High corporate cash balances and the worst economic environment for a generation have created huge challenges for treasurers looking to define and deliver prudent investment policies. The complex investment environment is also creating difficulties for money market funds (MMFs) – vital investment products providing security, diversification and liquidity. Greater flexibility and creativity among treasurers and money market managers will be needed in order to meet these challenges.
In a world where safe assets are in short supply, identifying secure cash investments is becoming more difficult. The huge debt overhang from the great financial crisis continues to weigh on growth prospects, making it harder for governments to stabilise fiscal deficits. Clearly, the problem is most acute in the eurozone where the currency block’s most indebted nations are trapped in a paradox of austerity: collective fiscal consolidation is dampening growth making it more difficult for individual governments to meet their deficit targets.
However in other developed markets still perceived as safe havens, debt and deficits remain huge by historical standards. The US, the UK and Japan, among others, remain vulnerable to contagion from the eurozone.
Deteriorating financial sector creditworthiness is a symptom of the feedback loop between sovereigns and banks. Since February 2008, the average credit rating of the top 51 European banks has fallen from Aa2 to A3 in June 2012, according to a study released in late June by Moody’s. Declining credit quality is undermining treasurers’ confidence in some of their traditional cash investments of short-term government debt and bank deposits.
In response, many institutions trading in multiple currencies have chosen to centralise their liquidity operations in order to develop a global approach to liquidity and counterparty management. Relationships with global MMF managers that provide a suite of funds across currencies have been strengthened as treasurers seek to increase diversification.
The importance of MMFs has increased, with a corporate cash investment survey of global treasurers and cash managers by SunGard in 2011 indicating that 55.1% ‘identify them as an extremely important part of their future investment strategy’, up from 48.4% the previous year. While not directly comparable to bank credit ratings, the high credit rating assigned to some MMFs, such as the Fidelity Institutional Liquidity Fund (rated Aaa-mf and AAAm by Moodys and Standard & Poor’s (S&P) respectively), is likely to support this trend while macroeconomic uncertainty persists.
Meticulous credit research has always been vital for achieving a high level of security and, in this environment, cannot be taken for granted. Larger institutions may be able to invest in increasing the skill and resources of their credit analysis function, but the options are limited for many small and medium-sized enterprises (SMEs). It is for these investors that MMFs are most important. However, MMFs have also had to adapt to the shifting nature of credit risk.
At Fidelity, for example, we employ intensive fundamental credit research to independently identify the highest quality issuers. This attitude to investment security has led us to a more conservative portfolio construction approach. We have reduced exposure limits and maturity guidelines since the financial crisis, while maintaining a high level of diversification within the funds.
A Global Approach
Treasurers are taking a more global approach to liquidity and so are MMF managers. Portfolios are now invested in issuers domiciled in a more diverse range of countries. A global investment reach is vital for providing the necessary insight into the credit strength of these global issuers. A greater focus on sovereign credit analysis has also helped strengthen, or indeed weaken, the investment case for some issuers.
Treasurers and MMF managers also face another major challenge: in a world characterised by capital market volatility and low interest rates, how can they generate relatively attractive returns without compromising the liquidity of their investments? This quandary appears set to remain for several years, given recent promises from the world’s major central banks to keep policy rates lower for longer. Most recently, the rates available on highly-rated short term euro denominated assets have fallen to virtually 0%. More unconventional monetary easing measures cannot be ruled out either as central banks are forced to counteract fiscal tightening and slowing growth.
As a consequence treasurers have to work harder to generate a return on their cash. The focus here has been on more efficient liquidity management and increasing the flexibility of investment mandates. Treasurers have moved to optimise the structure of their cash pools by cash flow requirements, ranging from the operating cash pool, where return expectations are lowest, to a strategic medium- to longer-term cash reserve. Short-term MMFs remain well suited to meet corporate demand for a highly diversified, secure and liquid investment solution for operating cash. Their flexibility and expertise in allocating across the most attractive points on the yield curve can help enhance yield, without compromising security and liquidity.
Investment managers can also help those treasurers willing to extend investment horizons for strategic cash reserves. As trusted advisors, investment managers can guide treasurers through various proposals and facilitate investment into new areas. For example, a basket of medium-dated triple-A rated sovereign bonds, with a small allocation to double-A rated non-financial corporate bonds, can be a way of increasing diversification while delivering a relatively attractive yield (even after currency hedging) and a high degree of liquidity. Fidelity’s analysis shows this type of portfolio fully hedged into euros could provide a yield over 1%1. The most important aspect of this approach is the continual review and monitoring of the initial investment thesis to ensure validity in a dynamic risk environment.
With euro-denominated funds, investment managers may need to extend that flexibility to the products themselves. In response to the prospect of negative yields, managers are already reviewing the structure and fees of euro MMFs.
Conclusion
In a benign economic environment investing spare corporate cash is a nice problem to have, but today that is not the case. Finding the appropriate balance between security, liquidity and return has never been harder for treasurers and money market investors alike.
For treasury departments this is demanding a global view of liquidity, greater accuracy in forecasting cash flows and increased flexibility within investment policies. Despite many challenges, MMFs will likely remain an important part of a robust, diversified cash investment policy.
1 Source: FIL, 15/06/2012. Based on a portfolio of bonds issued by eight sovereigns rated Aaa/AAA by at least one of Moody’s, S&P or Fitch and a selection of Aa/AA-rated non-financial companies. Portfolio duration is six years.