Revisiting the Risk – Reward Dilemma

by David Rothon, Director of Cash & Fixed Income Product Management, Northern Trust

The global financial crisis resulted in an immediate ‘flight to security’, with many corporate investors seeking to invest their cash in products with the lowest possible risk. This was reflected in the growth of money market funds (MMFs) that invested exclusively or predominantly in government debt. Over the past year, these government MMFs have declined in appeal as corporate treasurers revisit their risk management policies, and seek a higher rate of return without compromising their liquidity and security objectives. Consequently, the risk-reward balance continues to be a topic of frequent discussion as treasurers determine:

• Their acceptable level of volatility, and over what period;

• The amount of liquidity that is required over the short, medium and long term, including that required to cover unforeseen events;

• The minimum credit quality that is acceptable (often AA or higher), whilst recognising that the higher the credit quality, the lower the return;

• Sovereign risk policies, in addition to credit and bank risk.

With these various factors pulling cash investment decisions in different directions, treasurers may be finding it difficult to find investment products that meet their criteria.

Appetite for investment flexibility

In addition to custom-solutions that meet their specific short to medium-term investment needs, corporate investors are also demanding a greater range of skills and capabilities from their asset managers.

The European crisis continues to encourage conservatism in treasurers’ investment approach, particularly in relation to sovereign risk. However, we are also witnessing a growing appetite for a flexible MMF product to complement prime AAA-rated MMFs, to provide enhanced yield on a portion of company cash whilst upholding treasurers’ security and liquidity requirements. An obvious question, however, is what such a product could look like, bearing in mind the regulatory changes that are in progress in the MMF industry. The likelihood is that in addition to today’s stable NAV (net asset value) AAA-rated MMFs, there will also be some demand for variable NAV MMFs.

Not all institutions will be comfortable with this, so we also see the need emerging for more flexible products that can be customised to the needs of the corporate investor. For example: if some treasurers do not need immediate access to liquidity for part of the institution’s cash, they should be compensated for this in the form of a higher return (i.e., why pay up for liquidity if it is not required?).

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Innovation within regulatory restrictions

Despite the pending regulatory changes, there are opportunities available today to enhance yields using a variation of the familiar AAA-rated MMF, but these will more than likely require a separately managed portfolio. In an ultra-low rate environment where every basis point is important, treasurers can match the liquidity profile of a fund with their cash flow schedule and therefore take advantage of a higher yield in exchange for a loss of overnight access to liquidity.

Clearly, treasurers would not subject the cash that they need to satisfy their working capital requirements to additional volatility (for which traditional IMMFA AAA-rated funds are more appropriate), but there are wider opportunities for cash that is not required immediately. In addition to custom-solutions that meet their specific short- to medium-term investment needs, corporate investors are also demanding a greater range of skills and capabilities from their asset managers, including investment options for up to and including five years.

Cash investment in the future

With the adoption of new regulatory standards, AAA-rated funds will become more constrained in credit terms, and some will need to de-risk even more. This is likely to lead to further depression of returns and less differentiation between funds. For example, while there may be a performance range of 30-40 bps today, this is likely to be squeezed to 10-20 bps as investment options become more constrained.

This is likely to encourage more discussions between treasurers and their fund managers on how these basic instruments can be structured to match the institution’s yield, security and liquidity expectations. The result could be a ‘barbell’ approach with low risk at the short end and custom investment solutions for longer term investments.

A separately-managed portfolio does bring more complexity to cash management and to overcome this, we expect to see increasing collaboration between treasurers. Those that can find common ground with other investors could, through their fund managers, be able to formulate effective investment solutions that strike the right balance for them in the risk-reward dilemma.