Published: August 01, 2011
With markets braced for the normalisation of G7 interest rates, the outlook for global monetary policy is a major concern for all cash investors. The wrong investment strategy in a rising interest rate environment could lead to a loss of yield and potentially expose investors to higher credit risk. That’s why at J.P. Morgan Asset Management we are focusing our latest Liquidity Insights paper on the relationship between cash management and the interest rate cycle.
Our Liquidity Insights programme is designed to share the firm’s intellectual capital through white papers, economic and market bulletins, surveys, conference calls, web discussions, investment forums and other face-to-face meeting opportunities. Our aim is that the Liquidity Insights programme is relevant and practical and designed to deal with matters of current interest to cash investors. Recent titles include:
Interest rates in many OECD countries are at, or are close to, record lows. However, with inflationary pressures beginning to build, most investors expect the major central banks to begin raising interest rates soon. The European Central Bank has already started to tighten policy, following a 25 basis point increase in April. The Bank of England is expected to follow later in the year as it tackles an inflation rate that is more than double its target. Even the US Federal Reserve has signalled that rates are likely to rise in 2012, if not earlier.
With interest rates likely to rise quite steeply and for a prolonged period from their current ultra low levels, it makes sense for treasurers to plan ahead and adapt their cash investment strategies so that they are not adversely affected during the rising cycle. Choosing the right strategy is particularly important as rising interest rates will impact the return from cash and short-term investment vehicles in different ways:
* Overnight bank deposits should generally track rises in interest rates quite closely, although investors should be aware that, due to their exposure to only one counterparty, credit risks may be higher. Counterparty risks can be reduced by diversification, while potential returns may also be higher from a more diversified investment.
* Term deposits will lag shorter-dated deposits as they need to wait out the term of the deposit before resetting to a higher interest rate. They also carry the same counterparty risk as overnight deposits. However, as term deposits are not marked to market they will not suffer any unrealised losses.
* Money market funds will see their yield rise in line with prevailing interest rates, although with a small time lag. However, because of their diversified portfolios money market funds carry significantly lower counterparty risks than overnight or term deposits. They are also not marked to market so are not exposed to unrealised losses.
* Short-term bond funds can earn higher yields than cash instruments, but their longer duration and marked to market pricing means that they are more sensitive to interest rate movements. Investors may therefore experience unrealised losses and so really need to be sure of the accuracy of their cash flow forecasting before investing in a longer-duration fund in a rising interest rate environment.
* Separate accounts offer investors the flexibility to tailor portfolios so that they have the risk and duration characteristics that they are comfortable with. However, separate accounts are marked to market and may therefore suffer unrealised losses as interest rates rise.
All portfolios carry an inherent level of interest rate risk. However, cash investors can monitor interest rate expectations by looking at the yield curve and the forward rates market to measure whether the level of interest rate risk in their current cash portfolios matches up with their risk tolerance in a rising rate environment.
With inflationary pressures beginning to build, most investors expect the major central banks to begin raising interest rates soon.
The yield curve can help investors gauge how the market views future short-term interest rates, because rates on longer securities are an average of current and expected future rates on short instruments. In normal markets the yields on securities with longer maturities are generally higher than for shorter maturities. The yield curve will slope upward, suggesting that interest rates are likely to rise at a relatively steady rate.
If the market expects rates to rise sharply, the yield curve will steepen as investors move into shorter maturities to avoid being locked into lower yields at the long end of the curve.
If the market expects rates to fall, then the yield curve may become inverted as investors opt for longer dated securities in order to lock in a better yield for as long as possible.
Investors can also use the interest rate futures market to try to forecast the direction of interest rates. The price of a two-year interest rate future shows the level at which the market expects interest rates to be two years from now. Futures can therefore also be useful in predicting interest rate movements. [[[PAGE]]]
Neither futures nor yield curves can ever predict interest rate movements with full accuracy. Trying to time the market over short periods can be fraught with difficulty and can also be counterproductive as there can be false signals and reversals at any stage in the cycle. For example, reducing interest rate exposure when interest rates are falling can result in an unnecessary give up in yield. Similarly, increasing credit risk when credit is contracting could lead to a capital loss.
The wrong decision could not only cost yield but it could also expose treasurers to greater counterparty risk. Treasurers should therefore think carefully before switching into cash deposits in order to try to pick up a slightly higher yield as interest rates rise.
Investors should instead have an investment policy designed to manage for the long term across the full market cycle. One potential approach for treasurers is to design a cash investment strategy based on a clear framework of acceptable investment options and then to move cash reserves between these options when it becomes clear what part of the cycle we are currently in.
Such a strategy based on moving cash reserves to suit the prevailing market environment can be effective, but will require expert resources to continually assess the market so that treasurers can react quickly to changing conditions.
Many treasurers may consider outsourcing interest rate forecasts to professional fund managers. One way to do this is to invest cash balances in money market funds, which can provide attractive returns and high levels of security throughout the market cycle without the need to continually change strategy in search of yield.
The active yield curve management undertaken by money market fund managers means that over a full interest rate cycle money market funds can actually offer superior returns to other short-term investment vehicles, making it unnecessary for treasurers to attempt to make tactical allocation changes to mitigate short periods of underperformance.
In a declining interest rate environment, money market funds are able to offer investors better yields compared to short-term bank deposits, while enhancing security and maintaining liquidity. They can achieve this by extending the weighted average maturity (WAM) of their portfolios (up to 60 days for AAA-rated funds) so that they can hold on to higher yields for longer.
Conversely, when interest rates are rising, money market fund managers can reduce the average maturity of the instruments they invest in from around 60 days, which is conducive to an interest rate falling environment, to a shorter period of say 30 days. As such, the fund manager will have more liquidity available to invest in progressively higher yields as interest rates rise.
Given that fund managers must wait for instruments to mature before accumulating the cash that can be invested in these higher yields, a time lag occurs and as such, money market funds will periodically underperform short-dated cash deposits. Once the interest rate rise becomes a reality, money market funds can once again jump ahead of time deposits and benefit from the extra yield available as the yield curve shifts upwards. [[[PAGE]]]
The period between April 2004 and July 2006 illustrates just how quickly money market funds are able to reset to a higher yield in a rising interest rate environment. During this period the Federal Reserve raised US interest rates a total of 17 times in quarter-point increments. On average rates rose every four to eight weeks.
During this intensive rate rising cycle, the JPM US Dollar Liquidity Fund was able to benefit from the higher yields with only a small lag by maintaining a lower WAM, which averaged 41 days over the period. Average underperformance was just 11 basis points below seven-day Libid, while the fund increased in size from USD 21.7bn to USD 28.6bn.
When looking to outsource interest rate decisions to an asset manager, it is important to select one with the right experience and the appropriate resources and risk management tools in place. Historically, like deposits themselves, money market funds have largely been treated as a commodity. Yield has often been viewed as the key differentiator, followed by a fund’s credit rating. Beyond this, little attention has generally been paid to the internal mechanics of funds or the institutions that manage them.
Investors can use the interest rate futures market to try to forecast the direction of interest rates.
But as recent events in credit markets have shown, all money market funds – even AAA-rated ones – are not the same. Factors such as what a fund invests in, how it is constructed and who it is managed by have been shown to have a real and significant impact on the performance, liquidity and security of investor capital.
Credit rating agency Moody’s reports that, in the US, 36 money market funds registered under SEC Rule 2a-7 had to be supported by their sponsors in 2007/08 to avoid their net asset value (NAV) falling below USD 1 per share as the value of certain underlying investments were wiped out. Such interventions are extreme and rare, but they have been sufficient for many corporations to reassess how and where their cash is invested and the processes and policies they have in place to govern these investments.
To find the most experienced and secure money market fund managers, treasurers should ensure that they carry out rigorous due diligence before investing their surplus cash. Three areas to focus on are the credit resources and investment process, and the levels of liquidity offered and the strength of the fund sponsor.
1. The strength and track record of the manager’s credit analysis/investment process
Money market fund managers who have come through recent events most successfully tend to be those that have invested heavily in their own proprietary credit analysis. Extensive questions should be asked about the structure, experience and resources of the credit team. The last two years will, in fact, have served as a stern test of the robustness of a firm’s credit analysis capabilities and any RFP should request details of any security downgrades or security buy-outs that have taken place.
2. Levels of liquidity, investor concentration and access
A fund can only assure daily liquidity if it has the scale of assets and level of investor diversification to honour redemptions of any size at any time. It is therefore essential to assess the size of the specific fund in which assets are to be held (not just the firm’s total money market assets); the level of client diversification within the fund; and the fund’s internal policy on shareholder concentration limits. Questions should also be asked about how much of the fund is invested in overnight securities and whether the manager has ever restricted withdrawals from the fund or been required to inject liquidity.
3. The strength, commitment and record of the fund sponsor
Where money market funds are looking to maintain a stable NAV, it is essential that they are backed by an organisation with the strength, stability and commitment to ensure that they never fall in value. Perhaps more than any other asset class, money market funds demand detailed scrutiny of the sponsor’s current and historic financial position. It is also important to ascertain how long a firm has been involved in the money market fund sector and what proportion of its overall business and assets this represents. [[[PAGE]]]
With the right investment strategy in place, cash investors can ensure that they are best positioned to benefit when interest rates begin to rise. The first step to designing a robust cash strategy is to recognise that different short-term investments carry different yield, security and liquidity considerations through the interest rate cycle.
Treasurers then need to ensure that they are best positioned during each stage of the cycle. Rate forecasting techniques based on yield curves or interest rate futures can help cash investors with this positioning, but timing the market is fraught with difficulties. Treasurers may therefore opt for a flexible approach which allows them to move cash reserves between different options when it becomes clear what part of the cycle we are currently in. Alternatively, they could choose to outsource their interest rate positioning to professional fund managers by basing their strategy on money market funds.
The J.P. Morgan Liquidity Insights Programme can help investors with these decisions. We have many useful insight papers, including guides to cash management in a rising interest rate environment, designing a robust cash investment strategy and selecting the best cash managers. For details on our Liquidity Insights programme, including investing in a rising interest rate environment, please contact Jim Fuell, the head of Global Liquidity for EMEA by email on [email protected] or by phone on +44-20-7742-3620.
www.jpmgloballiquidity.com
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