Inevitable rate rises will provide welcome tonic

From Fund Selection 05 April 2011

George Tsapouris, Coutts

By Ceri Jones

Clients of liquidity funds are increasingly demanding active management of their portfolios to achieve a balance between safety and performance

Table: Money Market Funds

Interest rates appear certain to rise on both sides of the Channel, with the market pricing three 0.25 per cent rises in Europe and the UK by the end of this year, 2.25 per cent to 2.50 per cent by the end of 2012 and 3.0 per cent by December 2013.

Jean-Claude Trichet, president of the European Central Bank (ECB), recently spoke of the “strong vigilance” necessary to deal with price pressures, which suggests the ECB will hike rates in April. The UK’s 0.5 per cent rate has now been unchanged since March 2009, but the consumer prices index measure of inflation rose to 4 per cent in January – well above the Bank’s 2 per cent medium-term target – which also points to an inevitable rise. Recent monthly Monetary Policy Committee meetings have been increasingly divided, and the balance could be thrown by Goldman Sachs economist Ben Broadbent, who replaces hawk Andrew Sentence in May.

Diverse Requirements

The situation in the eurozone is complicated, however, because the ECB must try to set a single policy for the region as a whole, but the different countries have diverse requirements. A series of small quarter per cent rate increases would push up borrowing costs in Ireland, Spain and Greece, and price Portugal out of the debt markets, while the merit in raising rates to deal with inflationary pressure are questionable when the major causes are rising prices in imported commodities and increases in indirect taxes.

“Every central Bank has a different mandate,” points out George Tsapouris, investment strategist, Coutts. “In the UK, it is about controlling inflation, while in the US it is more about promoting growth; and so the US will probably be the last to raise rates this time as it wants to first see unemployment falling. With Trichet making it clear the ECB will raise rates in April, this means short-term rates can now reflect expectation of higher rates across the UK, Eurozone and US.”

The Triple A benchmark is in line with the base rate so what tends to happen is that while some of that money is held in short positions, a proportion is held at three to six months and the overall return takes advantage of expectations and should outperform by 15-20 basis points. This will not be static but modifying as rates continue to move and because of funds’ high turnover, any future rises should be reflected relatively quickly.

Last to implement rises will be the US. The Taylor Rule, devised by Stanford economist John Taylor, suggests the Federal Reserve increases rates in times of high inflation, but only when employment figures are good. The labour market now appears to be strengthening with unemployment declining in 24 US states in January while payrolls increased in 35 states.

Redemptions

Rate increases will be a relief for the money market fund industry which has suffered redemptions as the rates on offer have been so low. Total assets in euro-denominated money market funds fell by 15 per cent last year, by E108bn to E624bn, as investors looked for a better return from long-term asset classes such as equities. Corporate Treasuries remain good clients, however, as many businesses have been recovering well and generating strong cash flows.

Money market funds must adapt quickly as the economic backdrop changes, or risk losing market share to more flexible money market instruments and higher-yielding products offered by commercial banks.

“Recent pressure on the Eonia (Euro OverNight Index Average) and uncertainty in the interbank market raised the case for variable rate positioning,” says BNP Paribas Investment Partners’s fixed income product specialist Xavier Gandon. “To prepare for this, BNP’s portfolios were on average 80 per cent invested in variable rate instruments at the end of January 2011. This enables our money market funds to offer a strong correlation between their performance and the return of the risk-free rate. Our exposure to interest rates is low and we can be confident in a market where we expect interest rates to increase in the coming weeks.”

Proactive management is as critical in the money market space as it is in active equity management. “People may view money market funds as boring because they are on the low end of the risk spectrum, but it is a challenging area from an investment standpoint,” says Joe Sarbinowski, global head of institutional cash sales for DB Advisors.

“There is zero tolerance for loss in these funds, and a lot of portfolio turnover, and diligence is required to get a balance between safety and performance. Whether it is a sovereign crisis, a credit issue, or how events in the Middle East are affecting credits, the manager must always be on guard and have robust processes,” he explains.

“One also needs to look at the macro factors and secondary or tertiary risks by region and the impact of rate changes, particularly now with impending rate hikes in Europe. If one is investing in corporates, for example, one needs to consider the impact of continuing rising oil prices,” says Mr Sarbinowski.

“Yet there is zero tolerance for losses in these funds whereas in the equity world there is acceptance of some losses. A lot of the elements are far more timely – we are not looking at buying a stock for one or two years because it has a low valuation, but instead credits that must mature in equal or better shape in just a few weeks. The fund’s turnover is higher with weighted average maturities of approximately 45 days.”

Harmonised regulation

The segment is still trying to rebuild its reputation in the aftermath of 2008 when the Reserve Primary fund, the oldest money fund, broke the buck and its shares fell to 97 cents, after writing off debt issued by Lehman Brothers.

The industry is now developing transparent and harmonised regulation to avoid the problems of the past when the money market fund label had, at times, been misused. Use of the label “enhanced money market fund” will be banned from July this year and The Committee of European Securities Regulators (Cesr) has published a definition of money market funds which excludes use of instruments considered complex or risky, such as collateralised debt obligations.

Only funds that comply with the guidelines will be allowed to use the term “money market” in their names, making this the first pan-European definition of a money market fund. Managers will have to qualify their funds as “money market” or “short-term money market”, according to the maturity and life of the funds’ assets. Short-term money market funds will have a weighted average maturity of no more than 60 days and a weighted average life of no more than 120 days. For money market funds, those periods will be extended to six months and 12 months.

Cesr also wants to rectify the assumption many investors share that money market funds offer some kind of capital guarantee like a bank deposit. Although a triple A-rated fund that is diversified widely enough should be able to achieve a constant net asset value (Nav), this is not a given. Cesr has imposed other safeguards to both categories, such as daily Nav and controls over investments in foreign exchange so, for example, FX derivatives will be allowed only for hedging.

Wim Veraar, head of money markets Europe at ING Investment Management, says 2010 was a painful year for the money market fund industry as commercial banks seeking funding were able to propose higher rates, often yielding more than 1 per cent. Now that the definition is to be limited to short-term funds with an average 60-day average maturity and those with an average maturity of 180 days, the market will rationalise.

“In Europe, hundreds of funds call themselves money market funds but sometimes have a maturity of one or two years and may have a full position in credit, so a lot of these funds will be closed or merged or change mandates,” says Mr Veraar.

The Regulators’ involvement has of course been criticised as too little, too late. “The stable doors are being shut when the herd is way down the prairie,” says Chris Oulton, CEO at Prime Rate Capital Management. “It is a good three to four years after the criteria should have been called for,” he says.

Another debate is the split between rating agencies over whether parental support is relevant. Moody’s first produced a report in 2007 citing examples of previous parental support and concluded parental strength should be a factor. Standard & Poors says this should be considered only if mark to market NAV is below 99.75 per cent, otherwise the agency is happy to rely on portfolio strength. Fitch looks at each case individually. Mr Oulton says in reality the likelihood that a parent would step in and bail out a fund for reputational reasons is very slim.

“These are institutional investment products, not banking products; and it’s a mistake to regard them as such,” he says.

Increasing allocations

Wealth managers have been increasing allocations to cash as a tool to dampen the overall volatility of their clients’ portfolios. David Livingston, partner and portfolio manager at Thurleigh Investment Managers, is recommending 10-15 per cent in money market funds, such as the “boring but safe” BlackRock Liquidity fund, as clients switch out of bond portfolios, particularly local currency bonds, to reduce risk.

“As interest rates are low, people may be surprised we are increasing allocations to cash,” says Simon Miles, head of portfolio management of Emea Discretionary at Merrill Lynch.

“Typically we are looking at cash of 5.5-6 per cent. We like very diversified cash funds, and don’t want to take any risk, so a sterling or dollar client will have one denominated in their own currency. These funds may hold commercial paper but only up to 90 days, and we like to see floating rate instruments which will help with inflation.”

Taking money out of the market and parking it in cash pre-supposes that it is possible to time the market, however. Andrew Wilson, head of investments at Towry Law, warns that investors run the risk of failing to re-enter the markets at an optimal time – and will have only a 25 per cent chance of guessing correctly both the switch out and the switch back in.

“There has been a lot of talk about not being in cash because of negative real returns, but there are times when you might want a safe haven and I can see why some may feel it is a good time to do that now, but only if they fancy trying to time the market,” he says.

Some advisers are spending considerable effort trying to maximise the returns on each client’s cash portfolio, by trying to accurately match it to each individual’s potential expenditure profile. “Clients need to construct a liquidity ladder, ensuring maximum returns for their liquidity requirements over different term horizons, rather than having it all sitting there in one pool price to base,” says Jonathan Daly, head of Coutts UK Treasury Services.

“This is a concept of fixed income that broadly builds a portfolio over time, with a core of liquid cash but also term placings over one year between 3 to 3.5 per cent which will give an overall blended rate of 2.5 to 2.6,” he explains.

“A lot more of our private bankers are talking to clients about this, and clients who had been used to income at 4 to 5 per cent and are having to endure current low rates have been asking what we can do that is more constructive.”