The low interest-rate environment had already persisted since the Global Financial Crisis, but in response to the Covid-19 pandemic central banks cut interest rates even further and used non-conventional monetary policy to ease financial conditions. The impact of the health crisis on market conditions has further increased the challenges of holding cash for treasurers. Daniel Farrell, Director of International Short Duration at Northern Trust Asset Management, discusses how cash segmentation offers an alternative option for treasurers seeking to efficiently manage their cash and enhance those much sought after returns.
The low and even negative interest rate environment has dented the ability of treasurers to earn returns from traditional investments such as deposits, money market securities, or even money market funds (MMFs) – something not expected to change anytime soon. Undeterred by recent spurts of inflation, central banks remain committed to accommodative monetary policy to support the global economic recovery by keeping interest rates low.
“We have been proponents of the ‘lower for longer’ yield environment for the last 10 years and we expect it is now the case that it will be ‘lower for even longer’,” explains Farrell.
The second challenge that corporate treasurers should be aware of is the likelihood for increased regulation in MMFs. Following the market events in March 2020, regulators have begun consultations on further regulatory changes. Although European money market reforms in 2019 helped fund managers to navigate the challenging period, risks are tilted towards tighter regulations and more compressed money market yields. While undefined and still in discussion phase, any additional regulation will place even more downward pressure on yields in cash reserves.
As a result, treasurers must reassess how they can make their cash work harder for them in order to generate sufficient yields while maintaining their risk profiles. The good news is there is an alternative solution called cash segmentation. Rather than a one-size-fits-all approach to cash management, treasurers could look at cash by defining different “buckets” to make investment decisions based on short-, medium-, and long-term funding needs (see chart below). When it comes to managing cash, capital preservation and risk management are the top priority, so the number of investment options treasurers have at their disposal can be limited. Finding opportunity to increase yield generally requires a shift in approach along with tweaks to the investment lineup. For more than three decades, Northern Trust Asset Management has been working with some of the largest and most sophisticated institutions in the world on cash segmentation strategies that fit to their unique circumstances.
Cash Segmentation Buckets
“We partner with investors to identify the nuances of their own cash flows and needs, demonstrating how it is possible to bucket their cash into the operational, reserve and strategic buckets,” says Farrell. “This process requires an historical analysis that will generally uncover quite a bit of optionality and questions from the investor that we then work through to find the right path forward based on the institution’s risk profile, fee appetite and other business considerations. It helps bring a fresh perspective to treasurers that may unearth new opportunities, and at a minimum helps to alleviate some of the onus and analytical burden that can come with this type of deep dive.”
How segmentation helps maximise yield
Once the cash segmentation profile has been established, Northern Trust Asset Management turns to the possible investment solutions that could be applied. “We focus on finding opportunities to incrementally increase duration and credit risk, within the acceptable ranges of the institution, in order to seek to maximise returns while not compromising capital preservation.”
For operational cash, money market funds remain preferable for treasurers — despite returns — because they provide much needed safety and liquidity. For the reserve and strategic cash buckets, investors would look to short duration strategies.
BACKTESTED CONSERVATIVE ULTRA SHORT AND ULTRA SHORT STANDARD DEVIATION
Source: iMoneyNet,Barclays Live and Bloomberg as of 31/03/2021 - Conservative Ultra-short EUR= 75% IMMFA MMI EUR Prime Stable Avg / 25% Bloomberg Barclays EUR 1–3 Year Corporate Index. Conservative Ultra-short GBP= 75% IMMFA MMI GBP Prime Stable Avg / 25% Bloomberg Barclays GBP1–3 Year Corporate Index. Conservative Ultra-short USD= 75% IMMFA MMI USD Prime Stable Avg / 25% Bloomberg Barclays USD 1–3 Year Corporate Index. Ultra-short EUR= 50% IMMFA MMI EUR Prime Stable Avg / 50% Bloomberg Barclays EUR 1–3 Year Corporate Index. Ultra-short GBP= 50% IMMFA MMI GBP Prime Stable Avg / 50% Bloomberg Barclays GBP 1–3 Year Corporate Index. Ultra-short USD= 50% IMMFA MMI USD Prime Stable Avg / 50% Bloomberg Barclays USD 1–3 Year Corporate Index. For illustrative purposes only. Performance is gross of fees and does not reflect the deduction of investment advisory fees. Past performance is no guarantee of future results.
“Sometimes there can be a misconception that short duration strategies bring about lots of volatility, low levels of liquidity and far more risk, but this is not necessarily true,” notes Farrell. “It’s not like an unbreakable term deposit where an investor is locking up their cash for a period of time and cannot access without payment of a fee. There’s still a relatively high level of liquidity there. By constructing high-quality portfolios of short duration bonds through an investment process that emphasises thorough credit research, broad diversification across sectors and risk management, we can still offer some of the stability and liquidity money market funds provide.”
The most widely adopted measure to evaluate volatility is standard deviation which measures the dispersion of returns from the mean as seen in our illustrations here. Ultra-short strategies still have relatively low standard deviations meaning a low dispersion and low volatility of returns. It is important for us to look over a long time horizon to incorporate different market stress events including the global financial crisis, sovereign debt crisis and Covid-19 pandemic to see how these strategies would be impacted.
One short duration option is a conservative ultra short strategy for the reserve cash bucket, which takes incremental credit and duration exposure relative to a money market fund.
“Money market funds typically can’t invest out any further than one year. The conservative ultra short strategy extends that maturity limit to three years, and then we’re targeting a modified duration of half a year,” explains Farrell. “Even though we’re extending the maturity, the duration and sensitivity to interest-rate changes are still very low, making it a good option for liquidity investors. Obviously, with that extension of maturity, you also benefit from the opportunities to pick up higher returns relative to a money market fund with only an incremental increase in risk.
An ultra short fund also works for the strategic cash bucket, but with the maturity profile further extended again out to five years. Maturities range in the one-to-five-year section of the yield curve and they still are investment grade. Incremental moves along the curve provide opportunities for additional returns relative to the preceding fund.
BUCKETING CASH CAN ENHANCE RETURNS FOR INVESTORS
Source: iMoneyNet and Barclays Live as of 31/12/2020 - Conservative Ultra Short EUR= 75% IMMFA MMI EUR Prime Stable Avg / 25% Bloomberg Barclays EUR 1–3 Year Corporate Index. Conservative Ultra Short GBP= 75% IMMFA MMI GBP Prime Stable Avg / 25% Bloomberg Barclays GBP1–3 Year Corporate Index. Conservative Ultra Short USD= 75% IMMFA MMI USD Prime Stable Avg / 25% Bloomberg Barclays USD 1–3 Year Corporate Index. Ultra Short EUR= 50% IMMFA MMI EUR Prime Stable Avg / 50% Bloomberg Barclays EUR 1–3 Year Corporate Index. Ultra Short GBP= 50% IMMFA MMI GBP Prime Stable Avg / 50% Bloomberg Barclays GBP 1–3 Year Corporate Index. Ultra Short USD= 50% IMMFA MMI USD Prime Stable Avg / 50% Bloomberg Barclays USD 1–3 Year Corporate Index. For illustrative purposes only. Performance is gross of fees and does not reflect the deduction of investment advisory fees. Past performance is no guarantee of future results.
Farrell says: “We built these kinds of strategies purposely as a first step out of money market funds, ensuring we focus on keeping cash investors comfortable. By addressing two basic components – incremental credit risk and incremental duration risk – you can diversify your portfolio and also have the potential to achieve those higher returns. Treasurers are naturally concerned about volatility in step with cash preservation, and they understand the look and feel of money market funds, so we’re working from a perspective of how we could get as close as possible to that.”
For treasurers who do move into the ultra short space, the wider set of investment parameters provides a much broader investment universe. Money market funds have a high level of exposure to financials because of the restrictive guidelines and lack of corporate issuance in money market securities, as shown in European Commercial Paper outstanding issuance. With ultra short strategies, their extended maturity and credit profiles mean exposure to traditional corporate bonds, governments, agencies, utilities, and industrials, offering a more diversified portfolio. Even environmental, social and governance (ESG) principles can be included in the investment process.
ISSUER DIVERSIFICATION BENEFITS ARE SEEN WHEN MOVING BEYOND MONEY MARKET FUNDS
Source: Barclays, Dealer Logic, Bloomberg. Data as 31st March, 2021
Using cash segmentation to counter interest rate and regulatory headwinds
Treasurers are already well-versed in the benefits of cash flow forecasting and what that means for their much broader liquidity management strategy. With cash segmentation, a robust cash flow forecasting strategy can benefit treasurers from an investment perspective as well. It will highlight what the company’s short-, medium-, and long-term funding requirements are, covering everything from operational requirements to borrowing, debt repayment requirements, dividends, and merger and acquisition activities.
A cash segmentation approach can provide major benefits to treasurers looking for greater returns in the perpetual environment of low interest rates. For those able to bucket cash, it enables the performance optimisation of excess liquidity, widens risk management options through sector diversification, and can open options such as ESG investing. For treasurers that are not getting the most out of their current cash management strategies, cash segmentation should well be on the discussion agenda.
“Ultimately, it is all about getting money to work in a more efficient way in this low- rate environment,” concludes Farrell.
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