Potential sweeping changes in fiscal and monetary policies, a new order in international relations, and ongoing political conflicts are creating heightened uncertainty for institutional cash investors in 2017. The eventful first weeks of the Trump administration saw a rapid succession of executive orders impacting healthcare, trade, hiring, energy, education, border security, national defense, and numerous other realms. And there will be more to come.
Equity markets have reacted positively to the pro-growth, inflationary and deregulatory undertones of Trumponomics so far. But many market observers acknowledge the looming uncertainties ahead and wonder how to react to the new president’s moves.
Amidst ongoing debate about potential effects on risk assets, many stock and bond strategists urge caution and recommend active portfolio management to steer clear of looming risks and cope with policy and event uncertainties. We recommend the same for short-duration cash portfolios. And, as an advisor and manager of institutional cash investments for more than two decades, we believe separately managed accounts (SMAs) may be an effective means of risk management for treasury organizations.
Two Sources of Liquidity Risk
Uncertainties are by definition difficult to forecast. Without a crystal ball to tell how a number of risk factors may affect financial markets, liquidity managers will need to be mindful of the potential for evaporating market liquidity.
Liquidity risk often arises from: 1) perceived credit problems with specific issuers or asset classes, and 2) the reluctance of nervous market participants to trade for fear of disappearing liquidity.
For example, the Federal Reserve pointed out there may be risk in the repurchase agreement (repo) market if bond dealers or investors are forced to sell asset collateral either before or after their counterparties experience liquidity problems. And commingled investments such as prime money market funds and ultra-short bond funds may experience liquidity crunches and contagion if they must satisfy waves of sell orders.
Managing Liquidity in an Era of Uncertainty
What’s the best way to manage potential liquidity risk? We recommend that institutional cash investors arm themselves with a diversified, high-quality portfolio of assets in a separately managed account. Here are two simple guidelines to help navigate the uncertainties in the coming year:
- Diversify, Diversify, and Diversify: Regardless of objectives or asset choices, diversification remains a key risk management tool for uncertain times. A sufficiently diversified portfolio among asset types, industry sectors, and geographical locations may greatly reduce the impact from a specific unexpected event. For example, high-grade sovereign and supranational securities may be viable supplemental investments in a corporate bond portfolio. Similarly, a portfolio of unsecured bonds may weather risk better with asset-backed securities, which offer the double benefits of instant diversification and asset collateral.
- Maintain a High Credit Quality Bias: Born out of investment policy requirements, most liquidity portfolios justifiably have a bias toward high credit quality to provide a ratings cushion against negative credit events. Recent credit market performance, we think, anticipates the implementation of Trump’s economic policies that suggest more downside risk from policy disappointments. The additional yield benefit from lower quality bonds in the current environment may not justify the added credit and liquidity risks.
Take Control of Your Assets
The three legs of the cash management stool are: 1) safety of principal, 2) liquidity and 3) yield. Some cash managers view separately managed accounts primarily as vehicles to deliver yield, through portfolios with longer-duration average maturities and total return objectives. But others have come to regard the SMA as a vehicle for managing the other two legs of the stool, risk and liquidity, as well.
As a risk management tool: SMAs enable investors to directly manage safety of principal. Unlike owning shares of a money market fund with an independent manager who commingles multiple owners’ assets, SMAs consist of assets that corporate cash investors directly purchase and manage either on their own or with the assistance of a registered investment advisor. The investor is able to limit exposures to certain sectors, asset classes and securities with additional layers of maturity and ratings restrictions. In comingled products, those decisions are left to the portfolio managers, and shareholders play only a limited and indirect role. But SMA investors with convictions that certain securities will do better or worse may direct their managers to add or reduce exposure accordingly.
As a liquidity vehicle: An SMA can be constructed primarily with money market securities, with minimal trading and with income objectives. Yield can be managed through construction of an SMA portfolio of securities with laddered maturities, providing higher income potential in an upwardly sloping yield curve environment than government money market funds confined by maturity restrictions. A laddered structure allows reinvestment opportunities arising from unanticipated interest rate movements. One may adjust the “ladder”—meaning maturity distribution and weighted average maturity (WAM)—as growth, inflation or Fed policy outlook changes throughout the year.
Getting a Good Night’s Sleep
We should note that this year’s landscape is not all about the new administration’s policies. One needs to keep an eye on the Federal Reserve and interest rates, post-money market-fund reform asset movements, the states of the European Union and China and their respective financial institutions, property markets in Australia, Canada and the UK and their banks, credit performance of energy portfolios in distress…the list goes on.
While dealing with uncertainty is nothing new in treasury investment management, this year may bring more surprises than in recent memory. Taking direct control of your investments through a separately managed account may help you sleep better at night as you manage new risks and strive for an appropriate balance of safety of principal, liquidity and yield in your cash portfolio.
Note: For more information on how separately managed accounts can help manage liquidity and risk in an uncertain year, download our research report, Using Separately Managed Accounts to Ride the Tides of Uncertainty.