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Invesco

Assessing the alternatives

In the current economic environment, corporates are finding positive yields on their short-term investments increasingly hard to come by. Cash preservation should not, however, be viewed as an insurmountable challenge. With the right support from their asset managers, treasurers can find ways of making that money work a little harder for them. However, this will ultimately mean giving more consideration to what cash is required for operational purposes, and what cash can be invested in less liquid, longer duration alternatives. In this interview Invesco’s Paul Mueller, Senior Portfolio Manager, Sterling and Euro MMFs and Luke Greenwood, Senior Portfolio Manager, UK and European Investment Grade, outline some key points of consideration for treasurers looking at investment opportunities beyond traditional cash investments in a yield deficient environment.

Portrait of Paul Mueller

Paul Mueller

Senior Portfolio Manager, Sterling and Euro MMFs

Paul Mueller joined Invesco in 2003 as Portfolio Manager for enhanced liquidity strategies. Since 2014he has led the Invesco Global Liquidity team as Senior Portfolio Manager responsible for Euro and GBP denominated MMFs, and USD and Euro denominated Reserve funds. Paul is a qualified Chartered Public Finance accountant. He also has a BA (Hons) in Accounting, Finance and Economics, holds a UK Investment Management Certificate and is a member of the Society of Technical Analysts.

Portrait of Luke Greenwood

Luke Greenwood

Senior Portfolio Manager, UK and European Investment Grade

Luke Greenwood is a London-based Senior Portfolio Manager for Invesco Fixed Income (IFI). Joining in 2000, he moved to IFI in 2004. He has extensive global corporate bond market experience across multiple sectors, undertaking portfolio management for an array of credit funds, from short duration to total return. An Australian, his career began at Westpac, moving on to State Street in Sydney before relocating to the UK. He has an Executive MBA from Cass Business School.

How has the short-term investment environment in Europe changed in recent years? How big a concern is the negative interest rate environment for asset managers and corporate investors?

Paul Mueller: The Eurozone has been in negative yield territory for some time – and it would appear that the market has become used to it. If we look at AAA CNAV money market fund (MMF) assets in Euros, we have not seen a material fall since rates went negative. Total assets have since the end of 2013 fallen by a little over 6%. This move may be masked by an increase in overall cash balances during this period but this is a difficult figure to pin down.

Nonetheless, negative yields have clearly not been taken very favourably by clients; nobody wants to pay somebody else to look after their money when they used to get a return on it. In conversations with clients it appears to us that there has been a renewed focus on cash flow forecasting to clarify what is really essential operational cash, and what cash they can perhaps invest in instruments with more duration and/or credit risk, to try an obtain a higher yield. We’ve certainly seen some evidence of that over the past 18 months or so.

Although there is not a negative yield environment in the UK, following the recent Bank Rate cut the renewed focus on yield is unlikely to be a purely Eurozone issue. At best the UK is now in an ultra-low interest rate climate with markets not expecting the first increase until 2021. We have regular conversations with our clients, both in the Eurozone and in the UK, where concerns over the level of yield is a common topic. It’s particularly essential for us as a Money Market Fund manager to have regular dialogue with our clients, it helps us better understand their specific needs, their own particular business environment and importantly to meet their liquidity needs.

What we see as having perhaps an even bigger impact on the short-term investment environment is regulation. Basel III is creating challenges from an operational perspective. A consequence of the regulation is that banks are now less willing to accept investments below three months leading to a scarcity of supply. MMFs require high levels of liquidity not only for regulatory reasons, but also so that they can be confident of meeting client demands for cash.

Historically that liquidity has come from the banking sector in the form of overnight deposits. But with there now being a lot less issuance at the front end because of Basel III, maintaining adequate levels of liquidity has become more difficult and MMFs have had to increasingly look elsewhere, to different geographic regions and asset classes to plug that growing gap.

How is Invesco’s own portfolio of short-term investment products evolving in response to the changing regulatory and market conditions?

The evolution of our short-term investment products will ultimately be determined by several factors, yet to be fully wrapped up. Firstly, there is the ongoing European MMF reform, which has been dragging on for a long time but appears to be edging closer to a resolution. On top of that we now have, after the Brexit vote, uncertainty around what the UK’s future relationship with Europe will look like and stemming from that the prospect of a very low interest rate environment.

If the final regulation for MMFs in Europe does indeed include the proposed LVNAV product that is something we might be interested in adding to our product portfolio. In principle, it could have a lot of appeal to clients, not least because of the fact it can still trade at a share price of one. But there are some practical operational details that could have a meaningful impact on how viable this product might ultimately be, for example, what investment securities will be allowable in the liquidity bucket. Also it is crucial that the five-year “sunset clause” set-out in the European Parliament’s proposal is not in the final text because we do not think that this product would be viable if that were to be included.

Given the ‘lower for longer’ rate environment we now find ourselves in, we are also focusing on developing bespoke short-term investment solutions like separately managed accounts (SMAs); allowing clients to set specific parameters on what result they wish to achieve. We also have a Euro vehicle that is run broadly like a MMF but can take a little more credit risk. For clients in Europe looking for an improved return on their investment, this would be a product to consider.

Regulatory and market conditions are still evolving, so there is perhaps a risk of jumping the gun. But we do think we are likely to see an increased demand for slightly higher yielding, but still very liquid and relatively secure investment solutions.

Chart 1: Seven-day net yields (in %) continue to fall further into negative territory
Chart 1: Seven-day net yields (in %) continue to fall further into negative territory

Source: iMoney.Net

Is the growing interest we are seeing in these higher yielding short-term investment products purely a product of the negative yield environment?

The fact that corporates are holding considerably larger cash balances might also be playing a part. We are not just seeing this in the corporate sector but in the public sector too; cash balances have continued to grow and that creates challenges for investors. It means that the revenue that can come back from that cash has a bigger impact on companies and they have to look at ways of making that money work a little harder for them. If those surplus balances are going to be there for one or two years, is it relevant for all of it to be sitting in a MMF?

Of course, this does come back to the yield environment. If interest rates were at 15%, for example, I don’t think many investors would have any qualms about keeping it all in cash. It is a function of both the way in which cash levels have risen across the market and the need in this ultra-low interest rate environment (to generate some additional return).

Most corporate treasurers will be very well versed with respect to investing in traditional products like MMFs, but what do they need to do differently when it comes to putting cash into some of these less familiar investment products?

PM: It is very important for treasurers to properly understand the differences. First and foremost, is there the same level of liquidity – if they needed to redeem would there be a risk that they might not get all their cash back straight away? If you are taking on more risk, then usually that means relinquishing some liquidity. Treasurers who use these products therefore need to be more active in assessing the time horizon of their liquidity profile.

With some products the potential volatility of returns is also something that needs to be factored in. Say a treasurer is, for example, expecting a 4% return over a year with a particular product. If there are some negative price movements in the market amid a strong risk aversion period – as we saw in the first quarter of 2016 – that could definitely be an education process for those who have not used higher yielding investment products in the past.

Obviously if you are trying to increase your returns then you will inevitably incur more risk too. Whether the additional risk is acceptable largely depends on the tolerance of each investor over a certain timeframe. They must decide if they can accept short-term volatility for the potential of higher long-term returns.

Luke Greenwood: On a more general level, when it comes to stretching for yield a heightened awareness of monetary policy might also be beneficial. In an environment of low growth, low interest rates and low inflation, together with supportive central bank policies we are seeing default rates remain well contained. Security is always going to be a priority but it is perhaps less of a concern given the current supportive macroeconomic environment we’re in, for example, low interest rates reduce refinancing pressures.

We’ve noted that cash segmentation is something you are seeing your clients pay much closer attention to in recent years. Why is this becoming an ever more important consideration for corporate investors and how can Invesco help?

LG: Looking at where the yield curve is in Europe at the moment, even German bonds are negative at the ten-year part of the curve. So investors are getting pushed further out of the curve, and perhaps having to take on more security risk as we have spoken about. Perhaps that entails moving into securities like corporate bonds, which are a different challenge with the potential for capital loss, mark-to-market volatility and transaction cost.

But to use such products a sophisticated approach to cash segmentation is an absolute must. To help our clients with this we start by trying to develop a deep understanding of what they are trying to achieve. Once we have a clearer idea of that we are able to use our market experience to point out some of the factors we think they would need to take into account. Sometimes that involves educating clients about how markets are changing. For example, the traditional view of what constitutes a ‘safe’ credit rating has changed considerably, given that there are few governments let alone Corporates still holding an AAA rating. Investing in securities with lower ratings can present something of a psychological hurdle for some investors, but we think it is being overcome gradually and treasurers are beginning to recognise that BBB is not necessarily the same credit risk that it was perhaps ten years ago. For example back in 2006 the AA rated Sterling Corporate’s represented around 30% of total outstanding Corporate Debt today it is closer to 10%. That’s something we regularly discuss with clients in meetings.

We certainly have witnessed some seismic changes in the short-term investment environment in Europe over recent years. What do you think the future holds? Are negative rates here to stay?

LG: The markets are not pricing in any rate increases in Europe for many years to come. One of the biggest challenges for the Eurozone is reviving inflation. To that end, it seems likely that the European Central Bank (ECB) is going to have to extend their quantitative easing (QE) programmes beyond March next year. That said, however, we are certainly seeing a diminished utility with respect to further rate cuts, something which I would say is also reflected in what Mark Carney, the Governor of the Bank of England, has been saying with respect to setting a lower bound. So I think, all things considered, we will be in a low growth, low rate environment for a protracted period of time and the central banks will continue to endeavour to prop up economies in ever more creative ways.

With no end still in sight to the current low yield environment what final advice would you give treasurers in terms of managing their short-term investments going forward?

PM: It all comes back to the basics of good cash management. Investors ought to give real thought to the purposes for which they are holding their cash. If they need certain cash balances for operational requirements, then seeking additional yield at the expense of security and liquidity is most probably something they should not be doing.

For treasurers holding a certain amount of non-operational cash that they would like to invest in higher risk products, it is important they make sure they are comfortable beforehand; that they fully understand the risks they are taking. We are in an entirely new environment now, and I think we are all learning on the job because the market conditions we are seeing are unprecedented.

Important information

This document is for Professional Clients in the UK only and is not for consumer use. The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Past performance is not a guide to future returns. Where Luke Greenwood and Paul Mueller have expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Issued in the UK by Invesco Asset Management Limited Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority

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