Money market fund rules changes and difficulty of fixed-income trades are shaking up strategies and relationships.
TIMPG-2 members face significant investment challenges as new MMF rules and capital requirements take hold, both in terms of managing more risk and using a more complicated pool of investments. They see automation as a necessary part of the solution.
1) Addressing Market Liquidity. Fixed-income trades have become hard to transact through the dealer networks, giving the appearance of less-liquid markets. Peer-to-peer trading may be a solution.
2) Cash Investing Post-Regulatory Reform. Members are taking a range of approaches to money market reform, from maintaining the status quo to transferring funds to government money market funds.
3) What “Elements” Make Up a Best-in-Class Mandate? The drive for diversity in investment strategies means finding managers with well-matched portfolio skills—and ways to monitor them to ensure top performance.
Sponsored by:
Implementing Credit Strategies
Improvements in transparency and liquidity have led to greater diversification and lower transaction costs. Dimensional’s TRACE product (trade reporting and compliance engine) has led to more transparent and rapid flow of fixed-income trading information. This data has been critical to meeting sponsor Dimensional’s investment process.
Price reflects all of the information available in the market. Dimensional uses the power of markets to evaluate risk, affirm prices, and extend reach. Used efficiently and effectively, TRACE provides:
- Superior observation of credit markets and issuers
- Up-to-the-minute credit quality assessment for portfolios and bonds.
- Improved symmetry when trading.
Additional benefits include the benefit of a point of reference though greater transparency, timely data for credit research, and inventory modeling.
Credit spreads change over time and with change comes opportunity. Dimensional’s research suggests that credit spreads effectively incorporate information about credit risk premiums. With improvements in the transparency of fixed-income data, investors can leverage this information to make more informed investment and trading decisions.
Addressing Market Liquidity
Fixed-income market structure is rapidly changing, partly due to new regulations paring down market makers’ interest in maintaining large inventories from an economic standpoint and partly because brokers recall the excesses leading up to the financial crisis and don’t want to return there. Electronic markets may actually create new liquidity and introduce standardized bond terms to concentrate what is now a very fragmented market.
Key Takeaways
1) What liquidity crisis? Corporate debt outstanding is at historically high levels, and so is average daily volume. Turnover percentage has also risen since the lows of 2008. The story is the dealer inventory. The chart below shows the decline in inventory since the highs in 2007-08.
2) The times, they are a-changing. Regulatory pressures have shrunk dealers’ bond inventories, pushing them to support trades on an agency basis. New regulations made it more expensive to carry inventory. The role of the dealer has changed; dealer inventory has declined by 75% since 2007, while trading volume has increased.
3) Peer-to-peer trading offers a work-around. Electronic trading is approaching 20% of overall bond trading volume, led by MarketAccess. Increasingly, the dealer’s role is shifting to locating a buyer and facilitating a trade. If the seller can find its own buyer and facilitate the trade, the peer-to-peer trade avoids the dealer mark-up (bid/ask) spread.
Outlook
Life has gotten more complicated for asset managers as the bond market becomes less liquid in the wake of new regulations. Adapting will include using the offering of electronic bond trading venues. Bringing buyers and sellers together directly should improve liquidity and, more importantly, lower transaction costs.
Conservative Cash Investing Post-Regulatory Reform
One member company has decided to proceed with caution in its post-regulatory reform MMF line-up. Currently, the corporation invests in government money market funds only because of a possible merger and efforts to keep money liquid. The line-up currently does not include an enhanced cash fund. During the financial crisis the corporation lost money and was given in-kind securities in an offshore entity when an enhanced cash fund it was invested in had financial/liquidity issues. There were tax and accounting problems associated with the transfer—in all, a big mess. The corporation discovered first hand that the increase in yield did not justify the investment.
When possible, members have found that using a scorecard, preferably with some type of risk or income metrics in addition to total return is the most effective evaluation tool. Benchmarks are helpful and can be used as “smoke alarms” to alert moving into danger; however, benchmarks do not always accurately represent the actual investment mandate.
Cash Investing Post-Regulatory Reform
A substantial portion of MMF reform goes into effect next fall, and members are exploring alternatives, given anticipated shortages of government-only repurchase agreements (repos) and other now-liquid markets. Although the new floating NAV does not appear to concern members, concerns about liquidity were expressed.
Key Takeaways
1) Portfolio changes bubbling. The NeuGroup’s pre-meeting survey revealed that 23% of respondents’ companies are considering switching to government-only MMFs; 10% plan to switch to separate accounts; 10% are not concerned; and the remainder are making some type of other change or have not decided yet. About one-third said they do not anticipate changing their investment policies due to new regulations, and those that will anticipate changes by 2Q 2016.
2) The big switch. Upwards of $200 billion of prime funds has converted to government-only funds, with more transfers anticipated from both institutional funds and investors. Members expressed some concern that the demand will exceed the market supply. Unlike the prime funds, government funds will not have floating NAV and fees and gates.
3) Missing teeth. If a fund’s minimum level of weekly liquid assets falls below 30%, company boards can implement a liquidity fee of up to 2% and also declare a gate of up to 10 days within each 90-day period. If the level falls below 10%, a liquidity fee of at least 1% is “required” (at the board’s discretion). Nevertheless, no board will want to publicly announce that liquidity has dropped below a threshold and post that information on its website. Members who plan on sticking with the prime funds suggested sticking with bigger bank money market funds. That’s because they would be less inclined to impose fees and gates and incur negative publicity. In any case, recent history suggests that dropping below the 30% level is rare. Since December 2010, even with no real penalty for dropping below 30%, weekly liquid assets have averaged 37%, although a brief drop occurred in June when pressure on European banks prompted an outflow from prime institutional funds.
4) No more ratings. The only significant change to new MMF rules since the SEC released them in July 2014 has been removing all references to credit ratings. Funds are still required to buy securities that provide minimal credit risk, and given the lack of SEC instruction about what that means, advisors must determine how to manage that risk.
5) Set metrics to know when to get out. One member company does not use money market funds because of transparency (although this is improving). Gates and fees are a concern for the company. However, the company’s treasury investment manager does not believe everything will move overnight: “Prime funds are worth it, but set metrics to know when to get out,” he noted.
6) Will alternatives spring up? In any industry, regulation brings innovation—the money fund business is no different. Portals are expanding their offerings and money fund managers are offering “alternatives.” Again, members suggested buyer beware; more to come in this area for sure.
Outlook
The significant switch from prime funds to government-only has already begun and will likely continue in force. Supply, however, is unlikely to meet demand, and corporate treasuries and other investors will have to find short-term alternatives. Corporates’ boards will have significant discretion on whether to apply liquidity fees or gates to MMFs where liquidity has dropped below predefined thresholds. And since the SEC has eliminated credit ratings from regulatory requirements, corporates will have to ensure their external investment advisors are properly managing their credit risk.
When Best-In-Class Is In-House
One member company has taken the internal managed route as it pursues diverse investment strategies. The company’s treasury investment manager outlined the resources and expertise needed to manage investment funds internally. He has expertise having worked for an investment manager for a number of years; his expertise included managing corporates, ABS, and CMBS issues. When he first began at his current role, the portfolio was about liquidity and preservation more than return. Now the company measures against a benchmark. It uses an external consultant who oversees the strategy and reports directly to the board. The investment team meets weekly on tactics and monthly on strategy.
What Elements Make Up a Best-in-Class Mandate?
As corporate treasuries seek to diversify their investment strategies, finding top-notch managers has become ever more important. This session looked at how to go about matching portfolio managers (PMs) to a company’s portfolio needs, searching for best-in-class managers or building the best internal management. And then, perhaps the most difficult question of all: How do you know when they are doing their job?
Key Takeaways
1) You’re fired! The NeuGroup’s TIMPG-2 2015 fall pre-meeting survey found that 75% of responding participants have a formal RFP process for hiring investment managers. Only 62% of respondents do not have a formal process for terminating them.
2) Setting the stage. One member company’s recent growth in the investment portfolio has resulted in hiring some new external managers. Its investment policy had not changed and limits each manager to $500M. The company stopped at eight managers and now is focused on evaluating their performance.
3) Honesty is everything. Members did not have any hard and fast rules for firing managers, and many have not been through that process. Good communication with the manager is always important. Some members use scorecards to show how the manager stacks up either against their peers or a benchmark. One member company benchmarks managers’ performance to their peers; if a manager is underperforming, the company will first put them on a watch list and then make a decision. Sometimes, the decision will have to be quicker: if a fund could be in trouble, the company wants to be able to act fast so it isn’t last out of a fund.
4) RFP strategies. One of the member investment managers stressed that it is important to reach out to peers for feedback during the selection process. Other elements that he felt were important when selecting managers are the asset under management, management structure, research and models, and insight offered to the team. Many members also stressed the importance of not being an investment manager’s largest client (or percentage of assets). The relationship and insight a manager brings to the table is as important as historical performance. Shared with the group was a suggestion from a TIMPG-2 member: the corporation asks managers for their entire RFP template to compare what different ones emphasize. “By saying just send us everything, they have no ability to understand what we’re looking for besides what we tell them. But we can get an idea of what their organization’s strengths are,” noted the member.
Outlook
Corporates’ search for alternative investments and growing investment portfolios means finding new managers in sometimes unfamiliar sectors and invariably firing the ones that don’t work out. One question to consider is, How important is the relationship to the decision to keep or hire a new manager? Also consider (in case hiring externally is too complicated) what is needed to bring assets in house and just do it yourself.
Conclusion
Low rates combined with regulatory reforms impacting MMFs and banks’ capital requirements add another layer of complexity to the investment portfolio. The safe and simple prime money market funds are no longer with us. Members will have to rethink their investment asset allocations. Moving to alternative asset classes will require either more manpower or more technology. The regulation changes have also resulted in liquidity challenges as market makers reduce their inventories of securities, requiring corporate asset managers to familiarize themselves with new trading arenas, such as electronic trading venues. External managers with expertise in markets that are new to corporate treasuries will have to be thoroughly vetted, because it can be even harder to fire them. Members enjoyed learning from each other as they prepared for a busy 2016.