Published: July 01, 2010
The global financial crisis highlighted the importance of a disciplined approach to cash investment, with many corporate treasurers taking a more conservative view of how they invested their cash, with a clear emphasis on capital security and liquidity. Although the crisis in the financial markets eased over the latter part of 2009, the landscape for cash management and investment had fundamentally altered, shaped by a new approach to counterparty and market risk, and a changing regulatory environment. Furthermore, the emerging crisis in Europe emphasises that treasurers need to continue to be vigilant in ensuring that cash is invested appropriately and in accordance with the needs of the business.
As every financial text book will emphasise, investors consider three key priorities when making investment decisions: security of capital (credit risk); availability of cash when required (liquidity risk) and a return on capital to protect the relative value of cash (interest rate risk). These are frequently summarised as: security liquidity and yield. Treasurers increasingly recognised-long before the crisis – that while it is possible to manage these objectives in-house, such as by using a combination of deposits and repo instruments, few companies have surplus cash balances that are large enough, or sufficient treasury resources to undertake such a strategy effectively. Consequently, a simpler solution for many treasurers was to outsource their cash investment into constant net asset value (NAV) money market funds (MMFs). These initially took hold in the United States, and have since become popular in the United Kingdom, Europe and increasingly in Asia.
The emerging crisis in Europe emphasises that treasurers need to continue to be vigilant in ensuring that cash is invested appropriately and in accordance with the needs of the business.
The concept of MMFs is that they comprise the pooled assets of a number of institutions, invested in a variety of high quality assets with a short-term maturity. In addition to providing the necessary diversification on the asset side to protect investors’ capital, investors also retain immediate access to liquidity, due in part to diversification on the liability side, as investors have different financial drivers, and so withdraw money at different times.
In the years up to the crisis, adoption of MMFs continued steadily.During the crisis, the three pillars of investment: security, liquidity and yield, became just two, as investors largely discarded their pursuit of yield in favour of credit and liquidity risk management. MMFs that invested predominantly in government debt became very appealing, and we saw treasurers building up cash levels in these instruments throughout the first half of 2009. With market liquidity returning, but with ultra-low interest rates remaining, we have seen recent net outflows from MMFs across the industry of around 11.7% since June 2009, although HSBC has seen continued robust growth with a 1.9% increase in assets held in MMFs over the same period[1].
However, these statistics mask some interesting trends. Firstly, we have seen treasurers’ confidence in ‘prime’ MMFs (i.e., those that invest in financial institution and corporate assets) return, which reflects a more balanced view of risk than we saw during 2008 when government funds took precedence. For example, since June 2009, USD government funds have fallen by over 28% and EUR government funds by more than 26%. In contrast, ‘prime’ offshore MMFs have seen a net increase which is particularly apparent in EUR funds which have grown by over 20% over this period. Secondly, despite low interest rates, treasurers are still prioritising security and liquidity, and are not seeking to optimise yield. Although we have witnessed a net outflow from some MMFs, this is not matched by an equivalent inflow into enhanced funds. For example, in France, while there has been a drop in regulaire funds of over $39bn, dynamique or enhanced funds have grown by only $7bn. It is a positive sign that treasurers have not forgotten the lessons learnt during the crisis and have found an appropriate balance in their cash investment approach.
While the importance of MMFs was highlighted during the crisis, it also emphasised that there are changes required to ensure that MMFs are sufficiently resilient to withstand extreme market pressures. In reality, MMFs have proved amongst the most robust and reliable investment instruments; however, as Box One illustrates, it only takes one anomaly to destabilise an entire industry. The Reserve Primary Fund broke the buck as it had shifted the risk-reward balance by seeking enhanced performance through higher risk assets. To avoid contagion created by the actions of one fund manager, there is strong market support for tighter regulations to ensure that MMFs are managed according to common standards. In addition, MMF providers have refined both the way they manage their funds and how they communicate with investors to provide transparency and rigorous controls. [[[PAGE]]]
Not all MMFs are the same – as became clear when the Reserve Primary Fund ‘broke the buck’. In particular, some take more credit and/or duration risk than others, and, therefore, may be more susceptible to market shocks. So, how should shareholders in MMFs understand and assess those differences?
HSBC Global Asset Management (HSBC) recommends that shareholders should (a) understand the investment process employed by their MMF manager, (b) monitor certain key risk metrics, and (c) take account of third-party constraints on MMFs, for example those of regulators, ratings agents and the Code of Practice of the Institutional Money Market Funds Association. These are described below.
Understanding the investment process
HSBC employs a simple, two-step investment process:
The first step is to impose various limits on our MMFs which are intended to manage credit, counterparty, liquidity, market and interest rate risk. Those risk limits define the Fund’s investable universe. The risk limits are dynamic, and consequently the investable universe expands or contracts subject to our current view of the market.
The second step is to construct a portfolio within the Fund’s limited, investable universe that provides the best risk-adjusted return.
i) Step one: risk-limiting the investable universe
As one would expect of HSBC, we impose comprehensive and detailed limits on our MMFs which are designed to manage a variety of risks:
Counterparty exposure and tenor limits: In order to manage credit risk, HSBC’s MMFs are only permitted to invest in approved counterparties, and up to fixed exposure and tenor limits. Counterparty exposure and tenor limits are recommended by our global team of credit analysts. Credit research methodology, opinions, recommendations and documents are standardised to facilitate the comparison between US, European and Asian issuers and the use of this data by the portfolio managers. All output is captured on our proprietary database. Output is aligned to the credit analyst’s core duties and they are required to actively maintain ratings, recommendations and summaries on all ongoing credit research performed. The credit analysts work autonomously from the portfolio managers.
[[[PAGE]]]
Counterparty diversification limits: In order to manage counterparty diversification risk, HSBC’s MMFs are subject to strict diversification limits, which take account of the quality of the issuer and tenor of the issuance.
Liquidity and shareholder concentration limits: In order to manage liquidity risk, HSBC’s MMFs are subject to: minimum target liquidity ladders maturing overnight/within one week/within one month/within three months/within six months/and within one year; maximum weighted average life limits; and maximum target shareholder concentration limits.
Portfolio stress test: In order to manage market risk, HSBC’s MMFs are required to stress test the impact on their portfolios of: a shift in the yield curve; a widening in spreads; and redemptions. The impact is measured in terms of the divergence between the market price and the amortised price of the Fund’s portfolio.
These limits are dynamic. For example: names are added and removed from the counterparty approved list, and/or exposure and tenor limits adjusted in response to our analysts recommendations; and our target liquidity ladder changes in response to changing market conditions.
ii) Step two: constructing the portfolio
HSBC believe that cash and fixed income markets are not ‘strongly efficient’, and occasionally mis-price underlying risk. An active management approach can take advantage of these inefficiencies to add value and reduce risk.
Our MMF investment management teams therefore seek out relative value in the risk-limited universe, in particular by: allocating the Fund’s assets between government, financial and non-financial sectors; assessing the relative-value of individual issuers within each sector; assessing likely movements of the yield curve, and adjusting tenors accordingly; managing redemptions and subscriptions; and maintaining relationships with issuers and dealers in order to be ‘in the flow’ of the market.
[[[PAGE]]]
No matter how efficient an investment process may be, MMFs are not risk-free. For example funds may experience losses (credit risk), or be overwhelmed by redemptions (liquidity risk). How should MMF shareholders monitor residual risk?
HSBC discloses various risk metrics to enable shareholders monitor the residual risk in our MMFs, including:
Weighted average final maturity: This shows our funds’ average final maturity, and is therefore a measure of liquidity risk.
Portfolio final maturity mix: This shows the proportion of our funds’ assets maturing overnight/within one week/within one month/within three months/within six months/and within one year, and is therefore a measure of liquidity risk.
Portfolio short-term rating breakdown: This shows the short-term ratings/equivalent ratings of our funds’ portfolios, and is therefore a measure of credit risk.
Weighted average maturity: This shows our funds’ average period of interest rate reset, and is therefore a measure of interest rate risk.
MMF shareholders also take comfort from certain third-party constraints on MMFs. For example:
EU-based MMFs are subject to constraints on their investment and borrowing powers, as a consequence of their authorisation and regulation under the Undertakings for Collective Investment in Transferable Securities Directive and associated regulations;
In order to manage credit risk, HSBC's MMFs are only permitted to invest in approved counterparties, and up to fixed exposure and tenor limits.
Triple-A rated MMFs are subject to a variety of limits on credit quality, tenor and concentration, as a condition of maintaining their rating; and
The Code of Practice of the Institutional Money Market Funds Association (IMMFA) imposes various limits on weighted average maturity, weighted average life, final maturity and credit quality. HSBC is a founder member of IMMFA and strongly supportive of recent amendments to its Code. We regard IMMFA membership as an important indicator of the quality of a MMF.
HSBC’s internal risk limits are at least, or more, restrictive than those imposed by the regulators, ratings agents or IMMFA. More importantly, and as described above, HSBC’s internal risk limits are dynamic, i.e., they change in anticipation of, and in response to, market conditions, whereas the limits imposed by regulators, ratings agents and IMMFA are more static.
Nevertheless, HSBC recognises the value that MMF shareholders attach to third-party constraints.
HSBC has always had a conservative, risk-averse culture, and the crisis has illustrated the benefit of this strategy. While this has consistently proved attractive to corporate investors, we have seen an increasing number of treasurers recognising the value of MMFs, and specifically of HSBC’s approach, reflected in the relative growth of HSBC funds compared with the market as a whole. Gaining a reputation for good financial management has created a virtuous circle as investors who share our financial prudence are attracted to our funds.
As we sell our funds directly to clients, HSBC benefits from a direct, long-term relationship with shareholders of each fund. This commitment to maintaining direct relationships with our clients is a valuable way of managing risk, as we can maintain a close understanding of their financial objectives and requirements, and when they are likely to need to withdraw cash.
The combination of financial conservatism and vigilance in ensuring that we maintain a close appreciation of our client base has resulted in a lower volatility of HSBC funds. Looking ahead, HSBC will continue to build on the reputation, client loyalty and stability of funds for which we have become known, and to develop our international offerings, initially in CAD, for example, and then in additional currencies in the future.
While the specific nature of future regulatory changes is as yet unknown, we are likely to see a regulatory response that is proportionate and appropriate. It is not in central banks’ interest to frustrate corporates’ legitimate cash investment requirements, and MMFs fulfil a genuine market need and demand. However, it is in both fund managers’ and investors’ interests for the MMF industry to be as robust as possible, so although it may be difficult to find a clear consensus on the specific steps to take, the impact should be positive. As a global business, HSBC is keen to promote greater communication between regulators and encourage efforts to harmonise MMF regulations internationally.
Note
1. Industry growth figures: Sources iMoneyNet and EuroPerformance.
How Thought Leadership Can Reduce the Cost of Sales by Patrik Havander, Havander & Partners A focused attention on the costs incurred by the global sales and marketing processes is becoming increasingly important for corporate banks and their transaction banking departments. While the client/bank relationship remains vital, research has shown that in fact relationship selling […]
