Published: June 01, 2011
Money market funds (MMFs) are well-established in markets such as the US and UK as repositories of short-term or primary cash, and their use is increasing across Europe and Asia. Should market conditions continue to strengthen in the future, these products will remain extremely valuable in order to hold cash needed for working capital and other short-term requirements. MMFs have the potential to provide excellent security, where they offer AAA-rating, diversified assets, a high quality investment process, and same day access to liquidity.
There are a variety of situations, however, where treasurers do not necessarily need immediate access to cash. For example, companies that have achieved a reasonable degree of accuracy in their cash flow forecasting process may be able to structure the maturity of investments into the future to take advantage of improved returns further out on the yield curve. For example, cash being held in a ‘war chest’ for known outflows, mergers and acquisitions and/or future contingency could be held in longer-term investments; similarly pension funds and insurance companies may also have tranches of cash not required in the short term. In these situations, the first priority must remain the return of principal, but treasurers may be able to take advantage of the liquidity premium available by using a wider range of investment types.
Using secured instruments for secondary (medium-term) and tertiary (lond-term) cash brings a range of advantages over unsecured instruments in supporting treasurers' risk management strategies.
Investment expertise amongst corporate treasuries is growing, particularly since many treasurers went through a process of re-evaluating their risk budgets and investment decision-making process subsequent to the financial crisis. This results in the opportunity for sophisticated corporates to take advantage of the premium available through certain types of investment, particularly secured investments that should provide greater security than unsecured instruments.
It is often surprising that investors are willing to invest in unsecured instruments, particularly over the longer term, which would seem to contradict many companies’ appetite for risk. Secured instruments, logically, are designed to offer greater security for investors, as long as the collateral is of high quality. For example, while asset-backed commercial paper (ABCP) fell into disrepute in the run-up to the crisis, these instruments should not be disregarded simply because the collateral underpinning some issues in the past has been of low quality. Today, with greater financial rigour in the way that these instruments are constructed, ABCP may prove attractive prospects to corporate investors.
Another secured way to invest is in a tri-party repurchase agreement (repo). This is a mature and deep market in the US in particular, with over $2.6bn repurchase agreements as per the Federal Reserve(1) data. While repos have been less common in Europe historically, the market is growing as more sovereign debt has been issued, which is increasingly being used as collateral for repos. One of the advantages of a repo is the ability to select a maturity date linked to a company’s cash requirement, in a similar way to a deposit, whilst benefiting from the security offered by the underlying collateral.
The market in covered bonds is also developing rapidly, with a total market size of around $3trn2. These have a long-standing track record in Europe and North American investors are now able to take advantage of a similar offering. A considerable increase in covered bond issuance is being experienced by the market, with a 30% increase in the past year, and a 45% increase in four to six year maturities. As these instruments approach maturity, they may become particularly attractive to corporate treasurers in the secondary market for the investment of medium-term cash.[[[PAGE]]]
Using secured instruments for secondary (medium-term) and tertiary (long-term) cash brings a range of advantages over unsecured instruments in supporting treasurers’ risk management strategies. Different industry segments often take a diverse view of risk: for example, technology companies often have the greatest appetite for risk, while pharmaceuticals have the least, with industries such as energy somewhere in between; however, this can vary widely. One trend we are seeing across all industries, and amongst companies of all risk appetites, is the growth of separately managed accounts for secondary liquidity(2). Investors are gaining greater confidence in increasing their investment horizon out past the traditional 30-60 days of MMFs. Many companies are carving out a portion of their cash and outsourcing investment to a third party manager, who then manages the cash within the company’s treasury guidelines. In some cases, the boards of these companies may not have been comfortable with medium-term investment undertaken by in-house managers who often have a range of other priorities; however, we believe that there is typically less resistance if the investment process is conducted by a specialist manager.
Many companies are holding growing amounts of cash on their balance sheets as protection against economic uncertainty, or for future investment. This situation may be unlikely to change in the short to medium term, at least until we see a new generation of executives in influential positions within corporations whose recollections of the financial crisis are more distant, or a significant change in policy at national or supra-regional government level. Consequently, treasurers need to find secure ways of holding cash so that it is available at the right time, with a return that is at least equivalent to inflation in order to avoid deterioration of value, and ideally to enhance it. The majority of cash investors are still seeking to hold their cash in short-dated instruments, while governments and corporations are borrowing for a long term, so banks are tasked to effect a maturity transformation. At present, however, the short end of the yield curve is being squeezed, while the medium term offers greater opportunities. Expanding the spectrum of instruments in which a company invests should support, not compromise its risk management objectives and treasurers should consider widening the net beyond short-term investments that risk the attrition of value through inflationary effects. Risk management must remain treasurers’ key investment priority; this includes the preservation of capital and the appropriate access to liquidity. Working with managers with a structured investment framework and disciplined approach to risk transparency and mitigation is an essential way of managing risk and fulfilling the company’s cash investment objectives.
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security. Views and opinions are current as of the date of this article and may be subject to change; they should not be construed as investment advice.
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