The Importance of Liquidity

For treasurers, the pandemic and the low interest rate environment have brought the importance of liquidity in short-term investments to the front of their minds. Perpetually low rates have led to some treasurers exploring opportunities to generate greater returns, while still keeping a form of meaningful liquidity to their investments. But stepping out along the yield curve inevitably comes with some elements of risk – including the inability to withdraw funds on the same day. A careful balancing act must be struck.

Meanwhile, Covid-19 created a liquidity event in financial markets, which in the short-term space saw many treasurers liquidate their investments to ensure they had cash on hand to meet daily business needs while facing the extraordinary challenges posed by the pandemic. Today, understanding the liquidity of a treasury investment portfolio is more critical than ever before.

The deposit trap

Two of the most popular investment vehicles for treasurers are bank deposits and MMFs. Of those two, only MMFs can return cash quickly and without penalty. That said, all MMFs are not created equal.

Daniel Farrell, Director, International Short Duration Fixed Income, Northern Trust Asset Management (NTAM), explains: “If a treasurer buys a six- month or one-year term deposit, they are locked in for that time. Crucially, there’s no secondary market to go to,
to sell that term deposit. Instead, the treasurer would have to negotiate with the bank where they placed the deposit, which could be costly.”

The lack of a secondary market is not something that hampers MMFs, however. These can offer true ‘T+0’ liquidity, where the trade and settlement dates are on the same day. “Thinking about the underlying investments that we buy, such as commercial paper, certificates of deposit, treasury bills, and government bonds, for example, they may have different maturities out to one year, but they are all liquid as there’s a secondary market,” notes Farrell.

When bonds make sense

Short-term bonds are another investment option for treasurers. One-year and two-year short-term bonds still offer extremely high quality for the most part, which means they are desirable, and treasurers can sell them to release cash as and when required.

Ultra-short bond funds have stood out to treasurers during the persistent low-rate environment due to their ability to generate greater returns than other instruments. While they are not T+0, T+2 is possible on certain ultra-short bond funds, with the settlement date coming two days after the trade date. This offers good liquidity compared with, for example, a fixed-rate deposit in terms of a treasurer’s ability to liquidate that portion of investment portfolio whilst also achieving greater yield and reacting to a changing rate environment.

“Not all ultra-short bond strategies are equal, and corporate investors should always look ‘underneath the hood’ to ensure they are getting the best liquidity the market has to offer,” cautions Farrell. “Examine the details of the underlying holdings in the portfolio and make sure it is well- diversified. This will enable treasurers to gain a better understanding of how liquid the portfolio is.”

Considerations when ‘stepping out’

Ultra-short bond funds can offer potentially better yield and good liquidity to corporate investors because they also take incrementally more duration risk and credit risk than the other aforementioned investment vehicles. They represent the first step out of MMFs and those highly liquid T+0 products for treasurers wanting their cash to generate greater returns while still retaining relatively good liquidity.

“Ultra-short bond funds need to be used appropriately,” asserts Farrell. “If a corporate investor has volatile cash balances, then a money market T+0 settlement product is most suitable. But if they have more clarity of longer-term projects and payments – more of a three-month or six-month view that the cash is going to be more stable – that’s where stepping out in those ultra- short products is much more suitable.”

Ed Lopez, Chief Revenue Officer, Calastone, agrees that the viability of using ultra-short bond funds all comes down to a treasurer’s investment policy: “Internally, have treasurers established the guidelines of their strategy that determines the level of risk they would be willing to take?” he asks. “You can turn €1 into €1.02 in an ultra-short bond fund, for example, but are you willing to take the risk that you’d come back with €0.98?”

A treasurer’s investment strategy will also govern the liquidity requirements of their short- term investments, enabling them to open up to a certain level of T+2 investment exposure. Lopez continues: “As a treasurer, your strategy must weigh the merits of liquidity versus yield, and some may struggle to find that balance. That’s where an approach such as cash segmentation comes into play.” (See Chapter 3 of this guide for a detailed explanation of cash segmentation).

Identifying the various business needs for cash into different time horizons does require some longer-term planning but also presents an opportunity, when considering investment in an ultra-short bond fund, those with a T+2 capability give treasurers the confidence that they can get the cash back within two days if necessary. This means asset managers must ensure that they co-ordinate the instruments they buy within that settlement cycle to support that liquidity.

“We have got to make sure that the underlying investments in those ultra-short bond funds are still liquid and desirable in the secondary market,” notes Farrell. “That’s why we focus on our portfolio construction, around the high-quality, short duration bonds. This involves moving beyond the typical investments in financials seen in MMFs, stepping into the corporate bond space to obtain better diversification.”

In conclusion, it is more critical than ever that treasurers fully understand the liquidity profile of any short-term investment portfolio, regardless of their chosen investment vehicle(s). Treasury teams should also look to avoid the deposit trap by ensuring cash is only committed to a six-month or one-year deposit if they are confident that they can be without it for that time – in even the worst economic conditions.

Consider MMFs for instant liquidity and the chance for corporate cash to work slightly harder. Investigate ultra-short bond strategies and aim to find T+2 liquidity in an investment taking incremental duration and credit risk to offer the potential of even greater returns. Above all, ensure that treasury has a diversified portfolio that insulates the company’s short-term investments from liquidity risk.

_{For Europe and Asia-Pacific markets, this information is directed to institutional, professional and wholesale clients or investors only and should not be relied upon by retail clients or investors. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. Northern Trust and its affiliates may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, and its accuracy and completeness are not guaranteed. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor. Opinions and forecasts discussed are those of the author, do not necessarily reflect the views of Northern Trust and are subject to change without notice.}

_{This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. Indices and trademarks are the property of their respective owners. Information is subject to change based on market or other conditions.}

_{Forward-looking statements and assumptions are Northern Trust’s current estimates or expectations of future events or future results based upon proprietary research and should not be construed as an estimate or promise of results that a portfolio may achieve. Actual results could differ materially from the results indicated by this information.}

_{The Northern Trust Company of Hong Kong Limited (TNTCHK) is regulated by the Hong Kong Securities and Futures Commission. In Australia, TNTCHK is exempt from the requirement to hold an Australian Financial Services License under the Corporations Act. TNTCHK is authorized and regulated by the SFC under Hong Kong laws, which differ from Australian laws. In Singapore, The Northern Trust Company of Hong Kong Limited (TNTCHK), Northern Trust Global Investments Limited (NTGIL), and Northern Trust Investments, Inc. are exempt from the requirement to hold a Financial Adviser’s License under the Financial Advisers Act and a Capital Markets Services License under the Securities and Futures Act with respect to the provision of certain financial advisory services and fund management activities.}

_{Northern Trust Asset Management (NTAM) is composed of Northern Trust Investments, Inc. (NTI), Northern Trust Global Investments Limited (NTGIL), Northern Trust Fund Managers (Ireland) Limited (NTFMIL), Northern Trust Global Investments Japan, K.K. (NTKK), NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Belvedere Advisors LLC, Northern Trust Asset Management Australia Pty Ltd and investment personnel of The Northern Trust Company of Hong Kong Limited (TNTCHK) and The Northern Trust Company (TNTC). ).© 2022 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A.}