Central banks seem to be vying with one another to inject liquidity into their financial systems, in order to mitigate or avoid an economic recession. There are several variations on this Quantitative Easing but it comes down to purchasing government or government agency fixed-rate bonds in secondary markets, and releasing cash to the current investor in the hope that the investor will spend it.
This poses important challenges to Cash Managers when they are looking to fulfil their KPIs for investing corporate cash:
- The nominal return on an investment in government risk goes down to or through the magic number of 0% per annum: the investor may actually receive less later than they paid now;
- The real rate of return is negative: in the Eurozone the rate of inflation is around 1% and falls short of the ECB’s 2% target, so any return-on-investment below 1% represents a loss of value;
- The yield curve becomes flat or even inverted so there is no yield pick-up available from investing in bonds with a longer maturity date. Indeed the loss of value could be even higher.
Three refuges are thus denied in the current environment to an investor attempting to achieve a yield target:
- "Travelling along the yield curve": investing for longer maturities, and accepting a risk of a price loss if interest rates rise and the investment needs to be liquidated before its maturity date;
- "Travelling down the credit spectrum": investing in bonds issued by less well-rated names;
- Combining both of the above.
The bonds of less well-rated names are already expensive because of the number of yield-chasing investors who have chosen this pathway already.
For the Cash Manager whose prime duty is to preserve the value of the investment, there can only be one direction: to review the KPIs themselves.
Investment KPIs specify a blend of Safety, Liquidity and Yield, and Safety must be promoted in the current environment, because central banks are acting to head off a slowdown or recession. In those circumstances there will be casualties, both corporates and banks. Credit risk is increasing.
Investments in bank liabilities must be checked to see whether they are covered by a financial compensation scheme and up to what amount. If they are, they represent government risk in disguise, and can offer a higher-yielding alternative to a direct investment in government risk.
If bank liabilities are not covered by a compensation scheme, there is every reason to tighten up the credit rating criteria of the bank entities with whom money is placed, which will of course have a downwards impact on yield.
Liquidity conditions are bound to tighten in a financial market where the economy behind it is in slowdown or recession, so revised KPIs would shorten the average maturity of the investment book, and give preference to tradeable instruments over ones where early repayment requires a negotiation with the institution in whose books the money was placed. That would militate, for example, in favour of buying a bank's Certificates of Deposit as opposed to making a fixed-term deposit with it.
Shortening maturities and investing in tradeable instruments both also negatively impact yield which, in this environment, needs to be the criterion at the back of the queue. In all of the USA, UK and Europe, a minimum yield benchmark of 0% is appropriate: the nominal amount must be retained, even if that represents a reduction in value in real terms.
With short maturities there is the opportunity to re-invest at higher rates when yields rise. Central banks seem to believe that they can keep yields at these levels for many years, until economies start growing again. Where will the growth come from if economies are choked with zombie companies, who can only pay their debt service if interest rates are zero? Central banks then lose control and find that their actions have no impact, other than to tighten even further the coiled spring of bond yields. Central banks – not investors – have forced yields down to current levels, and so low that in the medium term they can only go up.
Once sentiment turns, the spring will uncoil rapidly. Cash managers need to be prepared for that, by avoiding the temptations of longer maturities and higher credit risk now. Rather than trying to fulfil KPIs that were drafted in a different environment, KPIs need to be adjusted to take account of central bank actions and the environment that central banks are reacting to.