).
• BAs. A banker’s acceptance is a draft drawn on a bank by a corporation to pay for merchandise. The draft promises payment of a certain sum of money to its holder at some future date. What makes BAs unique is that, by prearrangement, a bank accepts them, thereby guaranteeing their payment at the stated time. Most BAs arise in foreign trade transactions. The most common maturity for BAs is 3 months, although they can have maturities of up to 270 days. Their typical denominations are $500,000 and $1 million. BAs offer these advantages as a corporate investment vehicle:
  • Safety
  • Negotiability
  • Liquidity since an active secondary market for instruments of $1 million or more exists
  • Yield spreads that are several basis points higher than those of T-bills
  • Smaller investment amount producing a yield similar to that of a CD with a comparable face value
• Commercial paper. Commercial paper is issued by large corporations to the public. It usually comes in minimum denominations of $25,000 and represents an unsecured promissory note. It usually carries a higher yield than small CDs. The maturity is usually 30, 60, and 90 days. The degree of risk depends on the company’s credit rating.
• Treasury bills. T-bills have a maximum maturity of 1 year and common maturities of 91 and 182 days. They trade in minimum units of $10,000. They do not pay interest in the traditional sense; they are sold at a discount and redeemed when the maturity date comes around, at face value. T-bills are extremely liquid in that there is an active secondary or resale market for these securities. T-bills have an extremely low risk because they are backed by the U.S. government.
• Yields on discount securities like T-bills are calculated using the formula:

where
P1 = redemption price
P0 = purchase price
n = maturity in weeks

• Eurodollar time deposits and CDs. Eurodollar time deposits are essentially nonnegotiable, full-liability, U.S. dollar–denominated time deposits in an offshore branch of a U.S. or foreign bank. Hence, these time deposits are not liquid or marketable. Eurodollar CDs, however, are negotiable and typically offer a higher return than domestic CDs because of their exposure to sovereign risk.
• Student Loan Marketing Association (Sallie Mae) securities. Sallie Mae purchases loans made by financial institutions under a variety of federal and state loan programs. Sallie Mae securities are not guaranteed but are generally insured by the federal government and its agencies. These securities include floating-rate and fixed-rate obligations with maturities of five years or more as well as discount notes with maturities from a few days to 360 days.

How do you choose money market funds?

Money market funds are a special form of mutual funds. Investors with a small amount to invest can own a portfolio of high-yielding CDs, T-bills, and similar securities of short-term nature. There is a great deal of liquidity and flexibility in withdrawing funds through check-writing privileges. Money market funds are considered very conservative because most of the securities purchased by the funds are quite safe.

Money market mutual funds invest in short-term government securities, commercial paper, and CDs. They provide more safety of principal than other mutual funds since net asset value never fluctuates. Each share has a net asset value of $1. The yield, however, fluctuates daily. The advantages are:

• Money market funds are no-load (they have no commission).
• There may be a low deposit in these funds.
• The fund is a form of checking account, allowing a firm to write checks against its balance in the account.

Disadvantage: The deposit in these funds is not insured, as it is in a money market account or other federally insured deposit in banks.

Exhibit 34.3 ranks various short-term investment vehicles in terms of their default risk.

Is investing in preferred stock desirable?

Preferred stock carries a fixed dividend that is paid quarterly. The dividend is stated in dollar terms per share or as a percentage of par (stated) value of the stock. Preferred stock is considered a hybrid security because it possesses features of both common stock and a corporate bond. It is like common stock in that:

• It represents equity ownership and is issued without stated maturity dates.
• It pays dividends.

Preferred stock is also like a corporate bond in that:

• It provides for prior claims on earnings and assets.
• Its dividend is fixed for the life of the issue.
• It can carry call and convertible features and sinking fund provisions.

Since preferred stocks are traded on the basis of the yield offered to investors, they are in effect viewed as fixed income securities and, as a result, are in competition with bonds in the marketplace.

Advantages of owning preferred stocks include:

• Their high current income, which is highly predictable
• Safety
• Lower unit cost ($10 to $25 per share)

Disadvantages are:

• Their susceptibility to inflation and high interest rates
• Their lack of substantial capital gains potential

Preferred Stock Ratings

Like bond ratings, Standard & Poor’s and Moody’s have long rated the investment quality of preferred stocks. Standard & Poor’s uses basically the same rating system as it does with bonds, except that triple-A ratings are not given to preferred stocks. Moody’s uses a slightly different system, which is shown in Exhibit 34.4.

EXHIBIT 34.4 Moody’s Preferred Stock Rating System

Rating Symbol	Definition
Aaa	Top quality
Aa	High grade
A	Upper medium grade
Baa	Lower medium grade
Ba	Speculative type
B	Little assurance of future dividends
Caa	Likely to be already in arrears

These ratings are intended to provide an indication of the quality of the issue and are based largely on an assessment of the firm’s ability to pay preferred dividends in a prompt and timely fashion.

How do you calculate expected return from preferred stock?

The expected return from preferred stock is calculated in a manner similar to the expected return on bonds. The calculations depend on whether the preferred stock is issued in perpetuity or if it has a call that is likely to be exercised.

• In perpetuity. Since preferred stock usually has no maturity date when the company must redeem it, you cannot calculate a yield to maturity. You can calculate a current yield as:

where
D = annual dividend
P = market price of the preferred stock

• Yield to call. If a call is likely, a more appropriate return measure is YTC. Theoretically, YTC is the rate that equates the present value of the future dividends and the call price with the current market price of the preferred stock. Example 34.10 presents two preferreds.

• Comparison to bond yields. The example shows that yields on straight preferreds are closely correlated to bond yields, since both are fixed income securities. However, yields on preferreds are often below bond yields, which seems unusual because preferreds have a position junior to bonds. The reason is that corporate investors favor preferreds over bonds because of a dividend exclusion allowed in determining corporate taxable income, which will be explained next.

Should you consider adjustable rate preferred stock?

CFOs with excess funds can make short-term investments in long-term securities, such as long-term bonds and common and preferred stocks. They may be naturally adverse to the price volatility of long-term bonds, especially when they put money aside for a specific payment such as income taxes. Perhaps for a similar reason, common and preferred stocks would be equally unattractive for short-term investments. But this is not quite true, because these securities provide an interesting tax advantage for corporations. For example, if the company invests its surplus funds in a short- or long-term debt, it must pay tax on the interest received. Thus, for $1 of interest, a corporation in a 46 percent marginal tax bracket ends up with only $0.54. However, companies pay tax on only 20 percent of dividends received from investments in stocks. (Under current tax laws, corporations are allowed to exclude 50 percent of the dividends they receive from a stock—either common or preferred—from their taxable income.) Thus, for $1 of dividends received, the firm winds up with $1 – (0.250 × 0.46) = $0.23. The effective tax rate is only 9.1 percent.

The problem with preferred stocks is that since preferred dividends are fixed, the prices of preferred shares change when long-term interest rates change. Many corporate money managers are reluctant to buy straight preferred stocks because of their interest risk. To encourage corporate investments in preferred shares, a new type of preferred stock was introduced in May 1982 by Chemical New York Corporation. These securities—the so-called adjustable rate (floating-rate) preferreds (ARPs)—pay dividends that go up and down with the general level of interest rates. The prices of these securities are therefore less volatile than fixed-dividend preferreds, and they are a safer haven for the corporation’s excess cash. Yields obtained from preferreds may be lower than the debt issue. Corporations buying preferreds would be happy with the lower yield because 50 percent of the dividends they receive escape tax.

MONEY MARKET PREFERRED STOCK

Money market preferred stock (MMPS), also known as auction-rate preferred stock, is the newest and most popular member of the preferred stock group attractive to corporate investors because it offers these advantages:

• Low market risk in the event of price decline
• Competitive yield
• Liquidity

MMPSs pay dividends and adjust rates up or down, depending on the current market, every seven weeks. Unlike other adjustable preferreds, the market, not the issuer, sets the rate at the auction. If no bids are placed for a stock, the dividend rate of MMPSs is automatically set at the 60-day AA commercial paper rate quoted by the Federal Reserve Bank. There is a possibility, however, of a failed auction if no buyers show up. Corporate investors must take into account the credit quality of a money market preferred stock. Money market preferreds include:

• Short-Term Auction Rate Stock (STARS)
• Dutch-Auction Rate Transferable Securities (DARTS)
• Market-Auction Preferred Stock (MAPS)
• Auction-Market Preferred Stock (AMPS)
• Cumulative Auction-Market Preferred Stock (CAMPS)

PRIVATE EQUITY

Private equity is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange. Private equities are generally illiquid and thought of as long-term investments. Private equity investments are not subject to the same high level of government regulation as stock offerings to the general public. Private equity is also far less liquid than publicly traded stock.

What are some types of private equity?

• Venture capital. Venture capital refers to equity investments made, typically in companies in their early stages, to launch, develop, and/or expand a new business. Venture capital investment is often associated with new ideas or products that have not yet been tested. The earlier the investment stage, the greater the risk/return characteristics for the investor. In other words, investing at the very beginning of what may become a profitable technology could offer substantial returns if successful, but the probability of success may not be high. Waiting until a business or idea has begun and just investing in the expansion of that business may provide a lower return, but the investor has a higher probability of success when comparing to the start-up investor.
• Leveraged buyouts (LBOs). At its most basic level, an LBO is a method of acquiring a company with money that is nearly all borrowed. This allows investors to make a large acquisition without committing a lot of capital. The acquirers of the target company often attempt to sell or take the target company public after 5 or 10 years in the hopes of making sizable profits. Doing an LBO can be expensive and complex, but if successful can provide considerable returns. One of the most famous LBOs was the $25 billion takeover of RJR Nabisco by private equity firm Kohlberg Kravis Roberts in 1989.
• Distressed or special situations. This is a broad category referring to investments in equity or debt securities of financially stressed companies. Since this area focuses on investing in entities that are in default, under bankruptcy protection, or headed in that direction, investors must evaluate not only the ability for the entity to make a comeback but also which class of securities might be more beneficial to hold during a restructuring process.
• Mezzanine capital. Mezzanine capital deals typically are structured as either a subordinate debt or preferred stock investment with claims below that of the other debt issued by the entity but above that of the common stock holders. Entities that obtain financing in this manner must pay a higher cost due to the investor’s junior position.
• Other private equity strategies. Other strategies may include investing in real estate, energy and power, merchant banking, or infrastructure.

CURRENT TRENDS IN LIQUIDITY MANAGEMENT STRATEGY

The current business, economic, and regulatory environments offer both opportunities and challenges for cash managers seeking to optimize their cash positions. Coupled with the aftermath of the Sarbanes-Oxley Act of 2002, which enforced stricter regulations around transparency and fiduciary oversight, institutional investors face a challenging environment that calls for a proactive approach to cash management. Given this environment, maintaining an optimal cash position is essential for CFOs, controllers, and treasurers, who have the opportunity to improve their companies’ balance sheets through sound, flexible cash management strategies. Some of the key questions they are asking include:

• Given the current conditions, which vehicles are best for short-term investment of cash?
• What is the best overall liquidity plan and strategy for my organization?
• What are the trade-offs between outsourcing liquidity management and keeping it in-house?

This section addresses how companies are answering these questions, provides insight on key trends in liquidity management, and offers strategies for maximizing cash management.

Classifying Investments on the Balance Sheet

With the increased scrutiny and accounting changes that are occurring today, companies must be very careful about how they classify investments on their balance sheets. In the past, when a company classified assets on the balance sheet, they were classified as “cash and cash equivalents” and “short-term marketable securities.” The Financial Accounting Standards Board is dropping “cash and cash equivalents” and redefining what “cash” means. Anything that is not considered “cash” now becomes a “short-term marketable security,” effectively eliminating the classification of “cash equivalent.” International Financial Reporting Standards (International Accounting Standards No. 7) provides the following definitions.

• Cash: Comprises cash on hand and demand deposits with banks
• Cash equivalents: Short-term, highly liquid investments that are readily convertible into known amounts of cash and that are subject to an insignificant amount of risk of changes in value

Companies Flush with Cash

Many companies flush with cash have been redeploying surplus cash—not only in increased dividends and M&A activity, but also in stock buybacks and in some capital expenditures.

Cash-Investment Policies Gain Popularity

A number of developments in recent years—including the enactment of Sarbanes-Oxley—have prompted many companies to adopt stricter liquidity management policies as part of improving financial controls. One of the obvious reasons for developing a written policy is that these companies have a fiduciary responsibility to their shareholders. Clearly delineating cash investment policies helps address today’s more stringent transparency mandates and at the same time provides better controls for the company.

Diversification Not Fully Realized

While the policies of many organizations allow for the use of a significant variety of investment vehicles for short-term investments, relatively few of those companies embrace the opportunity to fully diversify. The number of different investments in a company’s short-term portfolio is often a function of an organization’s relative level of sophistication and resources. For example, companies with fewer resources or limited internal expertise may not have the ability to perform credit research. They may lean toward “plain vanilla” or more conservative investments, thereby making use of only a small portion of the market. To achieve a much fuller range of diversification, many more organizations are enlisting an outside professional investment manager to administer at least some of their short-term portfolios.

Expanding Allowable Investments

One category of short-term investments that could provide additional return, but that companies are not turning to in very large numbers, includes investment-grade securities at the lower end of the ratings scale. Companies’ investment policies often dictate the levels of investment quality that are required in order to invest in various corporate-debt or municipal-debt vehicles, and some policies ignore the potential viability of BBB- or even A-rated investments. These ratings may not be the highest, but the investments they represent actually can offer excellent risk/reward characteristics. In effect, policies may establish credit-quality requirements that could be described as too conservative in certain instances. For instance, a policy that forbids investment in BBB-rated municipal bonds might impose an unnecessary opportunity cost, when you consider that such bonds have had lower historical default rates than some AAA-rated corporate debt.

“Cash plus funds” could offer a similar opportunity for higher returns, but relatively few liquidity managers are including them in their portfolios. “Cash plus” indicates something beyond a simple money market fund, such as ultra-short bond funds with fluctuating net asset values or even what are sometimes called “enhanced-cash” funds.

Investing Offshore

Another growing trend is for companies to invest cash outside the United States. Companies invest offshore for many reasons, such as to avoid certain U.S. taxes or to domicile an offshore insurance captive. Of course, companies must assess the foreign tax implications of maintaining cash offshore before making substantial investments.

Taking Control with Electronic Trading Portals

Another trend is the choice made by many businesses to use an electronic, multi-family fund trading portal to execute at least some of their short-term investment transactions, including money market mutual funds. This “self-service” approach is more common among large corporations with dedicated teams that trade frequently and therefore can more readily realize economic gains from an electronic trading portal. Frequently, companies that use an electronic, multifamily trading portal complement this approach by having a professional investment manager oversee a core portion of their portfolios. The way some companies approach liquidity management is to make “overnight” or money market investments—representing their primary liquidity—through the electronic, multifamily trading portal. They then outsource to a professional investment manager the responsibility of investing the other core cash balances in longer-term instruments.

Outsourcing on the Rise

One way to achieve sound investment management is through outsourcing. Recently more and more companies have been looking for advice and guidance from professional money managers. Outside money managers can provide companies with the market knowledge and insight needed to more effectively diversify their short-term investments while seeking to capture opportunities for higher returns than they currently achieve. You should expect a liquidity investment manager to provide key ongoing services:

• Strategic consulting
• Investment policy development
• Delivery of consistent, informative and timely reports
• In-person investment reviews with you or other staff members