Yield has been an issue for the short-term cash investments of treasurers, as poor rates and tightening regulation have dramatically lowered the performance ceiling of traditional investment instruments. A recent TMI and Northern Trust Asset Management webinar illustrated how a cash segmentation strategy of splitting cash into different strategic buckets can bring about higher returns with limited additional risk.
The headwinds affecting the performance of traditional short-term investment options for treasurers have intensified over the past couple of years. Two trends in particular have stifled the performance of short-term investments: low to negative interest rates and tightening regulation in the money market fund (MMF) space. The low interest rate environment is hurting treasurers, particularly in the Eurozone where it has been negative for some time and looks likely to remain this way for the foreseeable future.
“They say cash is king, but this king has become expensive,” said Patrick Kunz, Managing Director, Pecunia Treasury & Finance BV. “For every euro, every pound, maybe even for every dollar, it’s either costing us money or not gaining as much money as it used to in the past. Now the prospect of inflation on the horizon again promises us relatively less money in future. Interest rates and inflation should definitely be on the radar for every treasurer going forward, particularly for those treasurers with a lot of cash.”
Regulators globally have started consultations with money market providers and insurance industry experts to examine what happened in March 2020 at the start of the pandemic in the West, and the impact it had on MMFs.
Daniel Farrell, Director of International Short Duration, Northern Trust Asset Management (NTAM), explained: “We believe that the regulation for short-term LVNAV [low volatility net asset value] funds and VNAV [variable net asset value] funds from the last reforms were appropriate, and our funds held up well under during the start of the pandemic. Realistically, however, we’ve got to look at the downside risk that there’s going to be some tightening in overall regulations. This may mean that we have to focus on holding more overnight or weekly liquidity, or turn to even higher-quality assets. Regulatory headwinds will exert downward pressure on money market fund yields, so those treasurers who utilise them heavily should factor this in, and in the longer term, they’re going to be at the lower end from a return perspective.”
Cash segmentation offers a solution
To navigate the low interest rate environment and possibility of even more regulatory reforms on MMFs, many treasurers are looking to deploy a cash segmentation strategy. Cash segmentation enables investors to achieve a better balance between risk and reward. With cash segmentation, treasurers bucket their cash according to its uses and its needs, which means they can consider investments further along the maturity spectrum than MMFs or traditional treasury products permit.
Farrell continued: “While many investors are happy to accept a lower return for peace of mind that comes with a money market fund, other investors with a longer investment time horizon may find the opportunity for incremental return well worth the modest additional risk. This is something that we have seen in the U.S. and to some extent in the Eurozone when rates went negative, but Europe and the UK are lagging behind the US in terms of adoption.”
For treasurers considering adopting a cash segmentation strategy, it is important to understand what is possible within their organisation, in terms of risk appetite and treasury policy, when researching an appropriate approach.
Kunz said: “I have clients that are fairly cash rich and it’s costing them a lot of money. It is fair for the CFO to ask what they can do to earn a better return on this money but at the same time keep the counterparty risk low. It is the task of the treasurer to create different buckets and to look at new investment strategies, while at the same time taking into account his/her risk and, of course, the treasury policy.”
Another company-specific consideration is the predictability of cash flow. The last thing treasurers want to do is set money aside for longer-term investment horizons and then find it is needed for day-to-day operations.
“There are companies that are fairly stable, have a pretty predictable cash flow and can confidently allocate some cash for the medium to long term,” Kunz added. “On the other hand, there are companies that can’t even predict what’s going to happen in two months’ time, so if they put out their cash for six months, they would be taking too big a risk. It all drills down to a company’s cash forecasting capabilities and their ability to know what their cash requirements will be in one month, in six months, in two years, and so on.”
The NTAM approach
Farrell explained that NTAM’s approach to cash segmentation defines three distinct buckets – operational, reserve, and strategic – and then allocates appropriate time horizons for investors to consider within those buckets.
“Operational cash is for day-to-day spending needs,” explained Farrell. “The time horizon from an investing perspective should be somewhere between one day and three months, which makes a money market fund the most appropriate option. With reserve cash, where you begin to be able to forecast a little bit better, it could be quarterly or semi-annual payments that are targeted. Reserve cash should have a three-to-nine-month time horizon for investing. Finally, strategic cash is for the longest spending needs, projects or cash allocations. This should have a nine-to-18-month investment time horizon where appropriate.”
By moving beyond the ‘one-size-fits-all’ approach to short-term cash investment, allocating funds into the reserve and strategic buckets offers treasurers the potential to achieve higher returns. This is due to the underlying investments that NTAM makes within them. The two strategies that NTAM has launched since 2019 for these buckets are the Conservative Ultra-Short ESG [environmental, social and governance] strategy and the Ultra-Short ESG strategy.
“The objective of both these strategies is to outperform money market funds on a total return basis while maintaining focus on capital preservation,” noted Farrell. “We do that by taking incremental duration and credit risk. These strategies are able to invest outside of the traditional money market fund opportunity set, into a wider sector diversification and into corporate bonds.”
The Conservative Ultra-Short ESG strategy is the first step out from MMFs. It has a target duration of six months and focuses on investment-grade bonds with maturities out to three years. Meanwhile, the Ultra-Short ESG strategy is suited to those treasurers with strategic cash. In this case, NTAM still only invests in investment-grade bonds and instruments, but can do so for up to five years’ maximum maturity, with a fund duration target of one year.
“Both of these are still very ‘vanilla’, they do not use any types of derivatives, cross-currency swaps or leverage,” Farrell explained. “We believe in constructing a high-quality portfolio through an investment process that emphasises thorough credit research, broad sector diversification and risk management.”
Corporate cash flows can be complex and Farrell was keen to emphasise that NTAM works in partnership with treasurers to understand their cash needs. “Often investors will come to us and say they love the idea of cash segmentation but they’re not sure where to start. First you need to understand why you need to hold this cash, what are its uses and needs? We then carry out historical analysis and see if we can identify some trends in that cash.”
Once the analysis is complete, the discussion can turn to the bucketing process. NTAM has created an allocation framework that is bespoke to each investor, which is used to illustrate how the broad cash allocation will change over time.
“For one investor, it may be more appropriate that they have a large allocation to the money market fund and a small allocation to the Conservative Ultra-Short strategy, perhaps an 80%-20% split,” Farrell observed. “Another investor may have a good chunk of operational cash where over 50% is well forecasted. They may be able to allocate 60% to the money market fund, 30% to the Conservative Ultra-Short strategy and 10% to the Ultra-Short. Once the allocation is agreed, we can show them, using their historic cash balances, what their cash segmentation strategy would look like, how those allocations would change, and what they would have seen from their total return in a cash segmentation strategy over a money market fund. This also shows the sector and credit rating diversification benefits versus a money market fund.”
Outcomes and benefits
Aside from the potential for higher returns, a parallel benefit of implementing a cash segmentation strategy is that it forces treasury to zero in on all areas of the business that affect cash flow. While this could generate more work in the short term, from a data perspective it is highly beneficial to the treasurer.
“The medium- and longer-term buckets are the harder part, because you can’t ask procurement or sales for specifics on what they are going to buy or sell in February next year,” said Kunz. “What you can ask other areas of the business, particularly on the strategic side, are educated guesses on expected sales, and whether there will be any significant M&A [merger and acquisition] transactions, for example. The treasurer is really dependent on the information from other departments, and will gather all this information out of ERP [enterprise resource planning] systems, strategic systems, and forecasting systems from FP&A [financial planning and analysis] and design these cash buckets. You will definitely improve your information flow within the company and be a smarter treasurer as a result.”
Moving beyond the duration and credit risk of an MMF has the potential for higher volatility, and is clearly a matter for consideration. However, using standard deviation as a barometer, the NTAM Conservative Ultra-Short and the Ultra-Short strategies were built to retain a low volatility in order to preserve the capital invested.
Liquidity is also a key characteristic of these strategies. Farrell explained: “These products have a T+2 [trade date plus two days] settlement as they hold a high portion of very liquid assets. It is important for investors to follow the recommended time horizons to make sure that we can keep that volatility at a low level, but if you compare this with a fixed-rate bank deposit, for example, you’re locked in for six to 12 months. We’re providing liquidity, so if you really need it, you can always get it in the T+2 basis.”
The cash segmentation strategies also support risk management in that they facilitate investment in a more diverse universe than more traditional instruments.
Farrell continued: “Bank deposits and money market funds are invested in financial assets, but as soon as you have the ability to step out of that one-year maturity, you can start to diversify your portfolio. A money market fund may have approximately 80% of its assets in financials, whereas a Conservative Ultra-Short strategy would have closer to 30 or 35%. If you want to minimise risk from a sector perspective, you are better looking at these types of strategies. It also brings in the ESG element, as bonds issued by companies with favourable ESG ratings tend to have tighter credit spreads and offer downside mitigation during periods of market turbulence, and we can benefit from this through the diversification of assets.”
Key takeaways
To conclude the webinar, both experts provided key takeaways for treasurers to consider as they evaluate cash segmentation as a strategy. For Kunz, cash visibility, risk appetite and information are key. “You need cash visibility, you need to determine your risk appetite, and you need to align your internal stakeholders, who have to provide you with the information you require as a treasurer to determine the strategy. In some cases, you have to revisit your treasury policy, which might include restrictions on external investments. In some cases, you may even have to talk to your banks, because they might have restricted your cash in some ways due to financing arrangements.”
Farrell concluded: “Interest rates are going to stay lower for longer. Regulatory changes are on the horizon, which will put downward pressure on yields in the front end. Incremental credit and duration risk to target a better balance between risk and reward will benefit those investors who are able to consider cash segmentation as a means to enhance yield in an increasingly challenging environment.”
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With the ongoing low interest-rate environment and increasing regulatory change, it’s more important than ever for treasurers to think outside of the box when it comes to cash.
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