Adapting to the New Realities of Capital Preservation and Liquidity Management

By Ted Howard

More companies are re-evaluating their general investment and cash-liquidity management strategies in light of increased regulations, shrinking supply and continued interest-rate compression. With these challenges in mind, iTreasurer interviewed PIMCO’s Jerome Schneider, who explained the current environment and how to pro-actively plan for what’s ahead. 

Liquidity management in the current market environment is becoming increasingly complicated. New regulations on banks and 2a-7 money market funds are prompting companies to revisit their investment policies as well as their portfolio strategies to come up with better ways to confront the changing liquidity dynamics and the ever-present quest to balance capital preservation with modest return expectations.

Against this backdrop, iTreasurer recently spoke with PIMCO’s Jerome Schneider, winner of the 2015 Morningstar Fixed-Income Fund Manager of the Year (US) award for the PIMCO Short-Term Fund, about how treasurers can navigate the current short-term investment environment.

iTreasurer: What key changes should treasurers consider when reviewing their current investment policy to allow for the necessary flexibility that will be required in the “new world” of liquidity management?  

Jerome Schneider: Treasurers have become used to a tool that’s been tried and true for many years, but now the paradigm is changing. The structure of regulated money-market funds is changing, the way that people, institutions and corporations interact with financial institutions is changing, and perhaps most importantly, the cyclical horizon, i.e., monetary policy and interest rates, is also changing. The combination of these three elements will have a profound influence on corporate treasurers in how they specifically manage liquidity and their excess cash.

iT: There seems to be a lot more to the situation surrounding MMFs. What’s going on?  

JS: Starting in October 2016 some money market funds will not only have the possibility of gates and fees placed on them, but also as a structural element, they will continue to yield low rates and potentially do so for the foreseeable future. Even as the Federal Reserve starts to hike rates over the next several years, supply and demand mechanics may keep yields offered by money market funds lower than would be expected. The key point is that the net yields they offer will remain structurally subdued for years, in my opinion. Up to now, investors and treasurers alike have gotten basically a free ride, a free option to utilize money market funds as a way to not only earn some income but also preserve their capital with a free liquidity option. That is definitively changing.

iT: And if they stay in MMFs? What are the precise risks emerging? 

JS: Those investors that remain in money market funds that have fees and gates are basically underwriting an option whereby they may have to pay an additional fee to get their money back during times of stress, which means it’s not 100% foolproof liquidity. Thus, the proposition is increasingly asymmetric: earning a few basis points to underwrite the potential (albeit low-probability) situation where you may not be able to get your funds back as quickly as you intended.

iT: Is that the only risk to consider? 

JS: Unfortunately no. The other issue is the mission of capital preservation when using regulated money-funds. There are two facets to this discussion. First, prime money-funds, those that can take credit risk, will now have a floating NAV. Consequently, you may or may not receive back the exact amount of funds you originally invested. These funds take credit risk, and when taking credit risk you need to make sure you are properly compensated for this added risk. Most money-market instruments such as commercial paper simply do not compensate investors for taking such risks. Moreover, many money-fund complexes simply are not structured to underwrite such credit risk as well as PIMCO, both in terms of fundamental solvency risk, as well as relative value compensation for taking credit risk.

The second aspect of capital preservation which must be considered is purchasing power preservation–i.e., will the value of a dollar invested today provide the same purchasing power as that of a dollar tomorrow. Most corporations don’t think this way, precisely because over much of the past 40 years they haven’t needed to. For much of this time, the returns for money-market funds have been higher than the inflation rate, thus protecting purchasing power by returning a positive “real” inflation-adjusted return. But that is changing now. With net yields on regulated money-funds being structurally subdued, they may provide nominal capital preservation, but will fail to protect the value of capital invested even at the current low inflation rate of 1-2% range. It’s mission critical to transform this construct for Corporate Treasuries, and adapt to this added risk consideration.

iT: Thanks for bringing this to our attention. How are professionals adapting? Or are many treasuries taking a “wait and see” approach?  

JS: Education is critical at this point; and most importantly consideration of the coming changes so that investors, corporate and retail, can react to them. Investors should take a moment to really look under the hood and examine the engine parts critical to their day-to-day cash needs; they’ll realize that with the changing landscape, the “approved” institutional guidelines they might have used for the last 40 years may not be the way to start the engine each and every morning in managing liquidity going forward.

Most importantly, investment paralysis–the fear of making an active decision to adapt–is the riskiest strategy of all. The “risky asset,” so to speak, is not acknowledging the changing landscape and incorporating investment flexibility, however modest and conservative, into your operating guidelines. Protocols need to allow the flexibility to utilize non-2a-7-regulated assets and funds.

We suggest to clients to consider a more dynamic approach to active liquidity management; come up with a policy that offers multiple degrees of freedom in terms of investing in a wide variety of assets–ones that not only diversify what you’re invested in but also offer the diversification that can give you several sources of liquidity during times of stress. Such a strategy not only balances liquidity management with capital preservation, but provides income which can protect the real, inflation-adjusted value of your firm’s capital. In essence you are adapting to a strategy which potentially offers better risk-adjusted returns by creating a more diversified approach for investing your funds.

For the record, we’re not trying to sound alarmist here. It’s just that the reality is that investment policy is often an overlooked part of the portfolio management world. Treasurers and investors have assumed that because these are regulated strategies they are a foolproof way to manage liquidity. What we’re saying is, it may be foolproof 99.9% of the time, but as a treasurer you’re now underwriting a risk that you may not be aware of. The key here is to have discussions with management and with external investment managers and become more educated. Some might choose to remain with the status quo. Others might choose to take a more dynamic approach and then do what we do each and every day here at PIMCO, which is to optimize the degrees of freedom we have to invest cash as safely as possible with the mission of preserving capital and providing returns commensurate with the risks being taken.

iT: How are rules transforming traditional liquidity dealers and providers? 

JS: When you look at the landscape, increased regulation has had two effects. Number one, in some cases it’s curtailed what investors can do but it’s also curtailed what banks can do. And the reason is banks are now held to higher standards in terms of their capital requirements. And frankly the way they’re managing that is allocating capital away from traditional liquidity product classes like T-bills or repurchase agreements or even some corporate obligations. These are now very highly capital-intensive transactions with low return-on-equity. So the institutional support for many money-market products like T-Bills and repo is dwindling, subsequently leading to observable and meaningful transactional costs for these products, whereas merely a few years ago they were assumed to be virtually free.

So there are two additional elements to consider, increased (transactional) costs for managing liquidity products, and a general dearth of supply of such products due to growing structural demand. Traditionally when you needed to obtain liquidity the main focus was trying to get out while minimizing cost, i.e., minimal bid/offers. To accomplish this, you needed dealers in the marketplace who could do relatively large-sized transactions. But the reality is that the depth of that market, even though it might be there, is not as deep as it was five or ten years ago, especially when you get to seasonal reporting dates like quarter- or year-end.

iT: More importantly, what does that mean for treasurers?  

JS: For treasurers it means that ultimately the frictional costs of managing liquidity are much higher. Also, treasurers need to be thinking about their real need for managing that liquidity on a tiered basis. For example, first you need to be defensive and have enough liquidity to meet those near-term obligations, i.e., payments today that are coming for payroll or capital expenditures that are coming over the next week or so. But then also think about the need to tier it out to be more strategic so that you don’t have cash idling in overnight transactions where you don’t necessarily need overnight liquidity. And that’s the challenge they need to understand. So again it’s important to create a system that allows you to tier liquidity effectively and capture those liquidity premiums instead of paying the liquidity premiums. So it is not that your liquidity profile is changed, but that you’re actually earning some income and potentially creating a better set of circumstances for yourself by diversifying into different strategies Finally, all strategies must be considerate of not only US domestic economic conditions which may affect interest-rate forecasts, but global considerations as well.

iT: Why would cash management need to have a view on global events and monetary policy? 

JS: As we are all aware, the financial markets operate on a 24-hour basis. As such, financial institutions have become global in providing services to their clients. So a demand for once “local” product becomes globalized, and monetary policy changes halfway around the world can have a profound effect on domestic investors. As an example, we are beginning to see this trend as negative rates emerge in Asia and Europe, and these conditions will drive foreign investors to find attractive yields, or RAIRP- Relatively Attractive Interest Rate Policy. The US will quickly become an attractive universe for such investors plagued with negative yields. US investors can seek to profit from this prospective increase in demand by purchasing assets at attractive spreads and return prospects today whose future potential for positive returns may be influenced by this increasing demand metric. It is important, perhaps critical, for short-term capital preservation strategies today to be cognizant of these global dynamics and influences.

iT: What are some of the mistakes treasurers make in this regard? 

JS: What a corporate treasurer might say is, “OK, fine, I’m not going to put my money in a money market fund. I’m going to go buy a laddered time deposit or a laddered CD program from all the banks I deal with.” The problem with this strategy is that while it’s good, you’re now obviously beholden to credit risk and to relationship banks. So the question to ask is, why put yourself in double jeopardy of sorts and get into a situation where you’re layering on additional risk, i.e., credit risk, and where you’re not necessarily getting paid for that credit risk? While optically it looks like a good, matched approached, it could actually be problematic to the rest of your business because you’re simply adding more risk to existing banking relationships. What you would seek to do in a true liquidity management strategy is to diversify away those risks, and look to take credit risk, if you’re comfortable with it, away from the non-financial sector and away from specific banking names that you might have a previous relationship with. But there’s an additional consideration: the impact of increased capital charges for banks holding client depository balances.

iT: So, are you suggesting that banks may not actually want client’s depository monies? If so, what recommendations do you have to allow for the effective placement of short-term cash without having to manage the increased concentration risk? 

JS: Treasurers have been getting phone calls routinely over the past few months from banks saying that they simply do not want to take their operational deposits anymore. It’s odd to think about, but actually giving a bank cash to deposit is a capital-intensive, money-losing proposition for the bank. As a result, some of these institutions have turned away deposits and over the last nine months returned more than $150 billion. And so now all those corporate treasurers are looking for a home for their cash. But the reality is that there simply aren’t going to be enough homes for that cash. The demand for money market funds will grow and the yields offered on those money market funds will remain compressed, as we’ve already seen despite the Fed’s December rate hike.

And so the goal is to find homes that can offer active liquidity management; and most importantly finding that balance between expertise and active management for the new paradigm. It’s time to actively cash in your deposit and find a solution outside of banks, because if you haven’t gotten that phone call from your bank yet, you may soon. It’s better to be prepared.

iT: How should investment managers evaluate and reduce risk in anticipation of future rate hikes? What traditional investment vehicles will cease to exist and what new alternatives might come to the forefront? 

JS: There are two elements of risk. Number one, you don’t want to have a tremendous amount of interest-rate exposure ahead of rate hikes; that’s important, and it’s very logical. Strategies that are all about capital preservation will focus on that and will have very limited duration or interest exposure. Number two is that you never know where volatility is going to come from during a hiking sequence. It could be emanating from a domestic issue; it could be coming from a global issue.

iT: So how else should treasurers respond? 

JS: What you want to have is a diversified approach. You don’t necessarily want to be only in one type of product. You want to have diversification across a series of investments, which should be short-dated, self-liquidating and continually producing income for your portfolio. In doing so you provide not only diversified income sources but you also provide diversified sources of liquidity that you can transact within the market. Unfortunately, many traditional investment vehicles fail in that approach; they’re focused singularly on one approach.

And as a result you need to think about ways to diversify that lever, that one point of risk. And although money market funds present minimal risk in terms of interest-rate exposure, they also unfortunately present asymmetrical risk in terms of liquidity management. They might help shield you from increases on rates, but over time money market funds may underperform more actively based strategies, which can offer diversity across many sectors. So it’s better to consider some non-2a-7 strategies.

We see this at PIMCO, where a lot of investors are looking, for example, at a prime fund that has a floating NAV and potential fees and gates. And then they look at something like a conservative, non-2a-7 strategy and conclude, “Well, I’m going to have a floating NAV anyway; I don’t want the fees and gates. And by stepping out I’m getting more appropriately compensated.” So we see many current and potential clients looking and beginning to utilize those conservative ultra-short strategies as offering a pretty compelling value proposition. Actively managed short-term strategies can offer attractive risk-adjusted returns for those seeking balanced capital preservation and income in this new paradigm.

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