Cash & Liquidity Management

Short-term investing

Published: Apr 2012
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Market stress began in 2007, claimed numerous casualties in 2008 and 2009 and continues unabated, despite the concerted efforts of regulators and monetary authorities. Since this time, corporate treasurers have faced increasing difficulty in balancing risk and return when dealing with treasury surpluses. In this article, we examine the available options.

After years of extending and disintermediating their balance sheets, banks are now perceived as considerably more risky than ever before. The credit rating agencies have, with very few exceptions, downgraded the banks and regulators have responded by imposing much more restrictive ratio requirements on banks and other market participants.

At the same time, the authorities have engineered a low interest rate environment through the provision of liquidity to the markets in the form of short and medium-term market assistance. This has been done through various mechanisms that include the Bank of England’s Special Liquidity Scheme and Discount Window Facility, the ECB’s standing facilities and long-term refinancing operations and the Fed’s Discount Window, in addition to rounds of quantitative easing.

Whilst record amounts of liquidity have been pumped into the banking systems of the developed world, much of it has been recycled back into central bank coffers and there is little evidence that the cash has left the financial system to benefit the ‘real’ economy.

Lower capital investment, maintenance of operating cash flows and general uncertainty against a backdrop of widespread economic and monetary fragility has helped provoke a significant rise in corporate liquidity. Whether or not required immediately, some corporates have also taken the opportunity to issue longer-term debt in the capital markets relatively cheaply.

However, the cost of maintaining liquidity and of restricting counterparty credit and maturity limits – a perfectly rational response in times of stress – is reflected in the paltry returns currently available on short-term investment. Typically, the better the credit and the shorter the maturity, the lower the return.

What is short-term investing?

This depends on who you speak to. To an institutional investor, short-term might mean anything less than one year, maybe even two years. Cash funds and short-term bond funds, for example, might have duration profiles that range up to two years. To a corporate treasurer, however, short-term will conventionally mean maturities of up to one year, although there will normally be a distinction between liquidity investment and term placements, with liquidity managed in time buckets of up to three months.

Corporate treasury balances could result from short-term frictional or operational cash flows, structural surpluses or core cash. It will depend upon individual circumstances as to how long the balances are available for investment. Even where core and structural balances may be available for longer-term investment, a treasurer may (as now) feel an increased need to maintain higher levels of liquidity and maturity selection may be kept short.

Where do companies invest currently?

According to J.P. Morgan’s 2011 Liquidity Survey of nearly 500 corporate treasurers (45% of which were from the EMEA region), bank deposits accounted for 56% of cash investment and were the most common investment destination for treasury surpluses. Cash allocation to money market funds was 21% and direct investment in securities such as repurchase agreements (repos), certificates of deposit (CDs), commercial paper (CP) and other bonds amounted to 11%.

As a rule, the larger and more sophisticated the treasury operation, the more likely it is that direct investment in debt securities will feature. This is unsurprising given that investment in anything beyond vanilla bank deposits or money market funds implies a requirement for a treasury to have a more highly-developed credit process and delivery/settlement infrastructure, together with an internal accounting and management information capability necessary to accommodate a range of market instruments.

Predictably, since the banking crisis took hold, there has been a notable reduction in investment demand (and issuance) for structured investments such as asset-backed CP, for instance, and a corresponding increase in investment in government securities both directly and through mutual funds. That said, continuing low money market yields, particularly in short maturities, has led some to revise their credit policies to permit investment with a wider range of adequately-rated issuers.

Rating agencies have been engaged recently in a widespread reassessment of bank financial strength and the trend is for lower ratings across the board. The danger is, of course, that market participants come to blithely treat lower ratings as the new benchmark (eg “AA is the new AAA” as was remarked when the US’s long-term rating was downgraded to AA+ by S&P in August last year) without considering the full ramifications of the re-rating.

Consideration of these matters is crucial in setting corporate treasury investment policy and any decision to expand a counterparty approval list, re-instate maturity limits or increase risk tolerance budgets in pursuit of improved returns should be very carefully weighed and could be premature.

Where to go for yield?

Bank deposits

Unfortunately, in today’s market, even less well-rated banks are unprepared to bid aggressively for deposits that may be categorised as wholesale markets funding. This is because regulatory impositions will increasingly require them to maintain high quality liquid asset buffers that, themselves, generate returns at or below official rates.

This represents a structural market shift that will see all banks willing to pay a premium for longer-term, assured funding; in particular to corporates that are existing customers with an established, operational relationship. Depending upon the jurisdiction and the funding mix of a bank, the pricing of corporate deposits will have natural breaks at one month, three months and one year. Evergreen deposit arrangements (ie call and notice accounts) are valuable in terms of bank liquidity planning and anything over one year, whether fixed term or subject to notice, is highly desirable in the new world.

Relationship banking has taken on greater significance in recent times for many reasons. From a corporate perspective, re-pricing of wholesale credit by the banks will reflect increased scarcity of credit although a more holistic approach to relationship pricing for ancillary business – such as treasury deposits – should enable a bank to justify a better bid for cash deposits.

From the perspective of the bank, repeat business from a corporate depositor supports an argument that the client is loyal and deposit is ‘sticky’, the objective being to demonstrate to a regulator that a smaller liquidity buffer (and avoidance of associated opportunity costs) can be justified. As a result, it can be worth rebalancing treasury policy to permit increased placement with relationship banks.

Spreading short-term (say less than one month) wholesale deposit business around the market enables counterparty risk to be diversified and can improve returns. But, it can be counter-productive, particularly where there is no obvious relationship angle and the improvement in returns for short-dated cash might be marginal at best. It can also be highly time-consuming for any thinly-staffed treasury. There are, however, occasions when banks are prepared to pay well for short-term cash; the difficulty is in knowing which banks and when. Current knowledge of relative appetite and capacity among the banks is central to the management of short-term cash and requires constant monitoring.

Certificates of deposit

CDs are widely used by corporates – particularly in the UK and Europe – in place of clean, fixed term bank deposits. They are issued by banks and are typically fully negotiable (ie transferable by delivery) which enables them to be bought and sold in the secondary market with relative ease and, for this reason, they will normally be issued at yields below those available for clean deposits.

Generally fixed rate, CDs can also be floating rate and even pay returns geared to external reference rates. They can be issued bilaterally or under established note programmes. The majority of CD issuance is now in non-materialised form, being deliverable electronically though Euroclear (or Crest) although it is still possible to request physical (security printed) primary issuance. In the UK, the term ‘certificate of deposit’ (so-called ‘London CDs’) is closely defined and cannot be applied to other notes and short-term paper issued by banks.

As with any instrument that can be traded, secondary market pricing can be affected – sometimes dramatically – by market sentiment. This means that bad news (or bad press) for any bank issuer can result in withdrawal of demand for, and an increase in, supply of paper in the secondary market. Improperly handled, either directly or by brokers acting for vendors, secondary market pricing can be highly volatile. A corporate investor intending to hold the paper to maturity will probably not need to be concerned with secondary market pricing unless the instrument had been purchased with a view to trading it on prior to maturity. In this instance, auditors may require market valuation of the instrument which would otherwise be accounted for as a deposit with a maturity value of par.

Apart from a possible yield differential, the main drawback of CDs as compared with clean deposits is the need to be able to accept delivery of the dematerialised form of the CD. This poses no issue for a treasury operation that has a regular custodian with accounts at Euroclear but, for those investors that do not, custodial arrangements will need to be made, managed and paid for.

Treasury bills/government securities

Most companies have, at some point, invested in short-term government securities and will be familiar with the operational features associated with such instruments. Treasury bills are short-term instruments issued by national monetary authorities through dealers that participate in regular primary auctions at a discount to par for maturities up to one year (most commonly, maturities do not exceed six months).

Investors would typically acquire bills through the dealers and settlement would be into a depositary or custodian account. In the UK, the minimum investment is £500,000 and issuance is aimed at institutional and corporate (crudely, wholesale) investors. In contrast, the US market encourages retail level access with bill denominations as low as $1,000.

As short-term money market instruments issued by central monetary authorities, they are considered (credit) risk free in their national markets and, as a consequence, are the first option of any treasurer wishing to minimise risk at times of market stress. Equally, markets for all the leading countries’ bills are deep and liquidity is generally undoubted. The downside is low yield which, although designed to mirror official rates, can be negative. Famously, in January 2012, the primary yields on German 6 month Bubills turned negative as investors became willing to pay for the privilege of parking cash outside the banking system. There are also moves afoot in the US to permit auction bids of less than zero to be accepted for primary issuance.

Medium Term and Floating Rate Notes

Medium Term Notes (MTNs) and Floating Rate Notes (FRNs) are generally continuously issued through appointed dealers for original (credit) periods exceeding one year although the structure of individual notes may well provide for coupon resets periodically (one month, three months and six months most commonly). MTN issuance can be by corporates and banks although banks tend to be the most prolific issuers of FRNs. Issuance is dematerialised (as with CDs and T-bills) and delivery is through a central counterparty (CCP) such as Euroclear, with a requirement to enter into a custody agreement either with the dealer/vendor or separately with a dedicated custodian.

Most note programmes permit the issuance of a variety of instruments and can be designed to accommodate note issuance tailored to individual investor requirements. In some cases, they can also provide for the issuance of short-term commercial paper although CP maturities tend to be longer (say 180 days plus) than for regular CP.

Short-term corporate investors in MTNs or FRNs are unlikely to be participating in the primary market in view of the longer-term nature of the issuance. Instead, they will be looking to invest in secondary paper offered by the programme dealers that maintain a market in the issues or by holders/vendors directly.

Much of the secondary demand for such paper is represented by the professional market (eg mutual funds). Secondary market liquidity is notoriously fickle, in particular where the MTN is anything more complex than a vanilla FRN tranche and where time to final maturity is longer than six months. Short residual life bank-issued FRNs that are into their final fixing period tend to fare best in the secondary market since the repayment obligation has, by this time, the same status as a bank deposit (ie fixed maturity and fixed rate.)

Generally, however, paper with short residual credit life is difficult to find and, where it does exist, would not necessarily offer yields superior to where the bank may bid directly for cash. For short-dated FRNs, secondary market liquidity may be less than for CDs issued by the same obligor depending upon market conditions; occasionally, lack of familiarity with an issuance programme may cause a trading desk to discriminate in favour of CDs regardless of the market status of a particular issue.

For corporate investors with a suitable risk appetite and credit process, longer-term bank – and even financial corporate – issuance can offer a significant yield pick-up but secondary liquidity (if required) could be an issue.

Commercial paper

Commercial paper (CP) can be issued by commercial and corporate issuers or by banks. Bank issuance is most regularly associated with securitisation programmes wherein bank assets are transferred into a conduit vehicle and from which CP is issued to investors. Whilst there may be little direct name association between a bank and its conduit(s), the CP issuance is generally considered to carry full faith and credit of the bank sponsor, not least given credit, servicing and liquidity undertakings by the sponsor to support an external credit rating. That said, such asset-backed CP (ABCP) programmes have to be explained (and understood) and secondary market liquidity can be patchy.

However, for corporate investors that have the capacity both to assess and manage such assets and that are willing to live with the possibility of constrained liquidity, investment in ABCP can generate improved investment returns.

A further aspect of CP that is often overlooked is that most highly-rated corporates (ie non-banks) have active CP programmes, whether in the US or offshore. In the US, the domestic CP market is highly developed and is a mainstay of short-term money markets. In contrast, Europe is not so well placed. France and the UK both have relatively modest domestic CP markets and the concept of non-domestic, cross-border issuance (ie euro commercial paper or ECP) is well established.

It is generally felt that if the European domestic and ECP markets were better promoted and more widely supported, then liquidity would improve and enable CP to enjoy a status similar to that which it holds in the US. Direct investment in well-rated corporate CP by other corporates would avoid bank balance sheets (freeing up limits) and could offer a considerable improvement in investment returns.

Repurchase agreements

Investment in reverse repurchase agreements (repo) by institutional investors and large, sophisticated corporate treasuries has increased considerably since 2007, reflecting the confluence of two imperatives. First the need for less well-rated counterparties to utilise assets otherwise owned to finance their balance sheets and, second, the desire of investors to invest short-term liquidity in a low risk and highly liquid environment.

A repo is the sale and contractual repurchase of qualifying securities for cash with delivery and settlement though a CCP on a delivery versus payment (DVP) basis. Collateral provided is typically government securities or other assets subject to an agreed additional collateral margin (or ‘haircut’).

Repo maturities can be overnight or term and, depending upon the agreement reached, collateral may be substituted during the course of a transaction. The key feature is that underlying collateral is legally owned by the investor who would have a right of sale if the repurchase counterparty were to default. The risk is that the collateral haircut is insufficient to cover market risk at a time when the counterparty had defaulted on its obligation to repurchase the securities.

Operationally, repos can be administratively burdensome which is why investors are typically institutional market participants with an infrastructure to suit. Repo pricing tends to mirror the underlying cash market for the term of the repo with adjustment for collateral quality. Accordingly, for example, overnight sterling investment in repo collateralised with general collateral (ie government securities) would normally trade around 0.05% per annum below LIBOR.

Money market funds

Money market fund (MMF) returns have generally held up well since the crisis gripped the market. Although regulatory change is on the horizon and threatens to impact either or both of the structure and economics of the funds, the proposition remains compelling.

As we have observed previously, money funds are not bank deposits. They are asset management products where, subject to strict investment guidelines, fund providers will manage the proceeds of sales to investors of shares in the fund. This is actioned through the purchase of a narrow range of highly-rated (largely bank) money market obligations and offers same-day dealing and liquidity. The main risk faced by investors is that of a ‘run’ on a fund caused by too many investors seeking to redeem at the same time and not being able to liquidate assets, either in time or at book value.

Superior fund returns are made possible by the funds’ investment in term instruments longer than overnight but with a weighted average final (ie credit) maturity of no more than 120 days and a weighted average (ie interest rate) maturity of less than 60 days. Investors accept the liquidity and credit transformation inherent in the MMF structure in return for higher returns that they might otherwise earn from overnight or very short-term investment. Funds are awarded a AAA fund rating (as distinct from a pure debt or credit rating) by one or more of the rating agencies.

Once an account is established by an investor, the operation is similar to that of a bank call account with share subscriptions and redemptions effected directly with the fund provider, through contact with the fund administrator or by using a portal.

MMFs now operate under a tighter set of rules than that which prevailed prior to the collapse of the Reserve Primary Fund in 2008. Nevertheless, they are perceived as remaining exposed to a weak banking sector and regulators are concerned to avoid a repeat of the Reserve collapse (albeit that the final dividend to shareholders exceeds 99 cents on the dollar).

Exchange traded funds

Ultra short-term exchange traded funds (ETFs) are a relatively recent development designed to offer (mainly retail) investors an ability to establish intraday value on their fund holdings and to buy or sell fund shares at a price that fluctuates during market hours – just as with any listed stock price. This contrasts with mutual (ie MMF) valuation which is dependent upon closing values for underlying assets and upon whether the fund is structured as a constant or floating NAV fund. ETF share prices fluctuate around par with an expected divergence of no more than +/- 3%. In contrast, variable NAV MMF pricing and constant NAV shadow pricing has remained comfortably within +/- 0.25%.

Although the objective of money market ETFs was originally to track money market benchmarks, the outlook is for more active management through the use of some leverage, derivatives and repo within the funds. Equally, the ETFs are likely to accept marginally more curve, liquidity and credit risk in a bid for out-performance vis-à-vis MMFs. The largest money market ETF (which is US-based) currently has only $1.4 billion in assets under management – considerably smaller than any established US MMF.

Promoters of ETFs argue that their product extends the parameters of regular MMFs so as to unlock potential that is constrained by regulations and rating agency strictures but not so as to threaten those adopted by short duration bond funds or enhanced cash products. In fact, promoters of enhanced cash products would argue that their products (mortally wounded as they were in 2008) were filling exactly the same space as that occupied by money market ETFs currently.


The markets remain in a state of flux and corporate liquidity is high with fewer outlets and increasing pressure from shareholders to improve investment returns but without foregoing liquidity or taking risk. At the same time, regulatory pressure on banks has reduced appetite for short-term deposit funding and we are in a low interest rate environment with little prospect of change in the near term. Money markets funds are doing well but are, themselves, challenged by regulatory and economic pressures.

The task is to find additional yield yet avoiding adding risk. One strategy might be to cut out the middle man and undertake more investment directly in harder-to-deliver money market instruments such as CDs, CP and maybe ABCP. Another might be to restore or extend bank deposit maturities beyond the magic 90 days and to manage more closely the utilisation of (or to become more imaginative in the management of) available bank placement limits to unlock relationship benefits. New product developments will inevitably follow regulatory impositions although it is premature to come to conclusions.

In the interim, it may be wise to re-examine treasury policy and to ask whether the reaction to the banking crisis has been overdone or whether sufficient uncertainty remains to justify maintenance of a risk-averse posture. The answer is that it is probably a bit of both.

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