MONEY MARKET RESOURCES: Drivers of Today's Corporate Investment Strategy

This article also appears in AFP's Money Market Resources www.afponline.org/moneyfunds

In the arena of corporate investment management, two things are clear: The low yield environment is hurting corporate portfolios, and everyone believes rates are destined to rise. While there is considerable debate over when rates will rise, the erosion of return is inarguable. This is shaping the way corporate investors manage their cash.

At the height of the financial crisis, corporates and other investors pulled money out of corporate bonds, mortgage-backed securities (MBS), asset-backed securities (ABS) and commercial paper (CP) and poured it into money market funds (MMFs). The flight to safety and liquidity drove MMF assets to a historic high of $3.92 trillion in the middle of January 2009.

Since then, the trend has reversed. Total MMF assets declined 16 percent by mid-January 2010 to $3.29 trillion and an additional 3 percent for a total of $3.17 trillion by mid-February 2010, according to ICI Historical Total Net Assets on Money Market Funds as reported to the Federal Reserve.
With MMFs yielding meager returns of 1 to 12 basis points (t is no wonder corporate treasurers are looking for alternatives. And things are not going to get any easier. SEC regulations (and similar, albeit less stringent, rules abroad) threaten to shave even more yield off 2a-7 funds by requiring funds to have up to 10 percent in overnight liquidity and 30 percent for weekly liquidity. "Having one-third of assets invested so short will clearly affect returns," says Matt Clay, head of Commingled Fund Solutions at Clearwater Analytics, a Web-based investment performance and analytics firm based in Boise, ID. "Fund managers will have to find lower-yielding, safer assets," he says.

Some fund managers' studies have shown that the regulations will "cost" eventually between 10 and 25 bps, according to Clay. In effect, says the director of treasury at one U.S. multinational, "Money market funds are already largely positioned for the new SEC requirements." The modified liquidity requirements restrict how much money can be invested in Tier 2 investments, which diminishes the attractiveness of funds even further.
Ironically, according to Clay, the SEC's new liquidity requirements have the potential to force billions of dollars in fund assets into a smaller set of issuers and asset classes, increasing the potential systemic risk. That is certainly not what the SEC had in mind.

Not that MMFs are going away. "There's a subset of cash investors who for a variety of reasons are comfortable with MMFs," Clay notes. "What you will see is further consolidation in the fund industry where, already the top five money managers control 55 percent of the assets and the top 20 control 93 percent of the assets. All this only adds to the argument of greater concentration of risk."

Certainly, some fund outflow is to be expected as a result of cyclical trends and the decline in interest rates, says Kevin Bannerton, managing director and head of institutional liquidity management, Americas for DB Advisors, the institutional asset management arm of Deutsche Bank. However, that rate has historically been around 10 percent. This time around, funds lost almost double that, approximately 20 percent since January 2009.

Diversification and transparency

Where did all the money go?
Some of it moved into equities. Much of it moved into bond funds. For corporate treasuries, two trends have taken hold, according to participants in AFP's recent roundtables. First, more companies are moving their assets into separately managed accounts. Second, more are investing directly in asset classes such as treasuries and agencies. The search for yield is only half the story, however. Another major factor in the shift in investment strategy is the desire for greater transparency.

"Post crisis, companies are reassessing and conducting a strategic review of their investment process and policies to be in line with their risk tolerance," according to DB Advisors' Bannerton. "Before deciding on a particular product and strategy, it's important to first review it to ensure it meets the new organizational objectives." Those objectives need to feed into the definition of success. It also matters how cash is "bucketed." Short-term liquidity may remain in MMFs, but strategic cash may be invested in higher-yielding or longer duration alternatives. "Before they make their move, each company is making these internal assessments, which means it will take time for these trends to emerge," says Bannerton.

For many companies, this has been a two-step process. First, corporate boards reacted with fear as the market tanked, ordering their treasury groups to pull back on asset classes and duration (hence the historic highs in the money market fund industry, particularly with treasury and government MMFs). With the dust settling, companies are taking another, and more methodical look at their longer-term investment policies looking for a more consistent approach.

"We are not paid to chase yield," says the treasurer of a biotech firm. "Our board has specifically told us that." His company maintains a balanced portfolio that includes longer duration assets of 1 to 3 years, some MBS, and some corporate bonds but no financials. "For those who moved everything into treasuries and agencies," this treasurer, who prefers not to be named, cautions, "I would argue that their portfolios are at greater risk than a more diversified and 'safe' portfolio, which should do well in a downturn." In fact, his portfolio fared well during the stressful months. "We had no credit losses," he says.

After the company's policy changed to allow for a maximum maturity of three-down from five-years, this corporate treasury executive remains cautious. "We are not to the point where we have changed our perception of what's going on in the market, or feel that it is safe to go into the areas that were hard hit or are still suffering," he says. For example, the company pulled out of asset-backed securities in early 2008 and has yet to return, even though auto and credit card-backed deals have performed well of late. "We don't want to jump in when things remain tenuous. We know we underachieve," this treasurer says. "But that's a conscious decision."

Several other treasury professionals interviewed for this article reiterated their aversion to the financial sector. "Even though banks and ABS performed well over the past year, we're still cautious," says one corporate practitioner. Those Lehman losses still hurt.

A clearer view, individual attention

Another outcome of the policy reviews is an emphasis on knowing precisely what is in the investment portfolio. Says one corporate practitioner: "From the investment guidelines perspective, we have become more explicit about our credit and counterparty exposures," he explains. "Before, we were rating-agency oriented. We got hurt more on the AAA-rated than BBB-rated paper." Going forward, this company and others plan to stop their exclusive reliance on rating agencies, instead setting credit limits and looking at exposures across all products and activities.

In truth, companies are in a bind. On one hand, yields are nearly non-existent. On the other, they are tightening credit limits and demanding greater transparency into underlying securities. As a result, and lacking internal credit analytics resources, many are shifting their money out of commingled funds (MMFs, prime funds) and into separately managed accounts, i.e., accounts managed by professional investment managers.

The search for yield, however, is only one component of the shift to managed accounts. Equally if not more important is another tectonic shift in corporate treasury investors' perception of risk, driven by losses on money market funds that invested in a subset of asset-backed CP, specifically, some independent SIVs, and Lehman paper. "In the wake of the financial market crisis, there's a greater emphasis on transparency and control," Bannerton explains. With MMFs, there is limited visibility. With managed accounts, companies can see through to each individual underlying asset. That is a source of comfort to treasurers and boards alike.

Indeed, the move out of MMFs into managed accounts and direct investments is the outcome of greater risk aversion and tighter investment policies "Historically, there has been limited information about assets in MMFs," Bannerton says. While it is true that the industry has suffered from a sense of opacity, there are pockets of visibility. New SEC disclosure requirements will aid this process.

DB Advisors launched its own transparency initiative in August 2008. It now provides MMF clients with a deeper view into their fund investments, including the true maturity of the underlying assets, their duration, credit maturities, how much is fixed vs. floating, who are the counterparties behind asset back CP, and more. Not coincidently, DB Advisors has enjoyed significant growth in their prime funds because transparency is provided, making corporate treasury investors more comfortable with moving out of 2a-7 funds because of the clear view into the underlying holdings.

"I've heard from every treasurer I've talked to recently who utilizes money market funds that he or she wants detailed disclosure of the underlying securities in a standardized fashion," Clearwater's Clay says. The fund companies move slowly and are averse to change, however. "The money fund industry has not been as responsive to investor needs and requirements as they could be," Clay says. "They want to do the right thing and are moving in that direction," he adds, "but just not quickly enough."

Therefore, companies are taking their own steps. "What we're seeing across the board is a move into separately managed accounts," confirms Courty Gates, CEO of Clearwater Analytics. Bannerton says he has witnessed a similar trend, and not just in the U.S. "For the first time managed accounts are also gaining momentum in Europe," he says.

Yield is certainly part of the story. "The returns in money funds are abysmal," admits the director of treasury at one multinational. "While a year ago we had all of our money in MMFs, now we have nearly no money in MMFs. We moved our cash into separately managed accounts."

Visibility is also important. "We have gotten more granular with regard to the sectors in which we invest in the big corporate 'bucket,'" says one treasurer. "We made sure not to be over weighted in financials, insurance companies or utilities. We go down into details." This company has all of its funds managed by external managers, thus having direct view into each underlying security.

As well, treasurers report growing interest in direct investment instead of indirect-for example, through government bond funds. In addition to transparency, there is clearly some additional yield by buying the securities outright. Three-month treasuries at 12 bps are the equivalent of the high end of MMFs. Six-month treasuries (as of March 1) yielded 18 bps and 12-month rates were at 20 bps.

Other direct investments, according to Clay, are bank deposits, insured CDs and CDARS (essentially a service for getting insured CDs above the $250,000 FDIC level by spreading out multi-million-dollar deposits with many financial institutions). The same holds for repos and the use of securities lending-all strategies that offer a yield pickup vis-à-vis commingled funds, but are highly rated and considered very safe.
Regardless of how they access the market (directly or through managers), corporate treasury executives are very conservative when it comes to both duration and asset classes. Principal protection remains paramount.

Even with external managers, "there's still a bias toward short term strategies," reports Bannerton, for both liquidity reasons as well as a hedge against the potential of rising interest rates. Corporate treasury executives agree. "Most of our managers are staying within one year," says one corporate practitioner. "When rates eventually rise, the curve may see a violent move." It is simple, he says: "When rates rise, bonds get killed."

Asset allocations also tend to be very company-specific, driven by the level of confidence the treasury department has for the company's upcoming cash needs in the short and long term. Bannerton says he has seen some companies putting more money at longer duration points in the one- to three-year area. Also, there is growing interest in munis, repos and securities that do not qualify for money market funds under the new SEC requirements, or which are not practical to own, such as A2P2-rated corporates. Corporate investors also report growing interest in high quality corporate bonds. "Strategic cash investments are becoming more diversified," Bannerton says.

International convergence

Many U.S. companies are accumulating much of their excess cash overseas, so it is important to look at how that money is being handled. Managed accounts are gaining popularity, not just among U.S. multinationals but also with European investors who historically gone with bank deposits and fund structures. "Currently, customized separate accounts are becoming more popular with European investors," Bannerton says.

As is the case in the U.S., companies also are investing directly in European sovereign debt in addition to investments via bond funds. Of course, the current investment climate in Europe is increasingly difficult. "We expect increased sovereign and credit risks," Bannerton says. "Investors, including money market funds, will be more cautious while investing in European sovereign/supranational securities and may in some cases limit or restrict their allocations to this sector." For Bannerton, the situation in Europe underscores the need for greater visibility. "It highlights the importance of maintaining and independent credit research effort to monitor risk throughout the credit cycle," he says.

Reflecting both their need for diversification and the growth in non-U.S.-dollar cash, U.S. corporate investors also are looking at local-currency investments.

A new landscape

The landscape for corporate investment management has changed irrevocably. There is a growing emphasis on visibility and control at the same time companies are looking for some diversification away from low-yielding MMFs. The result is a shift into direct investment and separately managed accounts. In both cases, investors have much clearer views into each underlying security and, in the case of managed accounts, the added security of independent research capability. While the flight to safety and liquidity is far from over, more companies are reviewing their investment policies and finding ways to eke out additional yield while remaining focused on principal protection.

For many corporate investors, the big question is what will happen with rates in months to come. While the futures market anticipates a rate hike in the second half of 2010, not everyone is buying into the notion of rising rates. At a recent series of roundtables hosted by the AFP in the U.S. and in Canada, an informal survey of over 30 corporate treasury executives revealed plenty of skepticism about a rate hike this year. Many were seriously concerned about the possibility of a double dip recession and the chance that rates will hover near zero well into 2011.

"We see no rate hike in the near term," says Beau Damon, managing director responsible for portfolio investments, foreign exchange and capital markets at Microsoft, although, he adds, "we are moderately positive on economic recovery."

"There's a lot of downside for the Fed in raising rates too soon," says one assistant treasurer, "and there's not much downside in keeping rates close to zero longer, in particular with inflation remaining low." The consensus was that rates would remain at current levels well into 2011. The upshot: Investment management will remain a challenge, driving a continued trend toward direct investment and managed accounts.

SIDEBAR: AFP Responds to New SEC Money Market Fund Rules

See AFP Money Market Resources: www.afponline.org/moneyfunds