By Barb Shegog
The Fed is expected to raise rates in the middle of the year; here are three trends treasurers should follow.
With extremely low rates across the board, investment portfolios have been held short with little consequence to yield and income. But with changes in regulations looming, now is the time to take a look to see what’s available for the company’s portfolio.
As Goldman Sachs has noted in recent liquidity management research, “the landscape for cash investors has changed dramatically in the years since the financial crisis. Regulatory changes and other factors have contributed to significant imbalance in the supply/demand dynamics of liquidity investing.”
Now that it appears rates in the US are poised to rise—at least in the short end via the US Federal Reserve’s expected increase of the fed fund rates, three trends are starting to emerge in cash management for 2015.
- Evaluating the use of money market funds.
- Assessing and seeking additional asset classes and reconsidering the level of risk in the portfolio.
- Calculating cash needs to see what more can be done with the cash on hand.
Evaluate the use of money market funds
Corporations use money market funds primarily for liquidity. Also important to cash investors is the money market fund’s flexibility, stability, and yield. New regulations on the banks as well as on the money market funds themselves will make it harder to achieve these goals.
After years of debate, the SEC has approved a series of reforms to US money market mutual funds, and most likely Europe is right behind with similar changes. Implementation of changes is two years away but corporations are starting to prepare. While the regulations did not impact the investments involved, the regulations will change the way investors use money market funds.
First, prime funds will have floating net asset values. A particularly attractive feature of MMFs is the stability of the NAV; holding the assets at book value manages any unrealized gains and losses. A floating NAV could have unintended gain/loss scenarios, not to mention new accounting headaches. Another consideration is the alteration to the investment universe.
The floating NAV only applies to the prime funds; government funds will still carry book value. Currently there is almost $950 billion is assets in prime money market funds, and $790 billion in Institutional Government Funds. (Data as of 12/14 per ICI.) A transfer of prime assets to Government funds will materially alter the supply/demand profile. This could drive up the yields on prime fund investments and significantly drive down government yields, to the point the fund is no longer a viable investment option.
When you consider the new regulations, consider the various risks. What in particular has you concerned? Is it liquidity, capital, or the investments? Breaking down the risk will help you evaluate possible next steps for a money market fund investment.
The best part about the change in regulation is that the change has been announced. Now we can plan. There isn’t anything that changes the investments, but will the managers manage differently knowing fees and redemption gates could be imposed? Can government funds handle the new demand, and is there even enough issuance?
Many of these questions cannot be answered until the regulations go into effect. In the meantime, cash investors should start to prepare for a change in the regulations and, more important, prepare for possible changes in the market.
Expanding universe, adding alts
One important goal of stricter banking regulation is to ensure that a financial institution can overcome any short-term liquidity distribution.
However in money markets this has had the effect of sharply reducing the available supply. Since financial institutions are required to hold a certain level of highly liquid assets, they are less able to lend out short-term debt, thus decreasing the supply of commercial paper, time deposits, and repurchase agreements—securities that form the bedrock of money market fund investing.
Cash investors are currently evaluating the trade-offs between quality, maturity, and yield associated with managing liquid assets. Yields have moved lower with the decrease in supply. As a result many treasury departments, including many in The NeuGroup’s Treasury Investment Managers’ Peer Group (TIMPG), have looked to expand their investment universe beyond the typical money market fund investments. Investments such as floating-rate corporate bonds and certain types of asset-backed securities are now being considered.
“Over the last year, we have seen a steady increase in demand for investment-grade floating-rate bond strategies,” notes Andy Smock, president and co-chief investment officer from Merganser Capital Management in Boston. “In anticipation of rising rates in 2015, many of our treasury clients have incorporated investment-grade floating-rate allocations into existing portfolios and/or established new portfolios to be sure they participate in the move towards higher short-term rates.”
TIMPG members are also considering increasing the level of credit risk. Many members have altered investment policy statements to accommodate new asset classes to their investment portfolios.
Holding cash is an expensive option for cash investors
Is the price for liquidity too high? In the current environment holding extra liquidity might even penalize you. Cash investors are evaluating their liquidity needs with the recognition that high-quality overnight liquidity now comes at a higher cost. Goldman Sachs Asset Management worked with several clients to assess their liquidity needs, relative to their investment strategy and found “many clients placed too much emphasis on overnight liquidity.”
To manage cash more efficiently Goldman Sachs is recommending the following: Dividing cash needs into three main categories of liquidity and investing in securities that are best suited for each category. Several TIMPG and TIMPG2 (The NeuGroup’s second investment managers group) members are doing this analysis. One member shared his analysis at a recent TIMPG2 meeting, showing how they tiered the portfolio. They use four tiers with tier one having the highest level of liquidity and lowest level of risk and duration; the portfolio consists mainly of money market funds. Tier 4 has the highest level of risk and includes 10-year hedges.
An additional consideration in determining the tiers—beyond liquidity needs—capital structure needs. For example, what needs to be returned to shareholders? The price cash investors have paid for holding liquidity has been minimal over the past few years. Regulations affecting money market funds, supply of investable assets as well as the potential for increase in the yield curve on the horizon, has forced cash investors to reconsider their true cash needs.