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The trm Report - May 2007 The sharp fall in equity values in 2000 and 2001, an inverted yield curve and soaring profits at corporations have served to increase sharply cash holdings by both investors and corporations. Banks, unwilling to accept a liability driven expansion of their balance sheet, and recent regulatory changes, encouraged the growth of money market funds. Demand for money market funds has been extremely strong because of their convenience, even though the returns were less than Libid (London Inter Bank Bid Rate). Investors, however, sought higher return money market funds which the industry is now duly providing. The opportunity to increase the efficiency of cash management is to be welcomed. However, the development of new types of money market funds is changing the risk characteristics of cash. The benign economic and financial climate has masked the risk of some of the new ’cash’ products.
Not so long ago corporate treasurers and asset managers would lend cash to the bank giving scant regard to the rate of interest they received. The lender’s main concern was that that they would get the money back when they needed it. The more active treasurer might phone more than one bank to check the deposit rates offered. The business of managing cash balances gradually became more sophisticated as treasury departments became seen as profit centres rather than cost centres. In order to take advantage of a positively sloped yield curve some treasurers placed Corporate treasurers had considerable experience of using the financial markets creatively by inventing financial instruments and selling them directly to investors. The disintermediation of the banking system, by the issuance of different types of short and long-dated corporate bonds, not only allowed companies to develop a tailor-made borrowing programme, often cheaper than bank borrowing, but also created products that would help their cash management. The development of short-dated financial instruments, such as commercial bills, corporate floating-rate notes and certificates of deposits exposed the low rates offered by the banks. However, managing a broad range of financial instruments required an enhancement of the corporate treasurer’s cash management skills. Money market funds grew despite yielding less than Libid The majority of money market funds have AAA ratings from the agencies and offer daily liquidity. Unfortunately, by offering Three factors that determine risk profile of money market fund In order to maximise the return from cash the investor needs to decide when the cash is required. The longer the cash is not required the greater the flexibility the term of the investment and the more possibility the cash manager has to increase yield. The investor also needs to decide how much credit risk they can take. Generally the yield pick-up by investing in commercial paper with the lower credit rating of A2/P2 rather than The wide range of money market funds now on offer to the investor permit the blending of different types of money market funds to suit more precisely the investor’s requirement. For example a corporate treasurer might be able to divide the cash balance into different liquidity periods and then select the appropriate funds. This same can be applied to both credit and risk. UCITS money market funds A common term used for money market funds are UCITS funds. In fact UCITS are a special case of money market funds. The term UCITS comes from EU legislation called the Undertaking for Collective Investments in Transferable Financial Securities. The legislation was designed to harmonise EU financial market legislation and to permit cross-border marketing within the EU region. In order to be awarded the status of UCITS the fund and the fund manager needs to be registered in the EU. The advantage of a UCITS lies with the manager of the fund. For the investor it is a question of preference as to whether they wish to restrict themselves to a UCITS fund or whether they would rather have a wider universe of funds to choose from. European regulatory changes spur growth The most important factor for the growth of money market funds has been investor demand. However, a number of recent European regulatory changes are causing the banks to actively promote money market funds and this will result in an acceleration in the growth of money market funds. The most important of these changes is the EU’s Basel II Capital Requirements Directive. Effective 1st January 2007, the risk weighting the banks have to attach to money market funds has been reduced to the same as bank deposits. Previously money market funds had to be treated in the same way as equity funds which were considered to be of much higher risk. This provides a powerful incentive to the banks to promote money market funds. Other regulatory changes are also occurring which is likely to increase the demand for money market funds from deposit-taking institutions and financial intermediaries who hold money on behalf of their clients. Changing nature of cash The evolution of cash management from strictly overnight bank deposits to ’plain vanilla’ money market funds is complete and now the industry is fast forwarding to a multitude of variations of money market funds that will provide investors with a large array of choices. This is a good development, but the broadening of the meaning of cash from overnight deposits to funds with long duration and the inclusion of derivative products means that the risk of the asset is increasing and The ability of a more sophisticated money market fund (generally called an enhanced money market fund) to deliver above libor returns depends on the shape of the yield curve, credit spreads and the ability of the investment manager to read correctly the future trend of interest rates. There is no guarantee that a money market fund will deliver a yield above Libor. The growth of money market funds over the past three years has been during a benign economic environment. The yield curve has been positively sloped at the very short end allowing for easy pickings for money market funds that can extend beyond one month maturities. Credit spreads have been very narrow and stable suggesting that credit selection has been of little value. This is unlikely to hold as credit risk will become more expensive in the next economic down turn and the yield curve starts to invert closer to cash as the prospect for interest rate cuts increase. The popularity of money market funds will continue to grow, partly because investor cash holdings are likely to increase over the next year. The rapid rise in the equity market makes a correction likely and the inverted nature of the yield curve makes bonds unattractive relative to cash. Against this background cash rate returns of above 5% are very attractive. However, as the economic climate becomes harsher the skills of the cash manager of the money market fund will become more prominent and a much needed weeding out of the cash management industry will begin. Regulatory information and risk warnings Oliver Boyle
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