Money Market Funds Weather the Credit Storm
The investment environment has been adversely impacted by the global credit crunch that began in the US. Market volatility increased in the face of the poor news flow, particularly in the financial sector, as investors became more risk averse and there was an increased demand for government bonds as corporate spreads widened. Asset-backed securities and financials were the key sectors hit amid aggressive sell-off in a market where investor sentiment, rather than underlying credit quality, determined prices. Although inter-bank lending rates moved up in the US, the UK and the eurozone, major central banks’ co-ordinated liquidity intervention helped to dissipate some of these funding pressures.
One certainty for treasurers in these trying markets was that treasury-style money market funds (MMFs) stood firm. Ever since the market turbulence began in earnest last summer, a wide range of investors have sought refuge in MMFs. The general flight to quality in the credit markets over the last six months has led to relatively higher yields for these funds. MMFs are investments that attract the highest credit and liquidity ratings from rating agencies, since the fund managers only invest in short-term highly rated securities such as certificates of deposit, commercial paper and government bills. Corporate treasurers are the dominant class of investors in these funds but other institutions are also catching on. A wide variety of investors from local authorities to hedge funds are using liquidity funds as places to park their short-term un-invested cash.
There are a number of ways treasurers can actively manage their dedicated cash allocation. The first and most widely used method in Europe is to invest the cash by placing funds in bank deposit accounts. However, by doing this, the investor becomes an unsecured lender to that bank, essentially taking balance sheet risk. Proper diversification may also be difficult to achieve, given the logistical and administrative issues of spreading deposits among 10 to 20 banks. An additional drawback to bank deposits is yield. A highly rated bank quite often has other sources of funding, thereby avoiding the need to pay competitive rates on relatively small deposits.
Another option for the investor is to hire an experienced ‘cash manager’ for a segregated cash portfolio. By using this approach, the investor does not pool assets in a commingled fund and, thus, loses the benefit of scale, which typically gives fund managers an edge in price execution. The investor is also dependent on an efficient flow of information between their custodian and their cash manager, in order to ensure full investment of surplus cash on a daily basis.
Perhaps the most competitive and logical choice for those looking to invest cash is through AAA-rated MMFs. As an alternative to bank deposits, they offer the perfect parking place for daily or ultra short-term needs, providing complete liquidity and security through diversification and risk management. Each fund contains a range of instruments and deposits from a variety of institutions, with limited exposure to a single counterparty. Liquidity funds are more efficient and safer in the sense that they are rated higher – AAA rating rather than a bank counterparty rating; they also provide same-day liquidity without tying up cash in deposits. One of the many advantages of an MMF to a treasurer is that once the investment has been made, it rolls over. The client does not have to worry about managing risk as it’s the portfolio manager’s duty to oversee that.
European MMFs have seen assets under management surge over the last few years. Although the growth in the initial years was much slower as compared to that in the US, it has gathered steam of late.
This can be attributed to a number of factors, but the most significant development has been the changes to the Basel II capital adequacy framework and the introduction of the European Union’s Markets in Financial Instruments Directive (MiFID). While corporate treasurers often use MMFs as part of a liquidity management strategy, the same is less often true for the proprietary cash of investment banks and other financial institutions. This was because under the original Basel Accord, financial institutions were required to make large provisions against these investments.
Moreover, MMFs were treated the same as higher risk equity funds, making them relatively expensive to hold. However, under the new framework, the risk weighting of these funds was reduced to 20% from the earlier 100%. Furthermore, banks will be required to hold far less capital in highly rated MMFs making them an attractive destination for short-term cash placements by banks.
Additionally, under MiFID, banks will be allowed to invest client money into AAA-rated funds, earning a higher return than just relying on bank deposits. With these structural and regulatory changes coming into place, we expect the market in Europe to grow significantly over the coming years.
Strategic cash management can contribute significantly to an investor’s profits. By investing in a customised blend of MMFs and enhanced cash funds, they can improve the efficiency and alpha generation of their cash management programme in line with their risk tolerance and liquidity needs. In addition to MMFs’ superior diversification, liquidity and yield, the current investment environment also offers a tactical opportunity to boost alpha generation through these funds. In short, there is a growing opportunity cost for not investing in MMFs.
The improved capital treatment of MMFs under Basel II and MiFID has provided an immense growth opportunity for the MMF market by attracting the enormous pool of banking sector cash. Additionally, while banks have long been familiar with the concept of managing the balance sheet by securitising assets, it is likely that as they become more active in the MMF sector they will come to see these funds as a vehicle that allows them to manage their balance sheet liabilities by offering clients an attractive off-balance sheet alternative for their short-term cash surpluses.