Cash Management in the Credit Crunch

by Wayne Bowers, Chief Investment Officer - International at Northern Trust Global Investments

Risk and return ... how things have changed, or more importantly how things are changing ... with the well-understood events surrounding the ongoing credit crunch and the potential / actual spread of tighter lending conditions, it is natural to question if we are going through a ‘temporary’ impairment of liquidity and issuance or if the last six months will result in a significant shift of capital market issuance behaviour.

Investor appetite in the front end of the yield curve now clearly understands the term ‘structure risk’. This risk can now be differentiated from ‘credit risk’ and also ‘liquidity risk’. There are clear and measurable price and yield differences between those securities that exhibit various levels of structure, credit and liquidity risk, whereas perhaps in prior years these risks have not been differentiated and priced accordingly, seemingly blindly off a stable libor curve. This has driven investors to demand, require and get used to a return requirement equally measured off a libor curve, with perhaps indifference to the levels of structure, credit or liquidity risk that the underlying securities contain.

Perhaps what the last six months have taught us most is the heightened level and need to better understand the structure of a security:

• Single corporate issue versus structured credit commercial paper

• Credit quality - here I mean not the ‘official’ rating but the underlying quality and potential for upgrade / downgrade

• Last but not least, the liquidity available in the underlying security - a bank issued certificate of deposit versus a structured credit floating rate note.

An understanding and need for price / yield differentiation is now required by investors and quite rightly so, for those securities with different levels of risk. What does this mean for issuance trends in coming months and quarters?

Clearly, investor appetite has changed, which has caused significant lack of appetite for certain structured credit and securitised products. Will this appetite come back? Not entirely and if it does, it will need a significant increase in underlying transparency and risk measurement by the investor, together with price / yield differentiation over and above the more plain vanilla, single issuer type security.

The speed at which securitisation has grown in the US has been phenomenal, but so has the decline. Europe and Asia have not ‘enjoyed’ the pace of growth in this market area and is thus less affected by the downtrend in securitised issuance. In addition, we should remember and note the more traditional banking model that still exists in Europe with regional small, medium and large commercial banks willing and able to lend from the balance sheet as opposed to arrange and issue debt on behalf of clients.

So where do we go from here?

Issuer and sector diversification, credit risk management, liquidity and maturity management all need to be employed to successfully run and maintain a principal preservation, liquidity providing, market yield generating cash management solution. Reliance on outsourcing this function should increase, while investor appetites for increased yield will be tempered without accepting increased risk.

‘No free lunch’ springs to mind and although investor education has been and will continue to improve, the risks of running a cash management investment solution focused on return rather than risk are now clear to us all. An understanding and need to price credit risk, appropriate issuer diversification and liquidity provision should enable an appropriate expectation of return to be produced. This then allows no room for ‘over promise’ and ‘under delivering’, while ensuring investor return expectations are anchored towards fundamentals rather than libor plus expectations.