Corporate finance departments need their treasurers to understand the modern nature of cash management. David Rothon of Northern Trust explains how products have evolved and why being fully aware of risk can offer alternatives to traditional banking solutions.

Ever since the financial turmoil began in August 2007, investing in the money markets has been extremely challenging and now a renewed importance has been placed on capital preservation especially in the world of corporate finance.

The heightened uncertainty has amplified investor nervousness as low growth and high inflation threaten to wreck havoc on capital markets aided by bank write downs, de-leveraging and a reduction of risk appetite in both credit and equity markets.

The interbank market, where money market funds operate, is still showing signs of distress with distrust amongst banks in lending to one another continuing to cause a dislocation in Libor levels, not helping business finance or institutional investors.

This may paint a volatile and gloomy landscape but money market funds still provide a relatively safe haven, especially AAA-rated money market funds.

By taking a step back to understand how the money market universe has developed over the last decade, it can be seen that ongoing regulatory changes in the US and Europe, as well as the increasing complexity of corporate cash management, the treasury function, have fuelled a dramatic growth in assets under management in the industry.

Attractive alternative to bank deposits

Money market funds offered an attractive alternative to traditional bank deposits, providing diversification, off-balance sheet exposure and access to active investment strategies without sacrificing liquidity. As the demand for such products increased so did the variety. The result was that an industry traditionally viewed as a conservative safe haven for cash actually became home to a multitude of disparate strategies ranging from very low risk government treasury funds to more volatile enhanced 'cash plus' vehicles and short duration bond funds.

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Yet in many ways this was a positive step for the corporate finance departments and investors. It gave investors the ability to parcel out their cash into buckets with different liquidity needs and therefore different risk profiles and allocate to the different strategies accordingly. As long as the risks underlying each type of strategy were clearly defined and monitored, investors and treasurers stood to gain significantly from this efficient re-allocation of capital.

Danger of increased yield demand

An investor seeking the security of a short dated government fund would typically expect a lower yield relative to investing in a strategy which has a greater interest rate and credit exposure. However, the previously benign global economic environment spurred investor demand for higher yields from cash portfolios. One avenue to increase yield undertaken by money managers was to increase exposure to securitised products.

Securitisation implies there are underlying assets providing the necessary cashflows. Unfortunately several of these products' underlying investments included subprime debt. Once the subprime products collapsed the market for these related instruments froze irrespective of whether or not the programme contained such exposures.

Crucially however, the market dislocations have resulted in a significant divergence in investment performance between the various strategies in the money market universe. It has served as a reminder that cash management involves active decision making and therefore robust risk management and a clear understanding of the underlying risks in any investment are critical factors in the potential success of a money market strategy.

The investment landscape has also changed for money market funds and the reality facing investors is that all money market funds are not the same. This has highlighted the importance of understanding the risk/return dynamics of differing types of money market products.

Labelling of money market funds in Europe has in some cases been misleading, for example, a short duration bond fund being described as a money market fund. Enhanced cash and short duration bond funds are distinctly different from AAA-rated Treasury-style money market funds.

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The definition provided by the Institutional Money Market Fund Association (IMMFA) defines Money Market Funds (MMFs) as: "mutual funds that invest in short-term debt instruments. They provide the benefits of pooled investment, as investors can participate in a more diverse and high-quality portfolio than they otherwise could individually. Money market funds are actively managed within rigid and transparent guidelines to offer safety of principal, liquidity and competitive sector-related returns."

Moreover, IMMFA implicitly distinguishes between treasury-style products such as constant net asset value (NAV) MMFs and investment-style funds with a variable NAV. In fact, IMMFA has worked hard to create a transparent code of practice for money market funds in Europe as a way of differentiating true AAA-rated funds from other money market vehicles.

Prior to August 2007, the focus amongst many managers had shifted towards maintaining lean liquidity positions and in many respects was to 'chase yield' in the market place. Investors contributed to this behaviour as fund managers were increasingly pressurised to generate yield in order to stay competitive in winning new business. For the most part, fund managers who kept true to the core objective of capital preservation were unable to compete on a yield basis and were considered to be inferior as a result.

Clearly this had now been turned on its head as conservative managers have benefited from investors making a flight to quality. The emphasis on capital preservation and maintaining a high enough level of liquidity has been necessary to guard against selling assets in markets where liquidity cannot be guaranteed.

Aside from liquidity challenges, trying to find high quality alternatives to bank risk in an area of the market dominated by bank issuance also presents challenges. Adding government/agency paper is possible but the impact to yield can be quite dramatic with levels posting in the region of 30-90 basis points less than the one month Libor rate. Despite the impact to yield, government/agency paper increases the overall credit quality of the fund and offers tight bid/offer spreads, which is very welcome when markets are illiquid. Corporate commercial paper acts as another diversifier away from bank risk although high Libor levels make short term issuance expensive and less attractive for issuers.

Prime objective - capital preservation

Maintaining a high liquidity profile, diversifying away from bank risk and keeping investments close to home, all contribute towards meeting and managing to the prime objective of AAA-rated money market funds, that of capital preservation.

The time will come for investors to move further out on the risk return spectrum but recent events have reminded us that despite sitting at the conservative end of the risk/return spectrum, money market funds are not risk free and active investment decisions do take place. It is equally important to remember that AAA-rated funds, as defined by IMMFA, have proven to be highly resilient to financial market volatility. It is key to understand the distinction between enhanced and short bond funds as they have a different risk profile to the aforementioned 'treasury-style' AAA-funds. Enhanced and short bond funds continue to be wholly appropriate as do money market funds as long as investors' risk appetite and objectives of a funds' strategy are in line with one another.

The capital markets have not been alone in reappraising risk. Whilst the capital markets are making adjustments to the levels of risk premia across asset classes and instruments, investors continue to take a close look at the appropriateness of their investment strategies against investment objectives. As this process of risk reappraisal evolves, investment strategies in the short duration space will become more clearly defined, enabling investors to better manage their risk budget.

A broader, better defined product array will give investors the confidence and conviction to tactically manage their cash going forwards.

David Rothon is a portfolio manager within the Global Fixed Income team, at Northern Trust Global Investments (NTGI) - the asset management arm of Northern Trust.  This information is provided for illustrative purposes only and does not constitute a recommendation for any investment strategy or product described herein. Northern Trust Global Investments (NTGI) comprises Northern Trust Investments, N.A. (NTI), Northern Trust Global Investments Limited (NTGIL) has assets under management totalling $778bn approximately.