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A new way for treasurers to find yield?

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Yields on short-term cash are increasingly under pressure. Here’s a way treasurers may be able to make the best of investing in the new, lower yielding world of MMFs.

As the weight of global regulation, such as Basel III, bears down on banks, they are finding it more expensive to accept short-term cash. Banks are passing these costs on to treasurers in the form of reduced yields. This, says Robert O’Riordan, Institutional Business Development Director for UK-based financial consultant, Insight Investment, is affecting deposits held directly with the banks, and investments in prime money market funds (MMFs), which predominantly have bank counterparties.

Prime MMFs are themselves being regulated. The latest European Union regulation published in June is set to increase liquidity requirements and reduce the maturity profiles of prime MMFs. This will apply further downward pressure to the yields they generate, notes O’Riordan.

Coupled with this headwind, prime MMFs will no longer offer treasurers a constant NAV in all market conditions, which they desire, he says. The new regulation has introduced changes to how MMFs are categorised, applying new criteria for constant NAV (CNAV) funds and introducing a new low volatility NAV (LVNAV) fund type.

“For the CNAV category, treasurers will have to invest in government MMFs. However, traditional government MMFs typically generate a yield significantly lower than prime funds, making them less attractive,” says O’Riordan.

Treasurers are also focusing on reducing bank risk due to the sector’s deteriorating credit ratings since the financial crisis. “As banks are continuing to cut yields, treasurers’ traditional reliance on them is waning,” notes O’Riordan. This, he adds, is leading them to consider diversifying outside of the banking sector to achieve their cash investment objectives.

Inefficiencies in the repo market

The Holy Grail for treasurers is for their cash investments to be backed by government securities, to have daily access to their cash and for the yield they receive to be comparable to a prime MMF. “A few years ago, this dream was unachievable given the limited amount of cash investment choices,” notes O’Riordan. “But this is now very much a reality due to the opening up of the non-bank repo market.”

To understand how the non-bank repo market can offer such benefits, O’Riordan says it is important to appreciate the “inefficiencies” of the traditional bank repo market.

In the repo market, banks have traditionally acted as the middle man between cash investors and cash borrowers, he explains. Banks take a spread between the interest they pay cash investors (the reverse repo rate) and the interest they receive from cash borrowers (the repo rate).

“As a result of Basel III, banks have to hold more capital against their gross repo books, leading to a notable widening of bank repo spreads,” O’Riordan comments. “Additionally, in a traditional repo contract with a bank, the cash investment may also be tied up in a fixed term contract, reducing liquidity.”

Diagram 1: Traditional repo structure
Diagram 1: Traditional repo structure

Source: Insight Investment

A new way to generate cash yields

However, he believes that it is increasingly possible for treasurers to transact repo directly with cash borrowers, “thus avoiding the large spread typically imposed by banks”. In this model, non-bank counterparties offer gilts as collateral for the cash they borrow, giving treasurers the highest form of security, with a yield enhancement over what they would receive if they went directly to a bank. In addition, it gives treasurers the ability to diversify their cash away from bank risk.

Diagram 2: Repo directly with cash borrowers
Diagram 2: Repo directly with cash borrowers

Source: Insight Investment

“Cash investment using gilt repos with non-bank counterparties, built into a MMF structure, would offer treasurers a solution that helps them maintain a constant NAV under the new regulation, without having to sacrifice yield,” explains O’Riordan.

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