Cash has come back, shoring up portfolios with liquidity that can be siphoned towards emerging investment opportunities or used to beat bonds by sitting safely in bank bills. SIMON MUMME looks at how some cash managers have either profited or been upended by widespread credit problems.
The global liquidity freeze has rattled even the traditionally stable cash vessels held within institutional investors’ portfolios. Simultaneously, the credit marketplace has become a venue in which sellers of liquidity rule. As some cash managers, and their clients, became more aggressive in their attempts to outperform the UBS Australian 90 day bank bill index, they blended larger amounts of longer-duration, fixed income assets among bank bills with shorter investment maturities. As a result, “what people call cash is really a spectrum of different styles,” Michael Korber, head of credit at Perpetual, says.
As sellers panicked about widening spreads and valuations deteriorated, these riskier debt components weakened enhanced cash, and aggressive cash funds.
The latest quarterly Mercer surveys found that in the three months ending with December 2007, the median cash return among Australian managers was 1.8 per cent against the index return of 1.7 per cent, while the median enhanced cash return was 1.4 and the median aggressive cash return was 0.7 per cent.
The outperformance of cash over credit should continue for the foreseeable future, Korber says. This is due to two factors: high underlying interest rates set by the Reserve Bank of Australia (RBA), and widening credit spreads driven by the credit crunch. Boutique fixed income manager Kapstream has parked up to one third of its capital into “cold cash,” Nick Maroutsos, Kapstream director, says. “The RBA is paying you to stay on the sidelines.”
He says the boutique, whose clients include AustralianSuper and the Catholic Superannuation and Retirement Fund, has roughly split the remainder of its capital between short-dated floating rate securities and short-dated corporate bonds. “We’re trying to get the cash rate plus a little bit more.” Korber says that the structure of the credit market has changed significantly.
Leveraged buyers of credit, such as structured investment vehicles (SIVs), which continuously issued short-term paper to finance their investments in longer term, less liquid, asset-backed securities, have either folded or become forced sellers of the rapidly depreciating assets they bought. Reliant on plenty of liquidity, their operations seized up when the credit crunch deepened. “They needed you to invest in them to roll their paper,” Subash Pillai, GSJBW Asset Management head of cash and fixed interest, says. The sellers of credit, who were pressured to offer loans on terms that greatly benefited buyers, became more powerful. Pillai says this shift in power was great. “For the last few years asset-backed paper issuers ran the market. This has reversed hugely. Now, I can say, I want asset-backed paper with maturity on this day, and at this price.”
As a result of this “liquidity event that turned into a pricing event,” the supply-demand relationship in credit markets has permanently changed for the foreseeable future, Korber says. “There was a leveraged group of buyers who will not reappear, as they have turned into a distressed-selling group. Markets will take time to adjust to this.”
He says that once the market has absorbed some of the credit ‘overhang’ created by forced sellers, spreads will contract, but not to the narrowness of those before the crunch. “Once these issues have cleared the price of credit will shift and spreads will remain wider. I wouldn’t be surprised if they stayed significantly wider.”
This does not bode well for managers of blended cash and credit funds. The Perpetual credit income fund, an aggressive cash fund which holds more fixed income than cash securities, according to Korber, returned -1.6 per cent for the fourth quarter of 2007. “Now most funds are seeking to have higher cash levels than 12 months ago, when spreads were tighter and you could earn a higher rate of return through credit holdings.” These credit securities are usually domestic residential mortgage-backed securities with an average duration between two and three years, and are in part responsible for the poor performance of cash enhanced funds and the swing in investor favour towards safer bank bills.
BNY Mellon Asset Management has responded to this, and is setting up an Australian dollar “pure” cash fund, with Standish Mellon as the underlying manager. Jonathan Little, chairman of the US$1.1 trillion manager, says this is due to the popularity of cold cash funds in 2007 and the strong performance of cash in the credit downturn. “You’ve had those instances where supposed short-term cash funds have drifted away from their initial benchmarks, added too much risk and been caught out by the credit crunch. So we’re seeing a lot of demand for pure, well-managed cash funds,” Little says. He says that a manager with BNY Mellon, Dreyfus Corporation, received inflows totalling US$75 billion into its flagship cash fund throughout 2007. It holds short-term deposits and corporate debt, of maturities between 30 and 60 days.
The GoldmanSachs JBWere (GSJBW) Cash Fund, ranked equal first among the cold cash funds in the December 2007 Mercer Surveys, is a cash management trust (CMT), comprised mainly of bank bill deposits and built similar to US money market funds. Money market funds are highly liquid, investing in AAA-rated cash securities, Pillai says. Unlike these vehicles, “cash-plus” funds can have between 50 and 70 per cent of their portfolios in floating rate notes, he says. Consequently, they are not so well-placed in the current market. “As a cash manager, you’re a provider of liquidity. And the value of this has skyrocketed,” Pillai says. “You can take advantage of this and time investments for when you think liquidity premiums will be at their highest.”
Pillai says that investors usually need liquidity at month’s end, year’s end and on bank balancing dates. “You target the maturity periods for when liquidity pressure will be its highest.” The liquidity premium now earns cash managers up to 30 basis points, far above its old yield of between five and 10 bps, he says. Most banks have now switched from issuing medium term debt from up to three years in advance to one year. “It’s gone crazy in the last six months because banks have moved their medium-term funding into one year. They consider the two or three year margin to be excessive. They’re bringing their issuance short. They’re taking the pain for one year and hoping that it gets better.”
Institutional investors use their allocations to cash either as a source of liquidity for when investment opportunities arise, or as an alternative to fixed income when that asset class performs poorly, Ken Marshman, managing director of investment consultancy JANA, says.
While some institutions have opted for cold cash managers, he says that some cash enhanced offerings are attractive. JANA likes some of the enhanced cash products that hold A and AA-rated corporate debt, such as syndicated loans and traded high-yield securities. Perpetual’s Korber says the manager now favours more liquid, short-dated securities. This paper is also less volatile due to its shorter maturity date, which reduces investor’s exposure to any prolonged periods of volatility that might occur within the life of the investment. This approach makes the fund more “transactional”, he says.
A peculiar risk involved in running a CMT is managing the client base, in addition to their money. BNY Mellon’s Little says careful selection of clients is equally as important as managing the bank bills. “You want a well-diversified group of investors and you’ve got to be careful which mandates you take,” he says. “We’ve had calls before, like ‘We want to give you $12 billion to manage for four days’. It sounds great, you make four days worth of fees from it, but usually we don’t want it. You’ve got to go really short [duration] on it and it wrecks the yield for the other clients. “It’s the same if you’ve got a cash fund with a couple of investors dominating the book: you have to be short because every investor has to be able to get their money out the next day.”
So a balanced mix of clients, who need liquidity at different times, is what CMT managers should aim to keep, according to Little. “So you’d mix corporates, for example, who tend to need cash at the end of the quarter to pay dividends, with credit card issuers who go through a 38 day cycle of collecting payments and then drawing down to pay their bondholders.”
However the major risks faced by cash managers are default risk and liquidity risk. Term risk, which describes the probability that a credit spread will widen during the life of a security, is a contributor to these two. While there is much liquidity risk in the domestic market at the moment, term risk has also rattled managers as spreads on some AAA-rated residential mortgage-backed securities have widened from below 20 to well over 100 basis points, Korber says.