My parents have always been conservative investors. Growing up, any time I had money to invest, the advice was the same: “…Put it in a money market fund (MMF).” Back then, this made sense. In the first ten years of my life (1978-1988) the average annualized yield on three-month U.S. Treasury bills was approximately 9.0%* while the S&P 500 returned about 10.5%** with considerable volatility, including the Black Monday crash in 1987.
The Fed was effective
A risk-off tilt in my parents’ portfolio persisted throughout their asset accumulation years up until their retirement in 2005. So I was taken aback in 2012 when my father called and told me he was reallocating some of his cash into equities. His MMF investments were not yielding enough and he was tired of waiting for yields to go higher. Like many, he was feeling the pinch of the protracted near-zero interest rate policy of the US Federal Reserve (Fed). (Since the end of 2008, three-month U.S. Treasury bills have averaged approximately 0.08%* annualized.) Searching for a non market-based barometer to measure the effectiveness of the Fed’s efforts to reflate risk assets? Look no further than my 73-year-old father’s decision to assume more market risk. (To what extent retirees should shift cash into risk assets is a separate question, beyond the scope of this blog post.)
Mom, Dad, we need to talk
I decided it was time for a talk with Mom and Dad. By design, the conversation evolved into a topic that I know quite well from speaking with institutional investors: cash segmentation. Like many corporate treasurers, my parents felt they had too much cash in low yielding MMFs. But with low risk tolerance and a horizon for investing that may be shorter than a full equity market cycle, they needed a solution with low risk of principal loss and a higher liquidity profile.
There are always investors for whom lower risk short-term fixed income investments are appropriate. Often, unknown cash needs lead them to keep their entire cash allocation in MMFs. But if short-term cash requirements can be predicted with a high degree of certainty, these investors can optimize the investment of their cash and enhance their yield and total returns by segmenting their cash into three buckets: operating, reserve, and strategic. Operating cash is typically used for daily operating needs, requiring preservation of principal and same-day liquidity. Reserve cash will typically have an investment horizon of six to nine months or longer, with fairly static balances and no need for same-day access. Finally, strategic cash should have no short-term forecasted use, with an investment horizon of at least one year.
New regulations, roll down the curve
With many liquidity clients feeling the same frustrations as my parents, we’ve seen a trend towards cash segmentation among institutional cash investors. Even as the Fed moves toward policy normalization, major regulatory changes will likely keep this trend in place.
Both the Securities and Exchange Commission’s recently enacted money market reforms, and Basel III – new global standards for bank capital, liquidity and leverage – will change the landscape for cash investment. We expect that it will result in more money chasing a decreasing supply of high-quality investments in the front end of the money market yield curve. This should keep that curve steep, creating roll-down opportunities for segmented portfolios.
In future blog posts we will discuss the impact of these regulatory changes and explore potential segmentation strategies and solutions. In the meantime, if you’re frustrated by low MMF yields, don’t take it out on your parents or children. Instead, consider taking some of your cash and segmenting it out the curve.
* Source: Federal Reserve
** Source: Bloomberg