Cash Management Perspectives on Short-term Investments
Ever since the financial turmoil began in August 2007, investing in the money markets has been extremely challenging. Now, a renewed importance has been placed on capital preservation. The heightened market uncertainty has amplified investor concern as low growth and high inflation threaten to impact capital markets, aided by bank write downs, de-leveraging and a reduction of risk appetite in both credit and equity markets.
The interbank market, where money market funds (MMFs) operate, is still showing signs of distress with distrust amongst banks in lending to one another continuing to cause a dislocation in Libor levels. This may paint a seemingly volatile and gloomy landscape but money market funds still provide a relatively safe haven especially AAA-rated MMFs.
Before describing how the investment landscape has altered for MMFs, it is important to be clear on what type of MMFs we are talking about. The reality facing investors is that all MMFs are not the same, which has highlighted the importance of understanding the risk/return dynamics of differing types of MMFs.
Enhanced cash and short duration bond funds are distinctly different from AAA-rated treasury-style MMFs. The definition provided by the Institutional Money Market Fund Association (IMMFA) defines MMFs as: “mutual funds that invest in short-term debt instruments. They provide the benefits of pooled investment, as investors can participate in a more diverse and high-quality portfolio than they otherwise could individually. MMFs are actively managed within rigid and transparent guidelines to offer safety of principal, liquidity and competitive sector-related returns.”
Moreover, IMMFA implicitly distinguishes between treasury-style products such as constant net asset value (NAV) MMFs and investment-style funds with a variable NAV. In fact, IMMFA has worked hard to create a transparent code of practice for MMFs in Europe as a way of differentiating true AAA-rated funds from other money market vehicles. This has proved necessary, as a number of high profile European-based short-dated bond funds and enhanced cash vehicles suffered losses following the credit rout, negatively impacting the perception of the money market universe as a whole.
Prior to August 2007, the focus among many managers had shifted towards maintaining lean liquidity positions, and in many respects to ‘chase yield’ in the market place. Investors contributed to this behaviour as fund managers were increasingly pressurised to generate yield in order to stay competitive in winning new business. For the most part, fund managers who kept true to the core objective of capital preservation would not be able to complete on a yield basis and were considered to be inferior as a result.
Clearly, this had now been turned on its head as conservative managers have benefited from investors making a flight to quality. The emphasis on capital preservation and maintaining a high enough level of liquidity has been necessary to guard against selling assets in markets where liquidity cannot be guaranteed. Aside from liquidity challenges, trying to find high quality alternatives to bank risk in an area of the market dominated by bank issuance also presents challenges. Adding government/agency paper is possible but the impact to yield can be quite dramatic with levels posting in the region of 30-90 basis points less than one-month Libor.
Despite the impact to yield, government/agency paper increases the overall credit quality of the fund and offers tight bid/offer spreads, which is very welcome when markets are illiquid. Corporate commercial paper acts as another diversifier away from bank risk, although high Libor levels make short-term issuance expensive and less attractive for issuers. Maintaining a high liquidity profile, diversifying away from bank risk and keeping investments close to home all contribute towards meeting and managing to the prime objective of AAA-rated MMFs, that of capital preservation.
The time will come for investors to move further out on the risk return spectrum but recent events have reminded us that, despite sitting at the conservative end of the risk/return spectrum, MMFs are not risk free and active investment decisions do take place.
It is equally important to remember that AAA-rated funds, as defined by IMMFA, have proven to be highly resilient to financial market volatility. It is key to understand the distinction between enhanced and short bond funds, as they have a different risk profile to the aforementioned ‘treasury-style’ AAA funds. Enhanced and short bond funds continue to be wholly appropriate, as do MMFs, as long as investors’ risk appetite and objectives of a funds’ strategy are in line with one another.
The capital markets have not been alone in reappraising risk. While the capital markets are making adjustments to the levels of risk premia across asset classes and instruments, investors continue to take a close look at the appropriateness of their investment strategies against investment objectives.
As this process of risk reappraisal evolves, investment strategies in the short duration space will become more clearly defined, enabling investors to better manage their risk budget. A broader, better-defined product array will give investors the confidence and conviction to tactically manage their cash going forward.
Any opinions expressed herein are made and honestly held at the date of production and publication and accordingly are subject to change at any time without notice. This material is directed to eligible counterparties and professional clients and should not be distributed to or relied upon by retail investors. For Asia Pacific markets, it is directed to institutional investors, expert investors and professional investors only and should not be distributed to or relied upon by retail investors