With policy interest rates at or below zero, cash managers need to be proactive to preserve principal and earn yield. Here we explain the cash strategies and investment vehicles that let treasurers seek greater return while managing risk and liquidity:
Developed market interest rates are poised to remain at or below zero for many years to come. Forward rates signal that the four most important central banks will not adjust policy rates any time soon. This presents a challenge for cash managers who seek to earn a return or even preserve principle, while maintaining safety and liquidity. A State Street Global Advisors survey of institutional investors found that two-thirds intend to take a more proactive approach to managing cash in the months ahead. This means capitalizing on a broader array of investment vehicles and cash strategies that offer greater return potential, such as separately managed accounts, enhanced cash and ultra-short-term bond strategies.
Still, many investors are leaving their cash in neutral. Trillions of dollars are idling in accounts with low or negative returns. Some cash managers are unknowingly risking their cash in undiversified, uncollateralized accounts with uncertain returns. To put this cash to work, investors need a better understanding of their cash options.
Choosing Among Cash Investment Vehicles Identifying appropriate investment vehicles is critical to optimizing cash. This entails understanding the tradeoffs inherent in the various vehicles. For instance, what are the hidden costs and risks of stashing cash in bank deposits? When does it make sense to subscribe to a money market fund or separately managed account, versus investing directly in a maturity ladder of individual securities? How do the cost and risk of managing cash in-house compare to those of using an asset manager? We cover factors to consider when choosing which vehicles are appropriate for your company.
Understanding Cash Strategies When it comes to cash, many institutional investors first think of government funds. In fact, four key strategies exist, each calibrated to meet distinct goals. Knowing how these strategies differ can help you decide when to allocate to them, optimizing performance.
Digging Deeper: Levers of Cash Performance Portfolio managers pull various levers to affect the liquidity, safety and return profile of a strategy. The levers include asset type, credit quality, maturity and liquidity. For example, how do traditional versus alternative repurchase agreements affect safety and return? What is the impact of weighted average life and weighted average maturity? And what is the impact of liquidity thresholds? To provide a deeper understanding of cash strategies, we explain how these levers work.
Attribution: Understanding Return Potential An important part of a cash team’s job is to analyze the contribution of each asset to portfolio performance. This is known as attribution. As an example, if a certain asset category is dramatically increasing the weighted average maturity of a portfolio but only adding a couple basis points of return, that asset would be better replaced with another option. In this article, we explain how attribution works and provide examples, to give you a more thorough grasp of how we optimize cash.
What to Consider When Choosing Your Manager Selecting the right asset manager for your cash is as critical as it is for any asset class. Key criteria include the size of the sponsor, depth of experience, the breadth of strategies and the amount of cash under management. Investors should also consider the manager’s investment philosophy and commitment to credit analysis. Choosing cash strategies requires multiple inputs and considerable analysis. Regardless of your risk tolerance, or how significant or unpredictable your liquidity needs are, careful selection can lead you to the most appropriate investments.
Choosing Among Cash Investment Vehicles
Clients frequently consult us on important cash management decisions. In addition to balancing safety, liquidity, and yield, they ask, how should we invest? What investment vehicles are suited to our goals? Should we use bank deposits, rely on professional asset managers — either money market funds (MMFs) or separately managed accounts (SMAs) — or should we purchase securities ourselves?
As a hypothetical case, let’s assume you are a treasurer with $100 million to invest. The money is to be used for operating costs and strategic investments, so it must be held in cash or cash-like instruments. Key questions include:
What management fees will we pay?
What liquidity will we receive?
What risks do we face?
To what extent is cash investing a competency we should develop in-house?
Option 1: Bank Deposits
After initial research, bank deposits appear appealing. A regional bank is offering 75 basis points (bps) interest, charges no management fee, and promises immediate liquidity. Yet a few months after opening the account the rate has dropped to 0.00%. On further analysis you learn that banks (unlike MMFs) have no fiduciary obligation to optimize your returns and can adjust rates without notice.
Meanwhile, you also consider the risks. A bank deposit is essentially an unsecured loan, a bet on the creditworthiness and risk practices of a single bank. There is no diversification or collateral, and insurance is limited to $250,000. If the bank fails, your operating cash would be at risk and liquidity would be compromised. Bank failures do occur. There have been at least 370 in the US since January 2010.1 You learn that you may eventually get a portion of your deposit back, but it can take years.2
In other words, you are providing the bank with an interest-free, unsecured and undiversified loan. In the event of default, this would be difficult to explain to the board. You conclude that bank deposits are useful as an immediate backstop for your operating accounts, but exposure should be minimized. Given the hidden costs and risks, you consider hiring a team to conduct credit analysis, but first you explore other options.
Option 2: Money Market Funds
You had initially declined to invest in a MMF because of a 12–15 bps management fee. But now you have a greater appreciation for what that fee buys. MMFs have portfolio managers and professional credit analysis teams. They are limited to holding no more than 5% of risk assets from any issuer, so they are diversified. Moreover, MMFs abide by SEC liquidity guidelines that have been strengthened since the financial crisis. These guidelines require portfolio managers to maintain at least 10% daily and 30% weekly maturing assets (or assets that qualify according to the SEC’s rule). With this liquidity, you can redeem any time (before the daily deadline) and you receive your cash. Although not guaranteed, there is generally no cost to this liquidity when invested in constant NAV products that use amortized cost accounting methods.
The bottom line: MMFs allow you to benefit from term asset returns while not being constrained by their liquidity. You get the yield on the portfolio without having to pay to sell an asset that matures in six months.
Option 3: Separately Managed Accounts
You also learn that SMAs offer advantages relevant to your cash needs. SMAs often charge lower management fees than MMFs, and you can customize the investment guidelines. You can put specific limits on asset types, issuers, durations, liquidity, and other parameters. There is one drawback: SMAs are less liquid. If you unexpectedly need cash, you may have to sell assets, which could generate either a loss if the market is down or a gain if it is up. Still, you decide to seek enhanced returns for the tranche of cash you are holding for future acquisitions, by bearing slightly more risk and duration.
Option 4: Investing in Securities
Another alternative would be to invest in individual securities. You consider creating a maturity ladder of investments, similar to a Government MMF, but there are tradeoffs to consider. As with an SMA, market moves would determine the cost of generating liquidity and you could generate realized gains or losses. Additionally, you have operational risk. If a member of your team is buying and selling treasuries, that process must be controlled. Moreover, what happens if that person is sick or leaves the firm? You must implement market and operational procedures and have backup and safety protocols. If you have credit exposure, who will monitor the credit worthiness? An asset manager has a dedicated credit team that monitors each name, formally reviews that name on a quarterly basis and determines if it qualifies as appropriate for investment.
In the end, you conclude that MMFs and SMAs make sense for your treasury department. Cash investing is critical, but developing the needed investment and credit-analysis expertise in-house would be inefficient, expensive, and potentially risky.
Understanding Cash Strategies
At its core, cash investing involves a subtle but important tradeoff among return, liquidity, and safety. Over a business cycle, investments featuring lower liquidity and safety are expected to produce higher returns, whereas those with greater liquidity and safety would yield lower returns.
Cash can be invested in a variety of strategies, depending on a company’s cash balance, goals and constraints. Safer, more liquid strategies are appropriate for near-term cash needs. Funds intended for longer-term purposes, such as future acquisitions or longer-term strategic reserves, can be invested to seek greater return. This can be accomplished using strategies featuring incrementally less liquidity and safety, provided that the investor would not need to liquidate this pool of cash at an inopportune time, such as during a near-term market disruption.
Generally speaking, there are four types of cash management strategy, each featuring parameters that impact safety, liquidity, and return. Below they are ranked from most to least conservative.
Government cash strategies Also known as sovereign strategies, these strategies own only sovereign debt, so they are a natural safe haven in times of stress. Because sovereign debt from major issuers is frequently and easily traded, sourcing liquidity from government cash strategies is easier than from other cash strategies, particularly during “risk off” market moves. Immediate liquidity and maximum safety make government cash strategies appropriate for daily operating cash.
Prime cash strategies These strategies provide an incremental yield advantage over government strategies by investing in short-term credit. These investments pose minimal credit risk and typically carry good market liquidity. Prime strategies can add incremental alpha by investing in short-term, floating-rate notes that mitigate the impact of rising interest rates, while increasing yield over fixed-rate investments of similar duration. Immediate liquidity and strong safety make prime cash strategies a good choice for organizations that seek additional yield on their operating cash.
Enhanced cash strategies Like prime strategies, these also invest in credit, but further out the maturity curve. During normal market conditions, enhanced cash strategies invest a portion of their assets in floating rate notes that mature in two to three years. They also allocate to other asset types for diversification. Asset-backed securities (ABS) provide AAA-rated credit quality while delivering similar yields to comparable unsecured credit. Because enhanced cash strategies tilt toward yield and take on slightly more market risk, they are better for reserve cash or strategic cash.
Ultra-short-term strategies These typically generate most of their alpha using lower-rated securities, and using investments with a longer duration. Ultra-short strategies also invest in ABS and non-agency mortgages to diversify and boost returns. The incrementally greater risk profile of these strategies makes them appropriate for longer term strategic cash.