State Street Global Advisors released a white paper called "Strategic Cash: The Case for Short Duration Portfolios," which analyzes the cash investing landscape in light of the new money market reforms. It looks at how money market funds will be impacted and suggests a bucketing approach to cash investing in which short-term bond funds should be considered to capture additional return. (Note: Watch for more on ultra-short bond funds next week when we reprint from our latest Bond Fund Intelligence "profile." Note also that next week's Money Fund Symposium, June 24-26 in Minneapolis, will also feature a session on "MMF Alternatives: Ultra Short, Private, SMAs.")
The SSgA paper says, "Recent regulation in the US has changed the rules of MMFs.... After putting further restrictions on MMFs in 2010, the SEC recently announced plans to have Institutional Prime MMFs float their NAV's, much like any other mutual fund. These rules -- which will be implemented over the next two years -- may also impose fees and potentially redemption gates during times of stressed market liquidity. Regulators in Europe are also in the process of changing regulation on MMFs with an agreement on final regulations not expected until late 2015 at the earliest. It is anticipated that the European regulations will include a portion of the rules enacted in the US. These major changes for Institutional Prime MMFs will likely cause changes in how investors approach their cash strategy."
Further, they discuss the need for a bucketing strategy. "As part of this change institutional investors will likely review their overall cash holdings with a close eye on cash flows and the increased cost of maintaining a high level of liquidity. While investing in a MMF may provide better liquidity, it can also potentially sacrifice return. For many investors, cash returns could be enhanced by a "bucketing" whereby cash needs are segmented into daily operating, core, and strategic buckets. Decisions that investors need to make may include the following: 1. Stay in your existing fund and adjust to the new rules (Floating NAV, Fees and Gates). 2. Move to a Government or Treasury version of a MMF ($1NAV rules apply but likely at a much lower yield). 3. Move to a separately managed fund with guidelines that are consistent with 2a-7 rules. 4. Short Duration strategies. 5. Some combination of the above."
It adds, "The remainder of this paper will explain how SSGA seeks to add consistent excess returns in the strategic bucket by investing in high quality, short duration portfolios. We believe this strategy will be an important component of many corporations' cash efforts. Most investors realize that with increased risk comes the prospect of higher returns. We will explain why we think certain opportunities in the front end of the yield curve are often worth taking. When framing the outlook around this strategy, it may be useful to explain how it differs from those of a typical MMF."
On Liquidity, SSgA explains, "MMFs are built primarily to help with capital preservation, liquidity and lastly yield. Regulations from a European perspective require a full 10% in next day liquidity and 25% of fund assets within 7 days. This obviously impacts a fund's yield and return profile as more assets must be invested in shorter instruments at the expense of longer term, higher yielding instruments. Short-term bond strategies, however, typically allow for a lower degree of liquidity with the advantage of being able to invest in securities with longer maturities and/or durations. Investors in short-duration strategies may not need the level of liquidity that's required of MMFs thus minimizing cash drag on the portfolio with the majority of the assets invested in higher yielding securities."
On Weighted Average Maturity, the paper comments, "Money market funds face a maximum duration or Weighted Average Maturity (WAM) of 60 days. The maximum maturity allowed at the security level is 13 months. Our short duration funds look to take advantage of the additional yield that is often available in maturities in the 1–5 year range. Through the use of floating rate securities, our shortest Short Duration portfolios can take advantage of the yields offered on these longer maturity securities while limiting overall portfolio duration. Typically, our floating rate focused portfolio durations are maintained in a range of 0.25–1.0 years or 90–365 days. Coupons on our floating rate securities reset every 30–90 days to limit interest rate risk. While this strategy works across a range of interest rate environments, its benefits may be most apparent when interest rates are projected to rise."
On Weighted Average Life it states, "MMFs adhere to a maximum Weighted Average Life (WAL) of 120 days. WAL is also referred to as Spread Duration. This is a weighted measurement of every security to its final expected maturity, not its next coupon reset date. For example, a 2-year maturity bond whose coupon floats quarterly would have a duration at issue, of 0.25 years (rate risk until next reset) and a WAL of 2 years. This is an important measure of portfolio risk that should not be overlooked. It would be very easy to build a portfolio with a very low duration figure but a large WAL number by owning a portfolio full of 10 year maturity, 1 month floating rate securities. This fund would show a duration of only 0.08 years, but a WAL of close to 10 years. While insulated against a rate rise, this portfolio may suffer greatly from a move wider in credit spreads because of its longer WAL. For this reason, we closely monitor our funds' WAL figures. We typically maintain this measure in the 1–2 year range in order to manage against a move wider in credit spreads that may negatively impact portfolio pricing and therefore performance."
On Credit Quality SSgA says, "Securities held in MMFs are generally required to be of the highest quality and carry a minimum combination of short term ratings A1/P1/F1 (Moodys, S&P, Fitch). Our short duration funds are generally run with a minimum security rating requirement of Long Term A-/A3/A-. When explaining this difference, it's important to equate short term ratings with long term ratings. Typically, a short term credit rating of A-1/P-1 by Standard & Poor's and Moody's respectively, equate to long term ratings of A/A-2 or higher. SSGA's short duration funds are effectively going one rating notch lower than what is required of a MMF. Our short duration portfolios typically are constructed with average ratings in the A-AA range depending on the types of allowable assets. Therefore, at the portfolio level, there is little difference between the average quality of our short duration funds and prime money market funds.... In many cases, we may own bonds from the same issuer that we own in our prime MMFs. As an added potential benefit, our short duration funds typically will have greater sector diversification than a prime MMF, where banks make up the large majority of portfolio assets."
In conclusion, the paper says, "With regulators in the US and Europe making it more difficult for both issuers (tougher capital & liquidity rules) and investors (lack of short dated investments) in the traditional money market arena, we believe it is an opportune time for institutional cash investors to examine their cash needs and investments. By bucketing their cash into distinct segments -- daily operating, core and strategic -- they may identify more efficient ways to invest their cash. Specifically, investors of strategic cash may benefit from slightly longer duration investments within a Short Term Bond Fund strategy. Historically, investors often realize higher yields when maturity, duration and quality constraints are relaxed only slightly. We believe by focusing on a combination of short and longer term investments, whilst maintaining credit quality in securities such as high quality Corporate bonds and Asset Backed Securities, portfolio quality and liquidity can be maintained at a level that may potentially be more appropriate for strategic cash investors."
