Cashing in? How to make cash allocations work

Now interest rates are rising, so is investor interest in the return on their cash allocations.

In the first blog of this series, we discussed the evolving interest rate picture for money market investors, and their options for segmenting cash into operating, reserve and strategic allocations.

When it’s same-day liquidity and daily capital stability you’re after, we believe triple-A short-term money market strategies are most appropriate. But here, we discuss some options and considerations for longer-term cash allocations when an increased return is the objective.

Seeking additional return on reserve and strategic cash

There are several classic approaches to capturing additional return:

• With direct investing, cash investors can look to manage a portfolio of assets where they have the appropriate internal credit research and trading resources available. A higher return may be possible, but potentially at the expense of capital preservation should the anticipated investment horizon change at short notice.
• In separate accounts, investors can have a professionally managed portfolio tailored to their specific return goals and risk appetite. In practice, however, separately managed account guidelines often deviate little from standard pooled strategies, but sacrifice the liquidity efficiency associated with a pooled fund. Separate accounts are useful where investors have particular risk and return profiles and where cash flows are predictable, or the investor is willing to sacrifice some return to meet unexpected cash requirements.
• Using liquidity plus or ultra-short bond strategies: Stepping back from the dual mandates of daily capital stability and liquidity, these aim to offer a return over short-term money market strategies in exchange for some capital volatility.
• Absolute return or asset backed-securities strategies, for longer-term investments, can provide an increased return while mitigating some of the interest rate and credit risk associated with traditional corporate bond portfolios.

Within these approaches, there can be some variety, but it’s important that investors assess their options with their investment horizon or capital stability requirements in mind.

Looking under the hood

Liquidity plus or ultra-short duration strategies can be useful when capital stability is a six- or 12-month objective.

That said, while triple-A short-term money market strategies are well established and understood, there can be significant differences between liquidity plus and ultra-short-term bond funds.

There are five key considerations for cash investors when evaluating these strategies:

1. The investment horizon, and how it is designed to target capital stability within that context.
2. The fund rating. While a bond fund rating assigned to a liquidity plus fund is less prescriptive than a short-term money market fund rating, they can provide a guide to overall credit quality and sensitivity to market risk. A bond fund rating will typically consist of a credit and market sensitivity component.
3. The investment capability of the provider, including its credit research resource, and where the fund fits within a range of investment products offered.
4. The underlying investments within the fund. These are particularly important with regard to structured finance, where the maturities of underlying loans can be very long dated (for instance mortgages) and perhaps not consistent with a shorter-term horizon.
5. How return is generated. A short-term money market fund generates return over cash through a controlled combination of duration and credit risk. A ‘liquidity plus’ fund has more flexibility, so investors need to be comfortable with how risk is allocated and managed.

Pulling it all together

To round off this series, let’s revert to the original notion of cash segmentation.

Rising interest rates have prompted an increased focus on the returns for cash. Short-term money market funds that prioritise daily capital stability and liquidity are likely to quickly pass on the benefit of higher policy rates to investors. However, where daily liquidity and capital stability are not required, potentially higher returns are also available for longer-term allocations.

However, it’s important for investors to consider their time horizons, stability and liquidity needs first. Defining the segmentation of their cash allocations between operating, reserve and strategic buckets is a helpful way to think about this.

Most of all, care is required when evaluating options for reserve or strategic cash to ensure it’s appropriate to the investor’s specific time horizon or stability needs.