With negative rates in Europe and a possible rate rise in sterling on the horizon, corporate investors may have some tough decisions to make in the coming months. In this interview, Jim Fuell, Head of Global Liquidity, EMEA at J.P. Morgan Asset Management tells us how corporate investors are adjusting their strategies to fit these new investment realities and why, in any type of investment environment, it always pays to work on cash segmentation.

Biography

Jim Fuell, Managing Director, is the Head of Global Liquidity for Europe, Middle East and Africa (EMEA) overseeing sales and marketing for the liquidity business. An employee since 2006, he previously worked to develop the corporate business as part of the Global Liquidity team in London and has also worked for Deutsche Bank, Bank of Tokyo-Mitsubishi and Citibank. He holds an MBA in Finance and International Business from New York University, Stern School of Business, and a BS in Business Administration, Marketing & Finance from Marquette University. He is a board director of the Institutional Money Market Funds Association (IMMFA).

How have your corporate clients been adjusting their short-term investment strategies in response to the negative rate environment in Europe? Have you noticed any disparity amongst your investment base in terms of the response?

We have seen a mixture of responses to the negative rate environment. There are those clients that need to act prudently, perhaps because they are managing pools of cash of quite significant size. These corporate investors have a good understanding of the risk-return trade-off, and appreciate the fact that negative rates are a reality of current central bank policy and cannot easily be avoided. There are other investors who, for structural or policy reasons, are unable to accept negative rates and have found that they must take on a significant amount of incremental risk in order to avoid them.

Both groups are exploring alternatives, and it is vital, before investing, that they ensure they fully understand each of the instruments that exist in the short-term investment arena that can generate some incremental return. Those investors seeking to avoid negative rates entirely need to be cautious to ensure they understand the level of additional risk they are taking to maintain that positive return.

Negative yield has proved a difficult concept for most investors – corporates included – to get their heads around. I would say though that, if there has been one benefit, it is that it has at least encouraged treasurers to reassess what their investment options are and better understand the risk-return of these products so that they can be utilised in what is a very challenging investment environment.

What, in your view, is the best strategy for corporate investors at the moment to mitigate the impact of negative rates?

Unfortunately there is no universally optimal strategy; the best strategy will be different for each investor. But I would say that, irrespective of the current yield environment in Europe, the corporate treasurer should always be looking to improve cash flow forecasting, and working to segment underlying operating cash pools, to the extent that they can, and identifying what, if any, portion of their cash can be invested beyond an overnight position and potentially be put to better use. So before they use levers – and there are a limited number of levers – and before they take incremental interest rate risk, credit risk or liquidity risk, it is important for them to understand the nature of the cash pools that they are investing. Segmentation is becoming increasingly important, not just because of negative yields, but for broader reasons as well. It has always been a tool that allows the treasurer to more effectively manage their operational cash.

With an increase in UK interest rates now looking imminent, what cash investment strategy/products best fits a rising rate environment for investors in sterling?

In any market environment, rising interest rates will have negative repercussions for existing holdings in most traditional fixed-income investments. But because rates have been low for so long in the UK, when the current market cycle does turn, it will present a particular challenge.

When the Bank of England (BoE) does decide to act to raise rates – which incidentally it is committed to do before unwinding its asset purchasing programme – treasurers may need to reconsider their investment strategies. The key elements of investing in a rising interest rate environment treasurers will want to consider are factors like duration, income and credit risk exposure. These are the key elements treasurers will need to contemplate. For investors with shorter investment horizons, like corporate cash managers, mitigating potential volatility during the anticipated rising rate environment will be a key priority. To prepare, investors would be advised to develop a thorough understanding of past market behaviour. Their strategic decision-making process should also be guided by a robust scenario analysis of the future possible directions of interest rates, credit spreads and the yield curve. Finally, it is essential that the evaluation of various investment strategies be informed by the investor’s short-term cash needs and risk tolerance. Once again, therefore, working to improve cash flow forecasting will be of critical importance.

There are various products corporate investors could potentially use and some of these products have been around for a long period of time. They could, for instance, look at laddering out overnight deposits, or they could make use of term deposits. These tend not to be marked-to-market so there is no unrealised losses for these types of instruments. Money market portfolios could also be useful; they have the benefit of full overnight liquidity but managed to a duration that steps out the curve beyond overnight. To the extent that you get the ability to segment your cash and invest it in products where you don’t need overnight liquidity, we have our Managed Reserves Fund, which actively manages the corporate’s cash investments, and invests in the types of securities that may be more beneficial in a period of rising rates.

How are investment product sets in the asset management space developing in order to help treasurers address the yield challenges currently being faced?

Some of the products being reviewed by investors are not necessarily new, but are products corporates may not have considered in the past, such as short-duration bond funds. With the onset of negative yields, treasurers are increasingly interested in gaining a better understanding the risks and features associated with them. The ability to invest in short-duration funds again demonstrates the benefits of segmenting ones cash. These are funds whose durations may be between one and three years and, as a result, the returns on those funds are typically going to outperform products like money market funds (MMFs). They are typically benchmarked against longer indices, but due to the longer duration the investor must be cognisant of unrealised losses, when rates do begin to rise again.

Segmentation is becoming increasingly important, not just because of negative yields, but for broader reasons as well. It has always been a tool that allows the treasurer to more effectively manage their operational cash.

The changes we have seen in the supply of assets as a result of regulatory changes in the banking space is also having an impact on how we develop investment product sets. Asset managers are looking at how new types of supply might be leveraged in a product that would be attractive to investors like corporates. For instance, the banks are seeking to extend maturities on some of their issuances as a result of regulatory changes. And some of the types of new products we will see coming to market going forward may look to take advantage of that longer-term issuance by banks, but still within a short-term fixed income investment environment.

There has been an increase in interest segregated mandates too. These might be a good fit for some, but not all, corporate investors. They tend to be used by companies with larger pools of cash to invest, and the structures that are put in place are done so with the expectation of the cash being around for an extended period of time. I would not be recommending, for instance, that a separate account be put in place for an investment pool that the investor only expects to have for a period of three months.

Ultimately, corporates can invest in a multitude of products that will potentially give them a level of additional return, but there is a need to understand the volatility within the investment period that exists for each individual product. Treasurers in general seek to avoid substantial levels of volatility – so the type of product we have in mind when we think of corporate investor audiences is one that generates a degree of incremental return for a level of incremental risk, but also managing volatility so that it is minimised.

Speaking of regulatory drivers, how else have recent regulatory changes in the banking sector – Basel III for example – been impacting short-term credit markets?

Firstly, it is important to note that full implementation of Basel III is not yet there. While we are certainly seeing some banks that are taking a quicker, more proactive approach to the implementation, the Liquidity Coverage Ratio (LCR), for instance, only has a deadline of 2016 for 65% adherence.

What I think it is quite evident already though is that the appetite of banks for corporate balances has changed as a result of the regulatory developments we’ve seen in recent years. They are now more discriminating about the type of liability balances that they want, and this is translating into reduced returns on investment alternatives, or increasingly no offering at all.

Subsequently, we have, at an industry level, seen a growth in the use of MMFs as a result of the implementation of Basel III. The changes are ongoing, however, and as the regulation continues to be implemented banks are going to discriminate on the type of balances that they want and, as they do that, MMFs may certainly be one of the main beneficiaries.

In the liquidity fund space, as banks have to adhere to the LCR and the Net Stable Funding Ratio from a Basel III perspective, they are being encouraged to term out some of their short-term issuance and be a lot less reliant on wholesale short-dated funding as a source of finance. That means the supply of short-dated issuance may be reducing over time and, for short-term investors that is likely to translate into further pressure on yield in the short-end. Again, this ties back to the need to segment your pools of cash and to understand whether you truly need overnight liquidity on a portion of it. Of course, there are products designed for that purpose, but using them is going to come at an increasing cost as the returns are going to be diminishing.

What is your take on the progress made in MMF industry regulation in Europe over the past year? How will the regulatory shake up in Europe shape JPM’s short-term investment product range going forward?

I would say that there is still quite a long way to go. At this stage, we know the positions of the European Commission (EC) and the European Parliament (EP). Now we are awaiting the Council of Ministers (CoM) to provide their own draft, after which it will be brought together into one final set of rules, with an implementation period thereafter. But until that happens there is no finality over regulatory reform for the European MMF industry, and many points are uncertain. For example, in its proposal the EC sought to preclude funds from seeking an external credit rating, but that didn’t find its way into the EP’s proposal. Again, the EC included the imposition of a capital buffer in its proposal, and that was not supported by the EP either.

Negative yield has proved a difficult concept for most investors – corporates included – to get their heads around.

The devil will be in the detail and, until those details are clear, I think it would be premature to think about how the regulation might impact product development. The details of the regulation will inevitably determine the nature of the types of products offered by asset managers, and it will be incumbent upon money fund managers to work to ensure that the key attributes appreciated by treasurers are maintained to the extent possible, and that any required transition is managed as smoothly as possible.

Of course, what will be introduced in Europe is not going to be a replication of what we saw in the US but, by point of comparison, the Securities and Exchange Commission (SEC) put forward a two-year implementation period for the regulation it agreed last year. So there is certainly still quite a bit of time between now and when the regulation comes into effect and, until then, everything is effectively still moving. This is not to say that corporate treasurers cannot take steps now to begin preparing. For example, they should, as I have mentioned, continue to seek to ensure their cash flow projections are as robust as possible; this will enable them to assess any new products opportunities or structures as they arise, and hold them in good stead as the next generation of opportunities in the money market sector presents itself.