Merrill Lynch Mercury Asset Management reports that UK FTSE 350 companies, excluding banks, are sitting on £65 billion ($108 billion) of cash, most of it placed on deposit in the interbank market. It further estimates that European corporations, insurance companies and pension funds are together rolling over some $561 billion of liquidity, mainly through interbank deposits. Corporates account for some 70% of that liquidity. These companies haggle with their banks to cut liability costs by a few basis points. They should ask themselves whether they are also earning a competitive return on their cash assets.
Just $10 billion of that European liquidity – less than 2% of the total – sits in institutional liquidity funds. While this remains a small sector of the European short-term finance markets, it is a well-established alternative to bank deposits in the US. There, institutional liquidity stands at $2.7 trillion, of which $1.3 trillion (48%) is invested in money-market funds. Some European corporates with very large core cash balances may have these managed through specialist accounts, but most are rolling over deposits, earning low returns and, arguably, taking undue risk by concentrating deposits in just a few banks.
Merrill Lynch Mercury along with several other asset managers – including Goldman Sachs Asset Management, Chase Asset Management, State Street and some European banks – have recently launched or are launching institutional liquidity funds. These aim to draw cash out of Europe’s banking system and manage it as an asset class. Such funds will spur the process of disintermediation, providing a capital-markets-type source of short-term borrowing as an alternative to bank loans. These vehicles will invest more in commercial paper and less in deposits and may eventually replace banks at the core of the short-term financial markets.
In the short-term, banks may not be too discomfited. “We are at a point in the cycle where liquidity levels are so high that the UK clearers, for example, are almost being overwhelmed with cash, to the extent that they are paying very low rates of interest as a strategy to deter new in-flows,” says Anthony Simpson, managing director at Merrill Lynch Mercury.
Why should corporations put their cash into funds rather than deposit it with banks? Three main reasons, say the fund providers: better safety, better liquidity and better yields. Institutional liquidity funds aimed at European clients are typically designed so as to meet SEC rule 2a-7 and to attract triple-A ratings from Standard & Poors and Moody’s. Meeting these criteria requires funds to invest in a spread of high-quality, liquid assets. Rule 2a-7 imposes a weighted average maturity of 90 days, with no single security to have a maturity greater than two years and one day. Obtaining triple-A ratings tightens these requirements to a 60-day average maturity, with no single security having a maturity more than 13 months plus one day. It also imposes a limit of 5% of a fund’s exposure to a single counterparty, and adds a requirement that at least 50% of investments be in triple-A-rated securities with no more than 50% in double-A-rated securities.
This provides a better spread of quality exposure than depositing the whole of a company’s cash with one or two double-A or lower rated commercial banks. It removes the risk of capital loss on investments. And corporations generally have same day access to funds. Subscribers to the Merrill Lynch Mercury fund – split into sterling, dollar and euro sub-funds – can contact the manager up to 1pm and withdraw sterling cash the same day, up to 5pm for dollars the same day, and up to 3pm for euro cash the next day.
Funds provide the advantage of extended duration to investors, which may invest money today, withdraw it in one month and earn interest in the meantime based on an investment portfolio with a weighted average maturity of two months. Merrill Lynch Asset Management aims to outperform Libid net of fees, whereas institutions might receive Libid less 12.5bp or Libid less 25bp on short-term bank deposits. So convinced is Merrill Lynch Mercury that the fund approach constitutes best practice for institutional liquidity management that it expects to sweep cash balances from its pension fund clients into the fund, adding £2.2 billion of cash, probably within 12 months. It projects the fund will grow to $5 billion over the next three years. That sounds a lot, but represents less than 1% of estimated institutional liquidity.
One of the arts in managing institutional liquidity funds is in forecasting investor behaviour and anticipating how long clients will leave cash invested and what may prompt them to withdraw it. Managing cash related to a large corporation’s pay-roll disbursements, for example, requires very liquid short-term investments. A corporation hoarding cash for a future acquisition may permit longer-dated investments. David Curtis, associate director at Merrill Lynch Mercury says: “We divide clients into hot, warm and cold. Hot clients may leave money in the fund for one week, warm clients for between one week and a month, and cold for longer than one month.” He adds: “Most investors in our fund to date are cold. That would imply that portfolio managers could extend duration. Although that is not much of a benefit right now in the UK where the sterling yield curve is inverted, it is an advantage in a normal yield-curve environment.”
These funds may offer a better return than deposits, but they are still at the conservative end of cash management. Many European corporations have hundreds of millions of dollars of cash which they may retain for months or years. Such firms often mandate fund managers to invest this liquidity in short-term bonds and money markets through tailored accounts, with the aim of producing Libor-plus returns. Examples in the UK of corporations that have had such high cash balances include Unilever, British Aerospace, Hanson, BT, Cable & Wireless.
“Mutual funds are attractive to investors who require highly-flexible and publicly-rated investment vehicles for cash balances. But there is increasing demand for tailored accounts from institutions who can identify surplus core balances in excess of €50 million [$58 million] which do not require the same level of daily liquidity offered by mutual funds,” says Gordon Ross, managing director at Chase Asset Management. Managers on such customized accounts might look at longer-dated and lesser-rated paper, including conventional corporate bonds at or near their last coupon date.
A typical customized mandate might seek to beat 6-month Libor by 25bp on a portfolio with an average double-A rating and 12-month duration. At the furthest extreme from liquidity funds, managers might aim for a return of Libor plus 150bp on such cash piles.
European banks will continue to lose cash deposits to institutional funds, tailored cash accounts and, if Europe follows the US model, to retail-targeted money-market funds. That will deprive them of cheap liabilities with which to make commercial loans. An obvious response would be to launch money-market funds of their own. However, banks respond, this looks like bad news. Margins, already seemingly narrow in Europe, will be squeezed further. Peter Lee
