The Chase for Yield

Interest rates are at historically low levels – and look set to stay that way for some time to come. How, then, can an investor in cash markets achieve a higher yield without taking excessive risks? Regulatory changes, for one thing, are having a number of unintended consequences for money markets and banks alike. Set up to stave off another financial crisis, they are proving to be something of a gift and a curse. As such, investors in cash markets are now having to decide what levels of security and return they are willing to risk when choosing which products to invest in for those prepared to be slightly aggressive, the rewards are certainly there.

In the boom years that preceded the financial crisis, the primary focus for investors in money market funds (MMFs) was yield; security of principal was largely taken for granted. Then the credit crisis hit and everything changed. A number of liquidity funds did the hitherto unthinkable – they broke the buck. Many, as a result, had to rely on their sponsor corporations to bail them out, buying up assets to stop the funds collapsing. Cash was poured in to sustain net asset values (NAVs) at the sacred £1 mark. This process was not cheap, with several parent companies losing more than the funds were actually making.

Some enhanced yield funds – with their policy of buying lower-rated or higher-risk assets to eke out additional yield – suffered the most pronounced losses. Asset-backed securities (ABS) – a mainstay of such funds – were particularly affected by the sell-off.

In this febrile atmosphere, the focus for investors diverged. The question became: what is more important: return of capital, or the return on capital? For those that valued the former, liquidity funds remained the most obvious destination for their cash. For, at the height of the crisis, cautious fund managers responded by reducing weighted average maturities (WAMs) of their portfolios. Perceived riskier assets – floating-rate notes, corporate bonds, asset-backed commercial paper – were replaced by overnight deposits and other forms of safe, short-dated, lower yielding assets. Approved credit lines were reviewed as the previously ‘credit-free’ money markets suddenly stopped operating. IMMFA (the MMFs industry body) reacted by re-defining its code of practice, making stress-testing of portfolios mandatory. Targets for the levels of overnight deposits a fund should carry, as well as for the amount that matures within a week, were imposed. All these measures served to reduce the returns available in the liquidity fund environment.

Safety undoubtedly remains uppermost in many investors’ minds, but there is an increasing contingent that are willing to give up a bit of capital stability in return for a better return. But with money market liquidity funds offering minimal returns, where should they invest?

Looking Elsewhere in the Money Market Universe

There are a number of money market instruments that can still generate attractive returns without compromising the principle value of the initial investment. Enhanced cash funds have recovered from the mauling they received during the credit crisis, with a host of managers having revamped their portfolio structures and reviewed investment strategies. Asset allocations – even for the more successful funds – have been changed in an effort to generate additional yield.

How is this done? One of the upshots of the new regulations is that they have created a disconnection in the market. With money funds having to focus on liquidity and keeping WAMs shorter, some assets are now more highly prized than others. As a result, simple supply and-demand means that a one-year floating rate note (FRN) from a UK clearing bank currently generates a lower return than a one-year fixed-rate certificate of deposit (CD) from the same lender – even though, from a creditworthiness point of view, there is no difference between the seniority of the assets.

But enhanced cash funds can run longer WAMs, and therefore take advantage of these higher yielding – but equally secure – CDs. Due to the new governance rules they can, in other words, generate greater returns without taking untoward risks.

This credit premium is an entirely new phenomenon in cash markets, where previously banks would only have to pay a small fee over and above interest rates to access funding. But it is looks here to stay – and represents a real opportunity for funds that can take the price volatility.

Figure 1: Enhanced Cash Funds Credit Premium

Source: Bloomberg

Another area that is functioning differently post-crisis is the MTN market (investment grade corporate bonds). Over the past three years, corporate and financial institutions have had to pay far more to fund themselves in corporate bond markets; and these higher yields are starting to have a trickle-down effect on cash markets. As a bond approaches maturity – a so-called ‘tail-end’ bond – it becomes less attractive to corporate bond fund mangers. The yield it offers, however, far outstrips those available in the cash markets. Therefore, an enhanced cash fund – unencumbered by the stringent liquidity rules governing some of its money market peers – can hold an MTN to maturity, thereby ensuring a superior return over a CD or commercial paper (CP) in a similar name.

Elsewhere, we have also seen selected ABSs come back into favour. At the height of the crisis, all names were tarred with the same brush, with pricing deteriorating across the board. But the asset-backed market has evolved for some parties, with many now showing improved trading and clearer pricing.

How, though, can we be sure enhanced funds won’t repeat the mistakes of the past? Can we be confident the recklessness, evident pre-crisis in some portfolios, has been quashed?

For one thing, enhancing yield in the current market has become far more of a credit-based decision. As such, credit desks are more prevalent than ever. These teams thoroughly analyse and scrutinise all counterparties a fund can deal with. By ensuring the creditworthiness of a counterparty, or an ABS asset, a fund manager can deal in longer-dated, riskier, but higher-yielding products with the upmost confidence. That these procedures are also in place in money market liquidity funds highlights the change in emphasis from yield to security, even in such short duration.

A Boon for Enhanced MMFs

The move away from complete reliance on short-dated liquidity products for investors is further emphasised by the new regulations being imposed on banks. Take, for example, the Financial Services Authority’s (FSA’s) individual liquidity adequacy standards. Under these rules, for any assets under 90 days maturity, banks must hold the same amount in capital. As a result, longer-dated funding is becoming increasingly attractive to banks, with many more inclined to pay the premium for this type of trading. This, though, means managers of enhanced MMF can generate superior returns with little additional risk.

At the outset we posited that the new regulations introduced in the wake of the financial crisis were something of a gift and a curse. And, indeed, depending on which MMFs you wish to invest in this is certainly true. On the losing side are money market liquidity funds: thanks to the restrictions placed on WAMs and the type of assets they can use, many will struggle to deliver heightened returns.

In contrast, the main beneficiaries, as we have seen, are likely to be enhanced cash funds. Reputations have been restored somewhat, with new strategies and asset allocations – all policed by diligent credit teams – attracting clients hungry for enhanced yield in a low interest rate environment. So, for investors looking to achieve superior returns – without taking the unnecessary risk of the past – now is the time to re-evaluate enhanced MMFs.

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