UBS Asset Management writes in a new "Liquidity Perspectives" about "Increasing liquidity: A framework for managing risk in volatile times." The piece says, "The global economy has experienced anemic growth in the aftermath of the financial crisis, which has been partially sustained by an unprecedented level of monetary policy action.... `From a corporate treasurer's perspective, this environment warrants caution and places a premium on maintaining a healthy level of liquidity, not only as a defensive buffer to protect against the unknown, but also to capitalize on opportunities."
It explains, "Preserving capital on a real and unadjusted basis is extremely challenging, especially given the "lower-for-longer" rate environment and the need to maintain a strategic liquidity buffer. Nevertheless, we believe developing a disciplined approach to segmenting cash into different layers and deploying it across various risk-and-return parameters is key and may provide some of the following benefits: Cost efficiency: having clearly visible and accessible stores of cash reduces the need to tap into credit lines and can help ensure business continuity at a significantly lower cost; Diversification: identifying levels of cash with different maturity profiles allows treasurers to use a variety of investment vehicles and counterparties, effectively reducing concentration risk; and, Enhanced risk-adjusted returns: categories of cash that are deemed "reserve" or "strategic" allow treasurers to utilize investment options that could potentially provide better inflation-adjusted returns."
UBS continues, "A diversified cash management strategy is critical to maintaining liquidity while preserving and growing capital on an inflation-adjusted basis. Investing cash in a diverse range of vehicles may require venturing into new territory further out the yield curve and down the credit spectrum. But this requires an understanding of key risk and volatility metrics such as liquidity, credit quality and duration."
They tell us, "Liquidity risk is the risk that a counterparty may be unable to meet a redemption call due to its inability to immediately convert a security or hard asset into cash. The liquidity related to each investment vehicle is usually agreed upon in advance. For example, bank deposits and 2a-7 money market funds typically provide daily liquidity, while short-duration bond funds and separate accounts may settle within a few days.... When investing in individual securities, treasurers should also consider the financial health of the custodian and have a clear understanding about their right to access securities if a counterparty fails."
UBS writes, "Credit risk is the risk that a counterparty may default in part or in whole on its principal obligation. Reference to credit rating agencies is useful when looking at diversified investment vehicles such as money market funds or short-duration bond funds.... Duration risk is the risk that measures the sensitivity of a bond's price to changes in interest rates. The vast majority of cash management vehicles, including bank deposits, are typically linked to fixed income securities sensitive to duration risk.... [D]uration risk becomes an especially important concept should central bank policy become more volatile, or move more quickly."
They discuss the risk/return tradeoffs for various cash vehicles, saying, "Money Market Funds ... are the most diversified and most liquid cash investment available to treasurers. Given their exposure to underlying US Government securities and related repurchase agreements, government funds score the highest in terms of credit quality. Furthermore, they are not subject to potential gates and fees provisions that apply to prime funds. Prime funds continue to be a high-credit quality vehicle for cash, providing daily liquidity under normal circumstances while potentially enhancing returns. Some of the key questions treasurers should consider when regarding prime funds include: 1. Is the liquidity risk associated with potential gates and fees well compensated? 2. Is it worthwhile to consider other options such as Short Duration Funds or Separate Accounts to mitigate the liquidity risk associated with prime funds?"
On Bank Deposits, UBS comments, "Similar to money market funds, overnight bank deposits usually provide immediate access to liquidity. However, placing cash with a single institution brings no diversification benefit and entails more risk especially when considering that banks, too, could gate deposits through suspension of convertibility. Additionally, new regulations aimed at eliminating banks' reliance on implicit government support in times of crisis must be considered."
They add, "Given the recent shift in money market assets from bank paper to government instruments, the Libor curve has experienced a significant upward shift, making investing in instruments such as commercial paper and floating rate notes very attractive on an absolute return basis. When investing in single issuers, it is important to consider incorporating it as part of a broader and well-diversified investment strategy so that the added risk aligns with the risk profile of the overall cash portfolio."
Finally, the paper discusses Short-Duration Bond Funds (SDBF) and Separately Managed Accounts, explaining, "SBDFs and SMAs allow access to a broader universe of securities but may cause higher volatility given increased credit and interest rate risks. We think such volatility can be tolerable for the portion of cash assets that is stable, provided that investors do stick with the strategy's underlying duration.... When duration increases, so does the volatility of total returns. However, when considering an investment horizon consistent with the duration of these strategies, rare periods of negative returns are typically offset by multiple periods of strong positive returns."
