In the current environment of low interest rates, investors are increasingly seeking alternatives to the traditional approach of placing cash reserves on deposit. Ideally, the investor is looking for assets that are liquid and that yield more than deposits, while maintaining a low risk profile. For these investors there are two methods of increasing performance:
q security selection and
q active duration and yield curve management.
Clients want a minimum desired return on the original investment. This can be managed with the value-at-risk (VAR) of the portfolio: a measure of the minimum return over a certain horizon with a certain probability. For example, by restricting the permitted VAR of the portfolio to a positive figure only, the investor gets the 'soft' guarantee that the potential capital losses in the portfolio will not exceed the (interest rate) income in the portfolio. It is important to include all types of risk in the VAR calculations. Therefore not only interest, yield curve and currency risk should be assessed, but also credit risk that can be caused by either defaults or changes in credit spreads.
The use of VAR restrictions enables the investor to extend the portfolio's duration, for example by investing in short term government paper. An investment in this liquid short-term paper gives the investor a yield pick-up, at the cost of an increase in duration. The VAR restriction ensures that the duration is limited, so that negative returns are unlikely. Besides the yield pick-up, the VAR approach enables investors actively to manage the portfolio's duration. Depending on the interest rate view, the duration of the portfolio may be increased or decreased. However, the VAR restriction must at all times be applied to the resulting portfolio.
History shows that this active duration approach gives the investor ample opportunity to achieve an attractive return. Based on studies we have made using our duration-timing model, a return close to a bond index can be achieved with a lower risk profile (Figure 1). This model holds limited risk of a negative 12-month return (Figure 2). Depending on the risk profile, the investor may choose to apply tighter or less restrictive VAR limits to reduce or raise risk to the desired level.
Active duration and yield curve management is complemented by active security selection. For optimal security selection it is important to include the full spectrum of available instruments such as asset-backed securities, structured deals, (reverse) repos at the desired level, etc. This full spectrum offers opportunities for yield pick-up, however, at the cost of liquidity. By limiting the amount invested in such assets liquidity can be held at the desired levels.
With cash management the name of the game is taking small risks in a controlled way. Duration skills combined with a solid VAR framework and active security selection can lead to attractive returns for a cash portfolio.
Erik van Leeuwen is head of Robeco's money market portfolio team in Rotterdam