Keeping their edge
Risk is a growing problem that has yet to be properly addressed by many cash investors. At the bottom of the economic cycle, investors would usually be expected to reduce risk, as rising corporate defaults and business failures significantly increase the chances of a loss of capital. But, because of the current combination of sluggish economic growth and falling interest rates, many investors, in an effort to chase marginal yield, have inadvertently increased the exposure of their cash portfolios to credit risk at a time when credit downgrades are accelerating.
This year has seen price volatility and credit rating deterioration hit the financial and banking sectors particularly hard. As a result, a major concern for bank account holders is the growing counterparty risk from global banks. The global banking system has come under pressure from the sustained global economic downturn and the credit quality of many banks has deteriorated significantly as plummeting share prices, rumours of large trading losses and corporate failures such as Enron and WorldCom have eaten away at their balance sheets. Resulting downgrades to many US banks have raised concerns among investors who previously viewed the banking sector as stable.
And it’s not only in the US where the credit rating agencies have been busy wielding the axe; bank ratings here in Europe are also now coming under severe pressure. Even in Germany, where the banking system had until recently looked solid, continued economic weakness and rising bad loan losses have led to credit reassessments.
Therefore, bank deposit accounts – which for institutional investors are usually unsecured – are not so safe in the current climate, especially because in a bank account investors are totally exposed to the balance sheet risk of the individual bank itself.
These banking downgrades have served to highlight the importance of risk management for institutional investors, who face the task of ensuring a company’s assets are managed effectively, balancing return potential with the risk being taken to achieve it. Therefore, any product that can reduce risk while enhancing return is likely to become ever more popular – hence the continuing growth in popularity of money market funds.
Unlike bank accounts, money market funds diversify counterparty risk across their underlying assets, allowing investors to achieve a spread of counterparty risk through a single investment. In the current environment, where it is even more important to manage counterparty risk, a institutional investors can also take comfort in the knowledge that the vehicle they are using to manage their cash holdings will be rated more highly than the banks with which they are currently placing deposits. There are few AAA rated banks today and those that remain are heavily targeted by investors - resulting in considerably less competitive rates.
But, even in the highly risk-averse world of money market funds, risks to capital have increased in recent months, as some money managers have increased their exposure to lower-rated credit in order to gain more business from yield-hungry investors. The result is that the cash holdings of some money market fund investors are often not as secure as they would believe, leaving them open to potential losses.
The experience of US money market fund investors in the early 1990s should serve as a warning for today’s investors to choose their fund providers carefully. A decade ago in the US, interest rates were low, yield curves were flat and credit conditions were deteriorating, much like the economic environment prevalent today. Also like today, institutional money market fund investors sought out the funds with the highest yields as they tried to compensate for the drop in interest rates.
With very small advantages in yield (maybe just a few basis points) leading to large cash inflows from investors, some money market fund managers were naturally tempted to invest in more complex assets in order to gain higher yields than their competitors. Many strategies were used to boost yields, including structured note range floaters linked to the most popular investments of the day - agency debt. These derivatives offered money market managers access to higher yields as long as interest rates remained stable. The complexity of the products inevitably led to problems, with some funds losing a large part of their cash portfolios after the market price of the notes dropped following a rise in interest rates.
The conclusion from the US experience a decade ago is clear: Investors must choose their money market fund provider carefully. The best money market fund managers have global resources focused on the efficient and secure management of cash, allowing them to use rigorous macro and micro economic analysis to avoid credit defaults. In particular, investors must ensure that their money market fund provider has a team of independent, experienced and highly incentivised credit analysts to ensure that the potential for credit mishaps is limited.
The ability to analyse independently credit is particularly important in these days of credit deterioration when the pool of good quality securities is shrinking. This is because thorough investigation of the market by professional credit analysts can expand investment choices in a shrinking universe of opportunity. Independent evaluation of the creditworthiness of companies is invaluable because it allows the money manager to build a portfolio without having to rely on the opinions of the rating agencies. The major agencies are a large determinant of price levels in the market and so opportunities arise when the inhouse team have an alternate view. Such rigorous analysis introduces a further layer of control and investigation to the management process of funds, helps add value and avoid potential losses.
Credit analysts also determine whether a security is fairly priced and the extent to which any potential credit upgrade or downgrade has already been priced-in by the market. In the larger investment houses teams of analysts are usually responsible for populating a frequently reviewed internal ‘approved’ list of securities eligible for purchase by portfolio managers, adding yet more security to the process.
To retain a triple-A rating and maximise security, the average weighted maturity of instruments held within money market funds should not exceed 60 days. Liquidity Funds should also ideally be rated by both S&P and Moody’s, which means that at least 50% of holdings must be rated A1+/P1 with the balance in A1/P1. In addition, a money market fund should be able to demonstrate a large number of diverse underlying investors so that the fund’s stability is enhanced and no single investor or group of similar client types will compromise the fund’s overall liquidity.
With regard to individual line items within a fund, these too should be of sufficient number to cushion any potential individual volatility. A typical number of holdings might be 75-100 on a medium size fund rising into the hundreds for a larger fund where a small percentage of the fund’s assets still provide a sizeable ticket in the marketplace – and therefore best execution. This overall spreading of risk is rapidly becoming the favoured route of investors wishing not to place their eggs in a few selective baskets where they may also bear the burden of monitoring short-term counterparty risk.
It is clear that money market funds can never negate risk completely. However, recent market action has highlighted that during certain parts of an interest rate cycle focus on credit risk needs to be heightened and so it is important to select a provider that manages risk appropriately for this type of vehicle. In particular, the provider must have a robust process, independent credit analysts and superior service. The objective of AAA-rated money market funds remains to focus on security and liquidity – and only after to concentrate on yield.
Peter Knight is head of institutional liquidity funds and Neil Ellerbeck is senior fixed income portfolio manager at JP Morgan Fleming Asset Management in London