Treasury Management 101: beware hidden financial options when managing financial risk

How is Rothesay still exposed to reinvestment risk? Permjit Singh Treasury Consultant finds out

Rothesay, a pensions insurer that is exposed to long-term pension liabilities, has partnered with a mortgage lender to invest in 40 year residential mortgages. 

Investment and Treasury management says reducing cash flow or reinvestment risks is possible by matching the cash flows of long term liabilities with offsetting long term assets.  That asset and liability management strategy can however backfire if a Treasurer or fund manager fails to recognise the early redemption options embedded in the mortgage contracts.  Just because a mortgage says it is for 40 years does not mean Rothesay won't be exposed to reinvestment risk years before the agreed 40 year  term is reached. 

If, for example, interest rates do rise as expected because of rising inflation, then homeowners probably won't redeem Rothesay's loans.  If interest rates again fall, and far below the fixed rate paid on mortgages, then borrowers probably will redeem their relatively high interest rate 40-year mortgages. 

In that case, Rothesay faces the cash impact of having to reinvest the cash at a lower market interest rate than the original fixed mortgage rate.  The consequence is reduced investment income to meet Rothesay's pension liabilities, and a negative return on capital that could remain for up to 40 years ahead.

Kensington Mortgages does not charge early redemption charges so not only is Rothesay exposed to reinvestment risk, it is not going  to be compensated for it with early redemption charges.

Financial options can be hidden within contracts so it is essential to read the fine print and thoroughly understand the contracts and the cash flow of assets and liabilities over the entire term of the exposure.  Only then can a Treasurer or Fund Manager be sure cash flows are genuinely matched or that they are, contrary to first impressions, mismatched and so the company remains exposed to financial risk.

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