The Ultimate Short-Term Investment Stress Test: Lessons From Covid-19

Treasurers were finding it hard enough to know where to invest their short-term cash before the pandemic hit. Now, the pressure is even greater. TMI speaks to five industry experts to discover how treasury professionals are responding to the financial impacts of Covid-19. We also ask what treasurers can do to ensure they have the right mix of short-term investments today, and take a look at the future of money market funds, post-pandemic.

Eleanor Hill (EH): How has the Covid-19 pandemic impacted treasurers’ behaviour around short-term investments thus far?

Alastair Sewell (AS): The pandemic has led to several notable effects. Number one, we have seen – in a broad sense – investors moving away from riskier assets and moving into less risky assets. This includes allocations to money market funds [MMFs] and anecdotal reports of inflows to gold exchange traded funds [ETFs], for example.

Scratch the surface, however, and you see that within MMFs, the flow patterns are starkly split. Specifically, we have seen very strong inflows into government MMFs and very strong outflows from non-governmental MMFs. So much so that some managers have even suspended subscriptions – Fidelity, for example, announced that it would be limiting investors’ ability to subscribe to government-only MMFs.

At Fitch, we revised our outlook for MMFs to negative in March, which was primarily a reflection of the highly challenging liquidity environment for MMFs at that time, exacerbated by quarter end. As we’ve come into the new quarter, and initiatives such as the US Federal Reserve’s Money Market Mutual Fund Liquidity Facility [MMLF] have kicked in, sentiment has improved, as have liquidity conditions, and importantly funds – including the prime funds – have started to see inflows again.

We believe that the liquidity stress affecting funds has significantly abated now, compared with what we saw in March. However, we are starting to see fairly significant rating activity on the banks, which is where MMFs are heavily invested. As such, we’re witnessing the beginning of a new phase of stress and we are maintaining our negative outlook for now.

Will Goldthwait (WG): Covid-19 and increased market volatility have led to many new questions from our clients. We have fielded hundreds of calls and answered many queries about the cash markets and how the pandemic is impacting liquidity. We have seen treasurers mitigate risk and raise liquidity. Understandably, treasurers have heightened concerns in this unprecedented time about their ability to access their cash, all of their cash, on any given day.

Kathleen Hughes (KH): Generally, we have seen what we would have expected. The demand for MMFs and other short-dated, high quality assets increases as treasurers build up cash on their balance sheet by drawing on credit lines or accessing the capital markets. Naturally, CEOs and CFOs are unsure of the economic impact of the pandemic on their businesses, with some industries being more severely impacted than others. However, and as Alastair points out, since the start of the second quarter with capital markets opening up for some issuers and the policies to support liquidity in markets taking hold we have seen assets flowing into USD prime funds.

Dan Farrell (DF): As Kathleen alluded to, the response by treasurers to the pandemic has been, in many ways, unique to their individual firms. However, we have seen many companies use pre-arranged credit facilities to fund their operations. This has, in turn, led to an increase in cash within the system and a greater need for counterparty diversification. From an overall investment perspective, we have also seen a definite flight to quality, with many US-based investors moving into public debt MMFs.

Tom Knight (TK): The main thing we’re seeing is that there isn’t the sheer panic that we saw in 2008, and rightly so. The environment today is far different from the financial crisis. First and foremost, the current situation is not a true credit crisis like it was back then, banks and companies are far stronger this time around and governments have put their weight behind these markets for further assurance. What’s also helped is that technology has evolved to assist treasurers in making quick decisions and being proactive with their investment choices. As an example, at ICD, we offer analytical transparency into the underlying assets of funds – a capability that didn’t exist in 2008. In addition, being able to access alternative investment options from a single platform without having to establish additional accounts provides a means for treasurers to react insightfully and quickly, rather than making hasty decisions based on fear and uncertainty.

EH: While there have been inflows, there have been redemptions too – so how have MMFs held up? Did the recently introduced MMF reforms do their job?

WG: The market was moving so quickly in March that, sometimes, it was hard to keep up with it as well as the speed of the news flow. There were challenges around pricing certain bonds in the portfolio. The pricing services were under considerable pressure given the speed at which the market was moving and prices were changing. Our portfolio managers were very diligent in finding liquidity and utilising all of their relationships to source the best price for assets that needed to be sold.

For US-registered funds, we saw elevated redemptions from US prime institutional MMFs and large inflows into US Government and Treasury MMFs. In our Dublin-domiciled funds, flows were quiet in the GBP and EUR funds but the USD funds saw outflows. Fortunately, liquidity levels were maintained and regulatory limits were upheld.

Dan Farrell Director International Short Duration Fixed Income, Northern Trust Asset Management

DF: As we all know, following the 2008 global financial crisis, regulators identified MMFs as integral to financial markets and as a result introduced new regulatory requirements. The regulations were designed to protect investors and ensure funds can weather future stress events and continue to provide daily liquidity to investors. MMFs have adhered to these changes while continuing to provide what is important to investors in the current market environment, capital preservations and daily liquidity.

As Will highlighted, the US domestic market has seen assets under management [AUM] meaningfully shift from prime to government or public debt funds, but – in our view – the offshore MMF industry has not witnessed the same trend across all currencies or to the same extent. While offshore US dollar-denominated funds did experience outflows, we did not see the same trend in euro or sterling-denominated funds, mainly for two reasons.

First, fund structures are different: European investors can access LVNAV funds that can provide a NAV of 1.00, while in the US, VNAV is the only option for prime funds for institutional investors [retail prime funds are still CNAV]. Secondly, investor options are reduced: the euro, sterling and US dollar public debt market is a small proportion of the European market, compared with the US market.

AS: It’s an interesting question. Despite our negative outlook, we do think funds are well positioned and that the industry is generally in robust shape – this is in no small part due to the recent reforms. Funds are running very high liquidity now, which means they have a good ability to adjust their holdings and exit any issuers which may face credit difficulties.

We can’t really compare the current situation with the global financial crisis of 2008, as the causes were so different. But funds are certainly in a much stronger position now. One interesting behaviour we saw, was that the funds were less willing to use their weekly liquidity bucket to meet redemptions. So, rather than allow their weekly liquidity to fall, they would use daily liquidity – obviously part of weekly liquidity – rather than letting their weekly liquidity dip below 30%.

Of course, this is a side effect of the regulation because in the US, if weekly liquidity falls below 30%, then the board of the fund needs to meet and decide to a) do nothing, b) apply a liquidity fee or c) apply redemption gate – and all of those choices are legitimate decisions for the board taken in its role of fiduciary responsibility. What that means is that investors in the US became very sensitive to this 30% point, since they knew it would crystallise a decision. In Europe, investors are slightly less sensitive to the 30% figure generally, given that it also tests outflows and is a joint probability event.

TK: I agree with everything my colleagues have mentioned. Thanks to all of the regulatory reforms put into practice, the MMF industry is in good shape. Personally, I don’t anticipate additional regulation at this time. There might be some fine-tuning further down the line, but the reforms appear to be working, which is great news.

Moreover, actions by the Federal Reserve and US Treasury to establish initiatives such as the MMLF have significantly strengthened money market investments. So, taking everything into account, the industry has weathered the storm very well, thus far.

Kathleen Hughes Head of Liquidity Solutions Client Business, GSAM

KH: The short end of the credit markets was stressed just like all markets, but MMFs continued to take purchases and meet redemption requests against an unprecedented rotation of assets globally. There was clear recognition by central banks and regulators globally for the need to support liquidity in the credit markets, including the money markets, as banks were unable to provide the liquidity intermediation as they would in normal circumstances.

Central banks around the world put policies and programmes in place to support proper functioning of the credit markets and MMFs have both directly and indirectly benefitted. Since the start of the year, nearly a trillion dollars has flown into MMFs globally with the industry at all-time highs.

DF: On the subject of central bank action, it’s worth talking about how the performance of MMFs may be affected by recent rate cuts made by the US Federal Reserve [Fed] and the Bank of England [BoE].

Since the Fed and the BoE cut rates in March 2020, both US-dollar denominated MMFs and sterling MMFs have experienced a decline in yields due to the immediate drop in overnight rates. We expect the yield will continue to decline as existing holdings in the funds mature and cash is reinvested at lower yields.

Prior to the pandemic and consequential market impact we held a long-term view that both the Fed and BoE base rates were to be cut. Based on our conviction, both our sterling and USD funds had a longer duration strategy with a weighted average maturity [WAM] of over 55 days at the time of the rate cuts on 3 March, allowing the funds to be well positioned for lower rates and a slower incorporation of yield decline.

EH: Are any alternative instruments faring well in this turbulent environment? Are treasurers thinking about different investment vehicles?

WG: Due to the illiquidity in the fixed income market it was very challenging for all comingled products, regardless of form, in the month of March. Overall, I would not expect significant changes in investors’ choice of investment instruments due to the Covid-19 pandemic but would expect further discussion on risk mitigation and the correlation of asset types that lead to allocation changes.

DF: We have seen investors take a more active approach to their cash. Some investors have elected to reduce their credit exposure and move part of their cash allocation to government funds while others have wanted to take advantage of the wider credit spreads and move further along the maturity spectrum, seeking higher yields and a better risk/reward balance. This journey towards longer maturities can extend beyond money market products into the ultra-short maturity segment of fixed income strategies. The key is to find the optimal risk/reward balance, and many investors have found an ultra-short fixed income strategy to be most consistent with this need, enhancing their high-quality short-duration exposure.

KH: This market has been one where the way that you own assets has potentially impacted ‘personal rate of return’ and ‘personal liquidity profile’. There are merits to the different reasons why investors own pooled liquidity investments, like MMFs, versus individual securities, either directly on balance sheet or via separate accounts with asset managers. We have seen increased interest in managed vehicles for both liquidity and short-dated fixed income portfolios as some investors evolve their short-term investment requirements.

TK: Based on the factors Dan mentioned, we have seen customers with excess cash and more stringent policy restrictions opt for other ultra-secure alternatives such as federally insured cash accounts (FICA). In addition, those customers wishing to shorten their investment horizon have begun to explore some of the short duration bond funds in lieu of longer-term managed portfolios.

EH: What can treasurers do right now to ensure they have the right mix of short-term investments?

WG: My best advice is for treasurers to ensure they have the right type of liquidity, both in terms of strategy and investment type. Many treasurers assumed they would be able to access their cash in enhanced cash, ultra-short and other type of short-term fixed income strategies. This was not the case without significant cost. As such, treasurers must stress test each of their strategies to ensure they understand what certain outcomes could mean for their liquidity. March was not the month to be changing plans and not the month to be scrambling to find liquidity.

DF: We believe the best way for investors to navigate the new interest rate environment is to adopt a cash segmentation strategy. Segmenting cash enables investors to achieve a better balance between risk and reward. Additionally, it is a more effective way of managing cash holistically. The ability to ‘bucket’ cash according to its uses and needs enables investors to consider investments further along the maturity spectrum, seeking higher yields and a better risk/reward balance. This journey towards longer maturities can extend beyond cash or money market products into ultra-short strategies that enhance investors’ high-quality, short-duration exposure.

Although many investors are happy to accept a lower return for the peace of mind that comes with an MMF, other investors with a longer investment time horizon may find the opportunity for incremental returns well worth the modest additional risk.

KH: Treasurers should revisit investment policies to ensure that they have flexibility to invest in a world where developed markets have interest rates near zero or negative. This may include MMFs and direct securities managed by asset managers in customised accounts. Treasurers should also revisit risk tolerance to ensure that it matches both the risk and the return expectations of the organisation. In a way, treasurers may need to go ‘back to basics’ as it pertains to reconfirming their liquidity time horizon, their sensitivity to mark-to-market volatility and their ultimate goals for their short-term investments, namely: stability, liquidity, yield.

AS: All that remains for me to add is the importance of diversification – and keeping a very close eye on counterparty risk. Obviously, cash is absolutely central to corporate treasurers’ thinking at the moment. We see this with the numerous drawdowns on revolving credit facilities [RCFs], but it’s important to be cognisant of the inherent risk of such behaviour. Drawing down on an RCF leaves you with a large amount of cash and if that’s put back on deposit with a relationship bank, this will inevitably lead to increased concentration and counterparty risk with a single entity. Investing that cash in an MMF would result in significantly lower concentration risk.

TK: The key to getting the optimal mix lies in diversification, both in asset class and counterparty exposure. Managing liquidity within this mix will also be critical, and doing this while trying to optimise yield can be a delicate process. However, leveraging technology should help.

As an example, using the transparency tools now available, prime funds can provide a level of diversification and yield that isn’t available in deposits or other bank products, and with a nominal amount of added risk. As treasuries approach 0% return, their place as the safe haven has diminished. However, they do provide the maximum level of security available. So, looking ahead, I would say that a layered mix of prime, government and treasury funds is the proven method for balancing liquidity, security and return.

EH: Kathleen mentioned reviewing investment policies. Let’s talk a little bit more about that.

KH: Yes, it’s a great time to review policies to ensure that there is flexibility and also that policies meet the current risk/return profile of the organisation. In addition, treasurers may also want to look towards the future and take this opportunity to add language as it relates to ESG [environmental, social and governance] investing as it may also be timely.

DF: From an asset manager’s perspective, we think it is too soon to consider the extent of this crisis and any regulatory changes to MMFs, or funds’ investment policies. With the five-year review of the European MMF regulations due in 2022, we will continue to work closely with regulators and industry bodies to evaluate any changes and work collaboratively with clients and prospects to ensure they are prepared well in advance.

However, for those investors who would like increased diversification, implementing a cash segmentation strategy should ensure their policies allow for incremental duration exposure in investment grade securities and a VNAV fund.

Tom Knight EVP and Treasurer, ICD

TK: The majority of our clients already have sound investment policies in place – and they make sure that they follow sensible principles, regardless of the external environment. That said, we are seeing some tweaking within the limits of those policies, looking at shorter maximum maturities, for example. Clients are also keeping a close eye on diversification, not only in terms of liquidity profile, but by sector too. They are drilling down to look at underlying fund holdings, and checking they are not overexposed in any areas.

One of the priorities for treasury departments should be to review the operational set-up supporting their investment policies. With the pandemic requiring remote-working, the short-term investment processes, channels and workflows treasurers previously had in place must be updated to reflect a more digital way of working. This might require new collaborative tools, whereby treasury personnel can access – from home – the information they would typically have had available in the office.

WG: I’d simply add here that stress testing and scenario analysis are imperative as part of the investment policy review process.

EH: Will the turmoil caused by Covid-19 lead to longer-term changes in the way treasurers manage and monitor their short-term investments?

KH: With any disruption in the short end, investor psychology and awareness of risk can be piqued. In particular, when we see liquidity risk manifest, as in 2008 and now in 2020, treasury teams are forced to reconcile their organisation’s cash flow and cash management plans with the current market environment. We are in many ways still very much in the midst of digesting the full impacts of Covid-19, so wouldn’t want to be premature about future implications. But we do think any risk event usually puts a premium on contingency planning, leveraging of technology, reporting and risk analytic capabilities, as well as revisiting ‘what’s most important’.

One other thing to consider is the role that technology can play in helping to provide connectivity and risk mitigation when teams are working remotely. The ability to trade in and out of funds and access reporting is critical at all times but it’s even more important when people are separated and performing multiple functions in a potentially stressed environment. Having investment portal technology that is integrated with the treasury management system can also mitigate settlement and operational risk as well as reporting duplication.

This reliance on technology to manage and analyse investments should also be viewed through a lens of selecting good partners with robust cybersecurity protocols and defences. The longer-term impact of the global situation may lead to staff wishing to explore different working arrangements in future, and any tools that can be used for monitoring, automation and reporting of their liquidity in the most efficient manner will gain favour among treasury teams.

DF: Absolutely. We believe many will consider how they transact and communicate with their counterparties. Business continuity plan implementation has been very successful for many firms, but operational efficiency and the ability to work remotely do not necessarily go hand in hand. Therefore, we also believe that many treasurers may consider other ways to manage their investment portfolios through the use of technology.

TK: Yes, investment technology will likely receive far greater attention going forward. Of course, not all technology is created equal. What treasurers need most, in my view, is access to information. Not just visibility over their investments and the ability to make switches easily, but technology that delivers insightful information enabling them to make the best possible decision, no matter how challenging the circumstances.

Another example of this level of access, given the unprecedented nature of the pandemic, is how ICD has created a complementary Covid-19 resource hub on our website. This brings together all the latest information about the market in one place, together with insights from our own experts and commentary from our fund partners and other market participants. The page is regularly updated with new information, commentary and webinars.

Alastair Sewell Senior Director, Fitch Ratings

AS: I agree that technology is key and it’s where we will potentially see significant development in the MMF space, not only within corporate treasury functions. At Fitch, for example, our standard process is to review, line-by-line, the portfolio holdings of every fund we rate, at least every two weeks in a normal operating environment.

In this period of recent market stress, we’ve been reviewing the holdings of every fund at least weekly. On top of that, we have been accessing information on all of the rated funds on a daily basis, either in terms of information received directly from the fund managers, from disclosures on their websites, or from industry databases and other sources.

Frankly, this has been a titanic effort, but it’s been a great learning experience too. Since many of the processes involved in our thinking require standardised data sets, we see huge opportunities to apply robotic process automation and artificial intelligence going forward. This would not alter the requirement for human input, but it would free up manpower from information gathering to enable even more time to spend on analysis and interpretation. This could lead to us being able to produce more powerful forward-looking analysis in future, helping to pinpoint trends further in advance.

WG: Aside from technology, Covid-19 should lead to longer-term changes in the way treasurers manage their short-term investments, especially when it comes to monitoring and adjustment. Just like any corporate strategy, short-term investment management is not something that should be taken for granted or deprioritised.

EH: We mentioned ESG briefly earlier. Do you see ESG investing becoming more prominent post-crisis?

TK: ESG funds were beginning to catch fire prior to the beginning of the pandemic. What treasurers are realising now is that ESG investing is not just a way to support societal endeavours, it’s also a risk management tool. Portfolios comprising ESG-screened securities typically have a higher governance score, which has historically shown better credit performance over time and better returns.

As such, I think the ESG space will continue an upward trend once we return to ‘normal’ – and I believe ESG funds will become more widely used as a means to manage downside risk, during typical times and market fluctuations.

DF: We expect the trend towards ESG to continue as prior to the crisis but the same challenges for MMFs to integrate ESG in the front end of the curve to remain complex. Investment parameters and the availability of eligible instruments reduce the investment universe and typically result in a high concentration in issuers from the financial sector. Furthermore, implementing negative screens on MMFs is impactful on the ‘Governance’ aspect of ESG, but often neglects the ‘Environmental’ and ‘Social’ facets.

At this stage, we see more opportunities for ultra-short strategies as they allow for a wider sector diversification than MMFs avoiding unintended risks. Broader sector diversification doesn’t only benefit risk, but also allows for a more impactful ESG solution. We will, however, continue to endeavour building a solution that is impactful within the unique parameters of MMFs and their investments.

WG: ESG investing will become more and more important. Over the long term, the values we adhere to in ESG investing will become the norm and no longer will there be ESG and non-ESG investing. We have already noticed certain improvements, like lower pollution levels. Now it will be important for companies to determine what is sustainable in the post-Covid-19 work world.

KH: We are already seeing evidence of the ‘S’ in ESG becoming as important as the ‘E’ as we manage through this crisis. How companies are reacting to this environment in the ways they treat workers and support their communities will be closely watched from an ESG perspective. Clients are asking questions and the ESG research community is already tracking the actions that companies are taking. So, the scrutiny of social responsibility and the impact this will have on ESG investing is only just starting, but it’s a trend that we think will continue and will strengthen the case for ESG investing going forward.

AS: There is clearly a very strong trend towards ESG investing. My sense is that this crisis has not dented that trend, so I would therefore predict that this investor focus on ESG will continue. The strategic announcements from the asset managers reflect this. BNP Paribas, for example, has published a plan to eliminate its involvement in all thermo-coal-related activity by 2030, which follows on from its total exit from all tobacco activity recently. Others, like BlackRock, have also been very vocal on this topic, and ESG is becoming increasingly embedded in major investment managers’ strategies.

EH: What could all of this mean for the future of the MMF industry?

KH: We have seen prior cycles of low interest rates impact the usage of MMFs, but it’s hard to predict what the long-term impacts will be. Since 2008, we’ve continued to see the evolution of the industry, whether it was new regulation or central bank cuts to zero and negative interest rates or both. Through it all, there has always been demand for a high-quality, liquid solutions that offer investors both daily liquidity and diversified exposure from banks. The money market fund categories implemented in Europe in 2019 have proven their utility during this latest period of volatility, and we continue to see interest in the MMF product.

Also, don’t forget that MMFs are a $5.4tr. industry globally and they play an important part in financing the real economy by buying short-term obligations issued by corporations, financial institutions and governments, a crucial part of the markets given the recent stimulus packages launched for issuers.

DF: It is likely the regulators will continue to analyse the MMFs and evaluate if the current regulations remain sufficiently robust for future market events. The standard five-year review of the European MMF Regulation is not far away in 2023 and will determine whether further regulatory changes should be made.

We are confident, along with the MMF industry, we will continue to support investors seeking a suitable vehicle to manage their liquidity needs, and we will evolve to meet clients’ regulatory or market requirements. The MMF industry has seen significant growth in recent times and this is further evidence that it forms a strategic part of the global financial system.

TK: The industry has performed very well in these challenging times. The transparency that we now have over funds has helped this, and I believe in the near future we may see more money flowing into money market funds as a result.

All of this relies on technology to continue delivering transparency, of course. And this goes back to the points we raised earlier around the industry becoming increasingly digital. Hopefully, one of the silver linings of the crisis will be the momentum it has generated towards a truly digital ecosystem for MMFs.

WG: Looking ahead, we should expect further analysis to be conducted on how the US and European funds performed and if the regulatory reforms that were implemented in 2016 and 2018 were effective in protecting shareholders. It should be expected that the regulatory authorities will take time to analyse the data to determine if further modifications are necessary.

Regardless, MMFs will remain a safe haven for cash investors looking for incremental yield in this low-interest rate environment. And we anticipate that they will continue to serve as a core allocation for cash.

AS: It’s hard to predict how the industry will evolve, although I’m sure that regulatory measures will be reviewed and fine-tuned if necessary. What’s most important at this point in time, in my view, is to remember that MMFs have been consistent throughout this period and they have a high ability to achieve their core investment objectives in providing liquidity. That’s not to say that the operating environment for them isn’t tough – it is challenging in every sense, but the fundamentals are strong and intact, which bodes well for the future.