Investing Through the Liquidity Crisis
Short-term investing is a critical function of most treasury departments. Investors work to preserve principal and maintain liquidity as their primary goals, while also attempting to maximise returns generated on their excess cash as a secondary goal. Historically, treasury and other short-term investors have viewed money market funds (MMFs) as safe havens to invest their excess liquidity. The past few months have tested historical norms around short-term investing. Investors are witnessing the sub-prime mortgage debacle and resulting ripple effects throughout the short-term fixed income markets. Are MMF investments really safe and exactly what does the future hold?
It is worth taking a historical perspective on MMFs. In the US, these are governed by SEC rule 2a-7, which provides guidelines for the type of instruments MMFs can invest in, concentration of any one issuer, average maturity and other restrictions all aimed at safely maintaining the fund’s liquidity and preserving principal at a net asset value (NAV) of US$1. As another layer of perceived protection, S&P and Moody’s rate some of the MMFs as a service to the fund, applying even more stringent guidelines than SEC Rule 2a-7. Funds that choose to pay for this rating and meet all applicable guidelines are designated AAA by one or both agencies. This historically provided some investors more comfort around the safety of a respective fund. The formula has worked well over the past decade for MMFs – until late 2007, investors would routinely look to the AAA rating as a sign of safety and sometimes merely pick the fund with the highest yield. Seldom did investors perform due diligence on the specific holdings of MMFs.
Beginning in August 2007, the first signs of trouble emerged in the capital markets. Several well-known extendible note programs exercised their extension features, implying they may not be able to fund their obligations upon maturity. Before long, widespread illiquidity emerged with asset-backed commercial paper (ABCP) issuers and problems with structured investment vehicles (SIVs) surfaced. Around the same time, there were several instances of auction failure within the auction rate securities (ARS) market. In response to mounting liquidity concerns in the capital markets, the Fed moved to lower the target rate, commencing an easing of monetary policy.
From the end of 2007 and into the first quarter of 2008, the liquidity predicament intensified. Certain enhanced cash funds, which had been gaining popularity among corporate treasury and other short-term investors, found themselves in trouble. Stressed with declining short-term rates and liquidity concerns, some of these funds’ NAVs dropped below a dollar. Institutional investors were quick to exit enhanced cash funds with large redemptions. One well-known fund with approximately US$40bn in assets lost over half of its value in a matter of days. The large redemptions of enhanced cash investments continued the chain effect in the short-term fixed income markets. Some of these enhanced funds held a high percentage of ARS. The redemptions, along with other market forces, pressured the ARS market and auctions began to fail. Large dealers, who formerly would have stepped in and supported auctions when backup liquidity was needed, refused to do so as they were already flushed with portfolios of illiquid securities and couldn’t afford to take on more exposure. As a result of lack of dealer support and other factors, auctions failed across the board and the ARS market became largely illiquid. Many market experts feel the ARS market will never come back as a viable investment alternative and these programs are currently being refinanced into variable rate demand notes and other obligations.
Widespread confusion cast itself into the financial press, as there were several erroneous accounts of MMFs breaking their dollar NAV and enhanced cash funds incorrectly referenced as money funds. In addition, there were several highly publicised bailouts of MMFs where financial firms actually purchased troubled securities out of the fund portfolios to preserve the NAV of these funds at US$1. There have been approximately 10 such fund bailouts noted in the market recently and, to date, no MMF through the current liquidity crisis has ‘broken the buck’ by falling below a US$1 NAV.
Where does all of this market chaos leave the treasury investor holding a portfolio of MMFs? No longer is it good enough for most investors to view an AAA rating on an MMF as a sole means of assurance. Management of many treasury departments has mandated the performance of in-depth due diligence and monitoring of specific MMF holdings. Fund families and other intermediaries are being flooded with inquiries around the safety of money funds and the specific holdings of these vehicles.
Noting there are many high quality prime MMFs in the market with little or no exposure to troubled securities, many investors were able to achieve comfort with the prime MMFs of several families and chose to continue their investment in prime funds. Others took the approach of exiting prime funds altogether, moving into government and treasury MMFs. As a result of the liquidity crunch in general, treasury prices have spiked dramatically, dropping the yields of treasury-only funds. Investors choosing to remain in prime funds have earned yields approximately 200bps over treasuries at times.
Over the past decade, many treasury investors have turned to web-based investment portals to conduct investments in MMFs and other instruments, such as commercial paper. Portal investors have seen time savings, enhanced compliance, and earning competitive returns all on one consolidated web-based platform. The market’s liquidity predicament further illustrates the power of an investment portal offering information on demand and a wide selection of investment choices. Some investment portals have proven useful in facilitating investors’ research by posting recent fund holdings, sub-prime/SIV statements, fact sheets, prospectuses and other useful information directly on the portal. In addition to online information, investment professionals, who are assigned to clients by some portal providers, continue to prove instrumental in assisting clients with due diligence around sub-prime/SIV exposure and general information regarding the liquidity crisis and how it’s impacting the financial markets. For investors choosing to change their fund investments as a result of the liquidity crisis, an investment portal executes the move between funds in seamless fashion with a few clicks of the mouse.
As mentioned, the Fed has launched a campaign of easing through the liquidity crisis, dropping the target rate significantly. Given this new stance from the Fed, MMFs are largely outperforming most short-term issuers of commercial paper and certain other corporate discount notes and government securities. As a result, many investors are choosing to shift their portfolios from individual security issuers into heavier concentrations of MMFs. An investment portal allows the investor to efficiently purchase a market of MMFs, taking advantage of their current out-performance. Should the Fed pause easing for an extended period or reverse course into a tightening posture, portal users can redeem their MMF positions and re-enter securities markets on the portal, purchasing instruments such as commercial paper and other discount notes. The portal arms the client with a tool that can be useful in an array of prevailing market conditions.
The current market turmoil has caused a great deal of apprehension and uncertainty among short-term investors. Such difficulties in the short-term markets aren’t historically unprecedented – in 1994, mostly because of exposure to Orange County debt, 20 fund families bailed out their MMFs by purchasing troubled securities from their portfolios. It’s difficult to predict when all of the liquidity issues will work themselves through the short-term capital markets during this current predicament but its clear most investors see MMFs as their investment of choice through the turmoil. New assets have been pouring into MMFs at record pace, reaching US$3.5 trillion for the first time in history, a figure that represents 34% growth over the past eight months. Investors are relying on the timely information available on their investment portals, access to a wide selection of investment possibilities, and their consultative relationship with investment professionals assigned to their accounts by portal providers to guide them through the turbulent market.