Making Cash Go Further
Many publications go to a lot of trouble to propose the best way to manage treasury processes – in particular, the most basic treasury processes of daily cash forecasting, collection and disbursement. Indeed, this is a critical activity and not getting it right leads to unnecessary cost and wasted effort. Once a firm gets their cash position right and determines exactly how much liquidity they want to keep on hand, what do they do? Surprisingly, the answer to this question is often ‘not a lot’. This cash stays with their bank or, in the case of some funds, their prime broker or custodian.
Many firms, whether corporates, funds, or financial institutions, negotiate long and hard with their cash service providers on all aspects of the offering including pricing and client servicing options, etc. As part of the process they also work hard to get the best pricing for overdrafts and credit balances to, of course, minimize the debit/credit spread. Banks and prime brokers rightly charge a risk premium for lending cash on an overnight basis. What they often do not do is offer true market pricing for the liquidity their clients leave with them. Generally, service providers offer anything from the index, whether Eonia, Fed Funds, Libor or something homegrown, less 10 to 100 basis points.
For those firms without meaningful cash positions, this inequity does not have a large impact. However, as is frequently pointed out, corporates and funds are accumulating cash in the present market environment. It is a matter of simple math to determine that if you have the relatively modest amount of US$10m earning, say, Fed Funds less 50 basis points that at the end of the year, you have foregone about US$50,000 (forgetting compounding) in interest compared to the index.
More to the point, cash is the poor relation of the process as it often sits around in several locations. Passive investment rates at bank/prime broker are well below rates available in the market. Cash can – and should – add to your firm’s total return, whether you make widgets or invest in companies that do.
What are the options for actively investing cash and what are the risks and effort involved in doing so? After all, if a firm can’t meet the primary objectives of security and liquidity for cash holdings, then it’s simply not worth it. Also, if the process is too complicated and time consuming for the level of cash assets, then leave it at the bank. Just make sure your banker takes you out to a good lunch every now and then.
The alternatives for increasing the yield on cash are straightforward:
Obviously, each strategy above has its pluses and minuses and we will leave out the discussion of the first option.
Investing your excess cash yourself can well be worth the while if you have a large and active treasury and, of course, if you want to spend the money on manpower and systems to execute and control the investment process. Using repos you can get your interest levels up to somewhere between 5-10 basis points below the relevant index. Your credit risk is also low given that most repos are government or agency based. Liquidity in these markets is excellent.
If you have enough funds to invest you may even want to duplicate what a money market or bond fund does, investing a bit longer out on the curve to maximize interest income while taking measured market risk. This is an option, but not one most firms are focused on. It is relatively expensive and has its costs and risks, primarily those of market pricing and liquidity (you do not want to have to sell a position to realise the cash). This option also requires a lot of cash to be worthwhile as the people and systems will not come cheaply.
Using an MMF is the next alternative and, for many, the most logical step. They can be accessed easily, either directly, via provider, or via portal. A portal can also offer real value as rates can be compared, execution is simple and deadlines are usually more than adequate for determining cash levels (for US$ funds between 4pm and 5:30pm New York time). The cost of execution and personnel is much lower than ‘self-investing’. Rates are also better than repos, generally at or slightly above the index depending on the market cycle. As of 19 October 2006, the best yield on ICD Funds (a webpage with a broad range of quoted funds) was 5.30%, five basis points above Fed Funds. Depending on the deal you are getting from your bank that can mean a lot of money.
Risk is also low as most funds are rated triple-A and liquidity is also excellent. There is some risk that the NAV (net asset value/share price) of the fund will fluctuate from US$1 (or £1, etc.) as well as the provision that in most funds that repayment can be delayed up to five days in ‘adverse market conditions’. Both of these risks, however, are generally very low.
Using an enhanced cash fund will provide the benefits of a standard MMF with more yield and, of course, more risk. This strategy is probably not relevant for the bulk of a firm’s overnight cash as these funds use derivatives and other higher risk strategies to increase yield. Also, some enhanced cash funds do not offer daily liquidity.
The next option is to use a cash manager. This market segment is not large or well known. There are several out there, but they have tended to maintain a low profile. A cash manager is a hybrid, somewhere between a money market fund and internal headcount dedicated to investing your liquidity. Essentially, it is an outsourcing of the overnight cash liquidity investment function. While there is not a lot of data about the yields they can achieve, the yields achieved by at least one cash manager have been considerably above those of other alternatives.
One of the factors enabling higher yields is the fact that most cash managers are not subject to rule 2a7 limiting MMF’s to investments of 13 months or less. Some also invest in corporate and ABS securities, generally on a floating rate basis. This gives them the yield but maintains spreads above the indices going forward.
Cash managers can structure a portfolio to provide the crucial components of an overnight investment: security, liquidity and yield. Also they can exploit what I call the triple-A illusion: i.e. that only a triple-A investment is appropriate for overnight cash. The reality is that most MMFs invest in A1/P1 paper, which is not, by definition, triple-A (outside of governments there is a scarcity of triple-A paper). A competent cash manager can exploit the difference in yield between either double-A, or investment grade, and triple-A securities. The designations double-A and triple-A relate to long term risks. The short term risk of these ratings are essentially equivalent as, according to the S&P, it takes about 11.7 years for a double-A security to produce a loss, while the securities trade quite differently.
It is important to evaluate the track record of a cash manager and questions to consider include:
It can be said that if the general questions above can be suitably answered in conjunction with the more specific concerns of individual firms, the cash manager will provide a viable alternative for maximizing the return on corporate cash.
In summary, there are several superior alternatives to leaving excess cash at your bank, custodian or prime broker. Banks and brokers are good credit risks (albeit probably not triple-A) and will give you your money back on demand. But they don’t provide the level of interest you can earn compared to alternatives. Solely using traditional means of investing money is comparable to how buying IBM used to be – safe, but perhaps not the best deal. Then came Dell. In the same way, MMFs and cash managers can increase the yield on cash from anywhere from 15 to 100+ basis points without greatly affecting the security or liquidity of your cash.