Cash investments: What you need to know

Executive summary

• Returns on cash are finally offering meaningful risk-adjusted returns.
• Idle cash cannot afford to be an afterthought in today’s rate environment. It's also not sufficient to simply lump cash into one ill-fitting vehicle that may not provide the liquidity it's assumed to.
• In order to maximise portfolio efficiency, it's critically important to make allocations to both government and credit instruments that consider secondary market liquidity in relation to the spread/yield they offer.

For a period of time going back to the first money market funds in the early 1970s, the idea of liquidity management was a fairly black and white one – cash on hand had a basic utility and was governed by basic principles:

• The protection of principal
• The provision of on-demand liquidity
• The acceptance of a reasonable return for minimal risk

The principal portion of the equation was primarily governed by a conservative allocation to safe, highly-rated credits; the liquidity component was largely accomplished by a mix of deposits and short-duration instruments that could be turned back into cash at little expense; and finally, returns were set by central banks that controlled rates paid on reserves in the banking system. With a small, largely predictable (and upwardly sloping) credit and duration curve in the short end, early money funds followed a similar playbook in managing deposit volumes and shareholder activity.

Like many assets in the early stages of development and evolution, homogeneous offerings quickly adopted minor variations in order to differentiate themselves in the marketplace. Small yield advantages from Fund A to Fund B moved millions in deposits. Soon, however, market stresses – in the form of Long-Term Capital Management, the Lehman Brothers failure, the SIV (structured investment vehicle) crisis, and most recently, the COVID-19 liquidity disruption – revealed cracks in the foundation. Chief among them was that the balance of risk + return + liquidity isn't always balanced.

The importance of understanding your specific liquidity needs

Russell Investments has helped clients structure their liquidity portfolios with a dynamic positioning that can adapt to changes in liquidity markets when funding behaviors change. Over the last two-plus decades, the assumptions of what liquidity means have been challenged with acute market stresses in the form of the Global Financial Crisis (GFC) and, more recently, the COVID-19 market crisis in March 2020.

In each instance, an abrupt shift in sentiment, aided by dramatic changes in U.S. Federal Reserve (Fed) policy, caused money market investors to hoard liquidity by shortening up the average maturity of their portfolios and eschewing almost all term investments that weren't in the form of Treasury bills. In isolation, this wasn't the cause of the crisis. Still, when retail and institutional investors began redeeming balances from money market mutual funds, the availability of liquidity in the form of secondary market trading began to evaporate almost immediately. Funds could not sell term positions to fund redemptions to the point where liquidity – at nearly any price – was unavailable.

In the U.S., as a result of those market experiences and some resultant regulatory proposals by the SEC (Securities and Exchange Commission), the approach for structuring short cash portfolios to provide adequate liquidity began to change. Larger allocations to U.S. government securities became commonplace in government and traditional prime money market portfolios. Targeted allocations to maturity buckets were implemented to provide natural liquidity from maturity runoff.

At Russell Investments, our conversations with clients focus on their specific liquidity needs and how those sources of liquidity might be accessed over the following weeks, months, and years. Portfolio construction is a byproduct of their risk-return appetite and a thorough analysis of how those needs might change under market stress conditions.

To maximise portfolio efficiency, it's critically important to make allocations to both government and credit instruments that consider secondary market liquidity in relation to the spread/yield they offer. In extreme market conditions, liquidity can be the ONLY consideration. "Cash is king…" is a common cliché, but it is nonetheless true when market participants attempt to sell risk in unison. Trying to de-risk liquidity portfolios on the fly has proven not to be a viable strategy, so we favour core positions in U.S. government securities that provide reliable liquidity during flights to quality.

Designing a structure for use

When evaluating pools of capital, it's important to recognise that all of our clients' cash rarely have the same purpose and function. As such, having a single profile for cash on the books results in a different type of liquidity error. It often means clients overpay for daily liquidity in a money market-type fund. As previously discussed, misevaluating liquidity in the market means that there are instruments that offer a positive yield pickup in exchange for less secondary trading liquidity. The credit profile may still offer a very low probability of default and a positive spread to more liquid Treasury bills.

From our vantage point, clients should be looking to stratify their pools of capital and make allocations to liquidity portfolios that maximise risk-adjusted returns. Most often, these pools of liquidity would fall into one of three categories: operational cash, intermediate cash, and core cash.

• Operational cash is generally available with same-day liquidity and services a number of known cash flow needs – payroll, regular business expenses, etc.
• Intermediate cash is often earmarked for specific capital purposes that are more medium-term in timing, and as such, those balances are not normally accessed to accommodate short-term flows. These balances may accumulate in the near term until they are pulled at a foreknown time. For these balances, taking on additional liquidity risk in the form of higher yield compensation may make sense since the maturity of these securities can be placed around the known redemptions, limiting the need to sell prior to maturity.
• Core cash is exactly what it sounds like – cash that is a core holding for clients that may be reserved for long-term planning, regulatory purposes, or other reasons but which require a high degree of principal preservation but lower liquidity provision than the other forms of cash. For these core holdings, there are opportunities to structure in more duration with longer maturity holdings, potentially capturing higher yields from a term premium.

The key analysis identifies what portions of a broad cash portfolio are best allocated to each purpose and how these designations may change in the medium and long term. Having a customised solution for these various cash allocations increases the efficiency of the overall portfolio by marrying the liquidity required with the investment opportunity (yield).

Why cash now?

One of the most common themes we've heard over the past year or so is that cash finally matters again, which is an oversimplification but is also strikingly simple to appreciate. Returns on cash – in deposit form or in a commingled money market fund – finally offer meaningful risk-adjusted returns.

Following the collapse of Lehman Brothers and the subsequent fallout from the GFC, the Fed floored the federal fund's target rate at a range of 0-0.25 basis points (bps) for over six years (2009-2015), which caused money market funds to waive fees and yield almost nothing for investors. When the Fed began hiking rates in late 2015, yields in short cash-like vehicles were slow to adjust but eventually got up off the mat as the Fed raised its target rate to 2.5% in 2019. These yields, which at the time were slightly positive to the CPI (consumer price index) inflation prints, were short-lived, however, as the onset of the COVID-19 pandemic again caused the Fed to lower rates to its absolute lower bound.

Fast forward to present day, and the elevated levels of inflation seen in the last two years have put the Fed near the end of a historic hiking cycle, increasing the lower bound of the federal funds rate by a staggering 450 bps in just a year's time.

Earlier this month, a headline came across Bloomberg that read, "Cash Pays More Than 60/40 Portfolios for First Time Since 2001" and highlighted that six-month U.S. Treasury bills had hit a yield of 5.14% – outyielding the classic mix of stocks + bonds for the first time in 20-plus years. Simply put, the risk-free rate on U.S. Treasury bills offered investors a significant risk-adjusted option for storing liquidity for the first time in quite a while.

The key for investors now is to recognise that idle cash cannot afford to be an afterthought in today's rate environment, nor does it suffice to simply lump it into one ill-fitting vehicle that may not provide the liquidity it's assumed to.

For the first time in quite a while, cash is king again.