In the shadow of cash
For institutional investors, seeing significant amounts of cash among their assets can be irritating even if their guidelines allow fund managers to have up to 5% in cash. In general, they would naturally prefer to be fully invested in the asset class that they have designated the investment to be in. As a result, there can be a tendency to either allow short-term cash to be left with custodians without any negotiation of rates, or left up to fund managers with the understanding that there will be nothing “exotic” incorporated into the portfolio. There are however, a number of pressures that make such a view seem naïve.
The first and foremost factor to consider is the new environment of low yields. An extra half a percent on a low risk asset is significant when yields from much more volatile assets such as equities may only be 2-3% more than cash.
There may even be a better trade-off to be made by reducing the equity component somewhat while squeezing more out of cash. Secondly, the move towards widening asset classes is often obtained through strategies that involve taking on synthetic exposure through derivatives whilst holding the majority of the assets in a cash fund. A good example would be taking on commodity exposure, which has been an attractive strategy given the increase in prices driven
by a combination of a rise in short-term demand from a cyclical recovery in the US and Europe together with the long-term secular demand from China driven by its rapid growth rate.
Institutional investors have been able to gain an unleveraged exposure to commodities by, for example, buying GSCI futures contracts for a nominal amount combined with maintaining a cash exposure for the same nominal figure. The total return can be enhanced by gaining extra yield on the cash. Investors who have bought into macro hedge funds, which are a combination of derivatives and cash, should also be aware of what the options are on the cash side.
If we take the commonly used benchmark of seven-day Libid, then parking spare cash into a triple A rated money market fund can offer perhaps 8-10bp net of fees above that, with arguably a better credit rating than the custodian. Such funds are becoming a much more widely accepted alternative to a bank deposit for parking short term cash. Despite this, John Luke, director of liquidity products at Morley Fund Management in London, points out that “40% of all cash in total is in current accounts according to a recent study”.
What are the choices beyond the use of AAA rated funds? The large banking groups such as Citigroup pride themselves on being able to offer a complete range of options against a variety of benchmark durations ranging from overnight to three years. The next stage for them from a triple A fund would be enhanced cash funds, which, Paul Timlin from Citigroup Asset Management finds, have recently become of more interest to their clients - “our enhanced cash funds are AA rated (Moody’s) and seek to increase yield by extending average duration and taking on slightly more credit risk in a well-diversified portfolio”.
The average pension fund will have someone doing treasury work part-time and the main option would be short term deposits. Going down a segregated route for cash does enable a cash strategy to be exactly tailored to the requirements of the individual institutional investor for amounts ranging in size from £20m (e29m) to £100m. There is a trade-off to be made between the extra yield and liquidity, yield curve exposure and credit risk. However, the gains of around 50-75bp above 7-day Libid with a diversified exposure to single A and above credits can make such enhanced cash strategies an attractive option.
The key distinction between this approach and a triple A rated money market fund is that a) the cash is segregated and not pooled and b) it is possible to use a wider range of instruments. These could be shorter dated, gilts and supra-nationals and high quality corporate bonds and c) whilst it is possible to withdraw large amounts at very short notice, it is preferable to have notice periods of as along as a couple of weeks for large withdrawals, managers may not be keen on more than two or three withdrawals a year.
The lowest risk active approach would to use certificates of deposit (CDs). These are issued by financial instititutions and rated by S&P, Moody’s and Fitch. Because of the high credit quality and low duration, the cost of moving the portfolio is relatively low. As Matthew Tatnell, head of money markets at Morley Fund Management, explains “the bid-offer spread on a six-month CD issued by Barclays is 1 basis point. This gives the ability to be nimble with an interest rate view”. The typical investment portfolio would be very short term CDs issued by high quality banks with a target of 20-30bp over 7-day Libid. Morley, for example, would “look to add that when interest rates are flat, eg, we are now in a period when UK base rates could stay at this level for the next 18 months. We try to take advantage of short term market volatility even if there are no moves in base rates. With gilts, we seek to identify switchable opportunities in sideways tracking on relatively small changes in yields – if yields are falling, we may hold them longer.”
Higher returns without necessarily sacrificing credit quality can be obtained by expanding the choice of instruments to include floating rate notes (FRNs), which are slightly less liquid but still high credit instruments. The ‘vanilla’ FRNs are issued by building societies, and banks typically for five years with quarterly roll-overs of interest rate and are relatively high quality. For Morley, the minimum credit rating looked at would be single A and they would go up to AA, but “it is not worth buying AAA as they are so expensive” Tatnell argues. A single A would add 25bp over 7-day Libid, although you are effectively taking five-year credit risk.
A major and rapidly growing market that offers attractive opportunities for enhanced cash strategies is the asset backed securities (ABS) which cover a wide range of receivables ranging from mortgages to credit card receivabless usually with an average life of five years. These are typically issued in a number of different tranches with credit ratings from AAA for the senior notes down investment grade for the subordinated notes. As Morley’s Tatnell points out, “you need to look through the structure of the deal, financial receivables could include film rights for example”. Tatnell would only buy the AAA tranches and these can offer 30-35bp over 7-day Libid - “they have been in good demand although in the last few months, spreads have come in as investors have searched for higher yields, giving some capital appreciation to existing holders”.
To fully take advantage of the possibilities, enhanced cash strategies would be juggling yield curve views with liquidity constraints and credit exposures whilst essentially investing ain a mix of term deposits, CDs, both vanilla FRNs and ABS as well as in the case of sterling for example, short dated gilts, supra-nationals and corporate bonds. Morley’s Tatnell has the approach of leaving “most of the fund for most of the time in CDs so there is always liquidity”. Credit risk is controlled by ensuring that “no more than 10% in any one credit with usually have 15-20 credits”.
When looking at enhanced cash strategies for institutional investors, it is worthwhile emphasising that the overriding emphasis is still on capital preservation and liquidity. In general, cash is rarely given as a separate mandate, but at the same time, it should not be ignored, particularly if diversification moves a fund into alternative investment strategies s where cash may form a major and integral part of the whole investment proposition.