On a steep learning curve
Momentous changes are taking place in the staid world of cash management. “The euro-zone single euro payment area (SEPA) took effect from 28 January this year,” says Andy Reid, head of northern European treasury for Deutsche Bank. This obliges banks to treat cross-border cash transfers as those within one country, charging for them at rates similar to those for low value transfers.
“This will have a dramatic effect on cash management as corporates and their pension funds realise they can pool cash balances more readily than ever before,” says Reid.
Not only does the advent of SEPA minimise the transaction costs entailed in pooling cash it also facilitates better risk management. “Centralised cash pools will permit more optimal portfolios of risk and return, particularly on the duration side,” he adds.
It should also facilitate the use of cash pools as collateral for pension fund swap and overlay programmes, a practice still far less widespread in Europe than the US. This is against a backdrop of suddenly increased risk aversion among trustees and pension boards. “To understand the current situation you have to look at the history of cash management over the past six to seven years and then what has happened over the past nine months,” says Paul Cavalier, head of fixed income research at Mercer Investment Consulting. During the liquidity bubble, enhanced return funds extended traditional money market portfolios from sovereign and AAA debt to, for example, commercial mortgage-backed securities (CMBS) and payment in kind (PIK) notes.
“The fundamental distinction here is between stable net-asset value funds and non-stable ones,” says Kathleen Hughes, (pictured above) head of global liquidity business in EMEA for JP Morgan Asset Management. Non-stable asset funds offered enhanced returns by accepting risks that were not properly understood.
“This is pretty typical of a bubble where some participants form unrealistic expectations and stop asking the hard questions about their sustainability,” warns Cavalier.
With a number of enhanced return funds suffering asset value right-downs, it is also a reminder of the obligation on pension funds to mark their assets to market. Some of these funds might, if given time, achieve their return targets. “But fund redemptions have also been a problem, leading to the forced selling of semi- and illiquid assets,” adds Cavalier.
The most tangible signs of risk aversion among trustees are the widespread changes in performance benchmarks for cash portfolios. “Instead of LIBOR plus there has been a shift to LIBID 7 day,” says Cavalier.
Some of the enhanced funds have performance targets of LIBID 7 day plus 200-300bps, which can only be achieved by extending portfolio durations and accepting more interest rate risk. Elsewhere benchmarks have been extended to LIBID 30 day plus or the average return of a group of funds selected by pension consultants.
“There is retrenchment from non standard benchmarks,” says Marcus Littler, director of sales for institutional liquidity at Bank of New York Mellon (BNY Mellon). The enhanced funds now look tarnished. “I would judge that now safer liquidity funds would have durations of no longer than 60 days and treasury funds of less than five days duration,” he adds.
Meanwhile, fund write downs have sparked a blame game among consultants and trustees with the rating agencies an readily visible target. “It is always easy to be wise after the event,” notes Littler, “but there is a sense that the agencies trailed the development of complex debt instruments which were held by the enhanced return funds.”
But the consultants also deserve some blame. Cash management has long been a low priority topic, with cash balances managed on a semi-passive basis. Ignorance also extended to the fund managers. “Nine months ago if you asked what a SIV was most people would have said a four wheel drive vehicle. The industry has been on a steep learning curve,” recalls Littler.
The beneficiaries of this are the Treasury and stable asset fund providers. “Our Treasury fund has grown by 100% over the last seven months” says Littler. The same is true at JP Morgan and elsewhere. Of course, the mainstream managers have been marketing now-unpopular enhanced return funds, but so have many boutique managers. “Some of these will be under real margin pressure as their assets under management crumble away,” says Cavalier.
Latest data from the Institutional Money Market Funds Association (IMMFA) shows that the supply side for stable NAV funds is concentrated. Of the sterling denominated fund providers, Barclays Global Investors is by far the largest with assets under management (AUM) of almost £18bn (€10.4bn) in a market with total AUM of £377bn. Insight and SWIP each have over £8bn but thereafter the market falls away with a total of 23 providers.
The euro denominated market is worth less, with AUM of only €56bn and 24 providers. Goldman Sachs and JP Morgan Asset Management both lead the field with AUM’s in the €9-10bn range.
One-year returns on these funds are not terribly high. The average net return for sterling denominated is 5.78% (end February, 2008) and 4.07% for the euro denominated ones. The respective seven-day yields for each currency are 4.28% and 5.66% (as of 1 February 2008). After deducting inflation they look very slim, which helps to explain why enhanced funds, some offering returns in the 6-9% range were able to gain so much new business over the last seven years. “But that was before the credit crunch,” adds Cavalier.
The big question is if and when these funds will be accepted as collateral by the banks. “This is already done in the US but the legislation does not exist here in Europe,” says Hughes. Change on this may be imminent. London-based boutique Prime Rate Capital (PRC) launched an onshore stable net asset value fund in March that will be regulated by the Financial Services Authority (FSA).
PRC’s chief executive officer Chris Oulton, says: “The key point here is that debt instruments can be used as collateral and our fund is being classified as a debt instrument.” MiFID and Basle II will also have an effect. MiFID permits intermediaries to use this type of fund instead of bank accounts. Basle II will also change the treatment of these funds to a risk adjusted basis.
“Under the old regulations they have a 20% risk rating, under the new, 100%,” adds Oulton. It is sign of the times that PRC’s new fund will not hold any asset backed paper and will have a maximum maturity duration of three months. “The market has re-priced risk. It will be some time before this changes,” adds Oulton.