Now that I’ve set forth basic rules and principles to keep in mind when composing an investment policy for corporate investors here, let’s take a look at some essential and non-essential elements to be included in the policy. In a future post, I will provide a couple of templates that you can download (for free, of course).

Scope (non-essential)

Sometimes it is necessary to clarify the portfolio to which the investment policy applies. Even though it seems obvious, adding a little paragraph may prove an effective deterrent against auditors or similar species.

You could write something like:

this policy governs the funds that have been safeguarded through third-party custodian [State Street] but excludes cash on the company’s various bank accounts.

Objective (essential)

Although many times a vague statement, the policy’s objective is an essential element of every policy. For corporate cash, it is very clear and simple: do not lose money.

Remember that you cannot expressly write “career risk” in your document, but you can definitely shape it in a way that factors in your own survival. I’m not advocating being so risk averse that you end up costing the company real money in the form of lost income or that you feel slightly ashamed of your portfolio. As I say in part one, we’re playing an infinite game. The goal is to play forever.

So, how do we phrase “do not lose money” in a slightly more sophisticated way? Try this:

The main objectives of the Company portfolio shall be: 1) safety of principal, 2) appropriate liquidity, 3) enhanced return within reasonable risk parameters.

Pretty vague, isn’t it? Don’t worry, that’ll do. The important sections come next.

Eligible Investments (essential)

Your list of eligible investments should be comprehensive enough to allow your portfolio manager to construct a portfolio that can outperform, or at least track, the returns of the benchmark. Best places to start when coming up with your list of eligible investments are the Barclays or Merrill Lynch indices.

In general, you can think of fixed income securities as broken up into these sectors:

  • Treasury: obligations of the U.S. Treasury with no credit risk
  • Government-Related: mainly government agencies or government-sponsored enterprises (think Fannie Mae or Freddie Mac)
  • Corporate: unsecured corporate notes and bonds
  • Securitized: mortgage-backed securities (MBS), asset-backed securities (ABS), and commercial mortgage-backed securities (CMBS)

A word of caution: while the idea is to allow a wide range of eligible investments, make sure not to open the door to asset classes that could compromise your “infinite game” strategy. For instance, be thoughtful when adding emerging market bonds, high yield, or derivatives to the list.

Interest Rate Risk (essential)

Once you have a list of what’s eligible, it is time to control for risks inherent to those investments. Start with interest rate risk. Here I have three recommendations:

  1. Have an overall duration limit for the entire portfolio
    Sub portfolios should have their own duration limits as well
  2. Introduce the concept of duration bands around the duration of the benchmark
    This will allow the portfolio managers to generate alpha through duration bets while at the same time controlling the size of their bets
  3. Have a specific maturity limit for each type of eligible investment
    Tip: make sure the limit is not so restrictive that it prevents the purchase of new bond issuances

Credit and Liquidity Risk (essential)

There are several factors to include in this section of the investment policy:

 Credit rating limits

  • You have to decide what is the minimum credit rating you’re willing to accept. A word of caution: playing too conservative may hamper your ability to diversify. For example, excluding BBB (triple “B”) credits from your portfolio may result in an excessive concentration in financial names, which may be contrary to what you want to achieve.

Sector and country limits

  • Define concentration limits (as a percentage of aggregate portfolio value) per sector or country: corporate bond sector, high yield sector, securitized sector, etc.
  • Use your asset allocation analysis or, perhaps more importantly, a stress-test analysis [future post: step-by-step stress test analysis in Excel] to understand how your risk tolerance translates into sector limits.

Single issuer limits

  • I advise you to introduce the concept of single name diversification; don’t let your portfolio manager’s bullishness for Lehman Brothers translate into a 10% position. I suggest you have a 2% single name limit for investment grade portfolios and a 5% limit for high-yield portfolios (a word of caution: counterintuitive for high-yield, yes, but excessive diversification in junk bond land can result in owning a variety of speculative names).

Minimum issuance size requirements

  • This is a nice-to-have element. To ensure adequate liquidity, mirror the minimum issuance size for index eligibility. Bonds that are not included in indices are more difficult to trade.

Non-eligible investments (essential)

I debated whether to include this element as essential or non-essential, but I think it is good practice to clearly state certain types of investments that are not permitted. One would think that, by having a list of eligible investments, anything that is not in the list would fall out of bounds. It is, however, better to be safe than sorry so, please, list the products you want to stay away from. Examples: naked credit-default swaps, selling short, derivatives.

Governance for handling policy deviations (essential)

It is important to outline authorization guidelines for situations in which the portfolio falls out of compliance. You may likely encounter policy breaches when a security is downgraded by the rating agencies or when portfolio liquidations render certain asset classes or sectors outside permissible concentration limits.

You have to decide upfront who has the authority to allow out-of-compliance securities to remain in the portfolio until maturity or until they can be sold in an orderly fashion.

The typical sequence of approvers is Treasurer → CFO → Investment Committee. Each approver is assigned a limit based on the percentage of the portfolio that is out of compliance.

Strategic asset allocation (non-essential)

I said in part one that I would include asset allocation in the policy only if my investment committee is investment savvy.

My take is that a strategic asset allocation (SAA) is not essential for corporate investors, but important for individuals and other institutional investors such as endowments or foundations.

If you decide to include a strategic asset allocation section, avoid being too vague.

This is an example of vague:

Vague asset allocation

If you want to show a SAA, keep it simple, yet be specific. For example:

Asset allocation - target and ranges

The idea is to add specificity and tighten the ranges so the expected return follows your efficient frontier analysis. [Another future post: how to construct an efficient frontier using Excel.]

Liquidity needs and time horizon (non-essential, but beneficial for individuals and endowments or foundations)

This section is a description of the liquidity needs and the time in the future in which the portfolio structure is expected to change significantly. I don’t think this is an essential element for a corporate portfolio that needs to stay highly liquid at all times and whose investment horizon is no longer than a couple of years into the future (you never know when you’ll need cash for an increased dividend payment or to fund a large acquisition). For an individual, on the other hand, it is very helpful because it will guide the allocation to cash (for living expenses) and to higher risk securities (no need to sell until retirement).

Other exposures: trade and related parties (non-essential)

Consider adding restrictions to buying securities issued by companies with which you may have significant trade receivable balances or own equity. Just to avoid being hit twice if their credit position deteriorates.

Final step

Once you have drafted your investment policy with the above elements, there is one final step before having it blessed by your oversight committee. You can read about the final step in part 3 of this series, where you can also download a couple of investment policy samples.


Did I miss anything? Too much detail for something that should be kept simple and clean? Does anyone google “investment policy” these days?