Treasury Prepares for the Unexpected

Current low and in some cases negative real yields on short-term investments have not completely whetted the risk appetites of treasury investment managers. Despite record-low returns on cash and related securities, very few raised their hands at this month’s EuroFinance meeting when asked whether they were chasing yield. Perhaps that’s because, as RBS chief economist Andrew McLaughlin suggested, the current recovery, which he believes is U-shaped, could quickly become a W-shaped one if policy-makers raise rates too soon. Or perhaps it’s simply that there are far fewer attractive options—and these are being further truncated by the Securities and Exchange Commission’s new money-fund rules. But in any case, the largesse available on the funding side of treasurers’ equations—with capital markets accessibility and pricing at nearly boon-time levels—is unlikely to be replicated on the investment side.

A U-shaped recovery could become a W-shaped one if policy-makers raise rates too soon.

Mind you, despite plenty of evidence that the US Federal Reserve is signaling that its quantitative easing program is at an end and a rate increase could be forthcoming, the crisis in Europe and continuing levels of US unemployment make that scenario seem a bit far-fetched. Indeed, the Fed has extended a significant dollar swap arrangement—in addition to its crisis-era efforts—to help the European Central Bank manage the strain of its nearly EUR1 trillion bailout package.

Nonetheless, members of The NeuGroup’s Treasury Investment Managers’ Peer Group and attendees at EuroFinance’s recent meeting in Miami expressed concern that there would be a significant roll-up in the US dollar yield curve, accompanied by a steepening, and this makes the choice of short-term cash investments at this time significantly fraught with peril.

“Low interest rates are a tax on people who keep their money in MM funds. Obama is taxing not only the wealthy but the un-wealthy.” — Rob Kapito, BlackRock

Unfortunately, there is also a peril to standing pat. As Karen Snow, treasury operations manager at AES, noted at the EuroFinance meeting, “Now there’s a big opportunity cost to being liquid overnight.”

So what’s to be done? Sunder Ramkumar at BlackRock gave a few ideas at last month’s TIMPG meeting. He sought to address the goal of maximizing expected returns while preserving capital, or minimizing the probability of negative returns. Based on the efficient-frontier model, a low-rate environment increases the likelihood of negative returns and requires the portfolio to step outside of the “admissible region” of investment options to compensate.

Since this is obviously not an option in the real world there is a practical need to dial down the risk in a low-rate environment. Conversely, as rates rise from a 0.5 percent environment to 2 percent the risk of negative returns diminishes significantly and goes to a one percent probability in a 3.5 percent environment, where the efficient frontier shifts inside the “admissible region.”

The impact of unexpected inflation can have a detrimental impact on portfolios. In the current rate environment, a 0.97 percent increase in inflation will push the current policy portfolio into negative returns. The asset management specialist’s recommended course of action was to incorporate TIPS into the portfolio. This results in less yield but allows for greater absorption of inflation increases before taking a hit.

Another investment specialist, who focuses on cash products, noted at the TIMPG meeting that the perception and usage of money funds has shifted over the past two years in light of the financial markets, beginning with liquidity. He pointed out that money market participants undervalued liquidity risk until 2007 and 2008 and also reminded the TIMPG of the adage: “Liquidity doesn’t matter until it does and when it does it’s the only thing that matters.” Even Michael Milken, the maestro of illusory liquidity, knew it’s a chimera.

Liquidity is the one thing everyone expects will be there, until it’s not.

The current low-rate environment has highlighted two groups of MM participants, the investors and the savers. The low rates have been driving the investors out of the MM space since 2009 while the savers remain focused on preserving capital and ensuring there is a ready buffer for unexpected events. The asset management specialist believes there will be as much as $500 billion exiting MMFs over the next year. Further, banks are shifting their deposit focus from “other” deposits to “core” deposits, which have a lower cost basis.

Several treasurers have discussed using a “barbell” strategy to take advantage of the steepness of the yield curve while not sacrificing liquidity on the short end, so they can deploy cash rapidly later if the interest rate environment changes significantly. This does provide a measure of protection, although it does not immunize the investor from interest rate risk.

Nonetheless, some, including Maria Wronski, treasurer at Broadcom, are venturing back out along the risk spectrum. Ms. Wronski, speaking at EuroFinance, said Broadcom had moved to 85 percent Treasuries and agencies during the crisis, but has since scaled that back to about 65 percent.

The company is feeling more optimistic, she said, and has put on more commercial paper and bonds. But there remains a core of defensiveness among corporate investment management personnel. Ms. Snow noted that AES has remained wary of commercial paper and bonds, and has used allocation of deposits among banks as a carrot to develop those relationships.

That involves, she noted, a lot more homework than in the past, now that the credit quality of banks is no longer a foregone conclusion.