Throughout the COVID-19 pandemic, the Federal Reserve suppressed interest rates, pushing the so-called federal funds rate close to zero. As a result, traditional liquidity products used by cash managers didn’t fare much better. In the money market fund industry, for example, the prevailing yield in recent years has been just one basis point (0.01 percent). Banks likewise have paid virtually nothing on their money market deposit accounts and short-term certificates.
But now the Fed is “tightening” to fight inflation, and rates for both short- and long-term investments are creeping upward. Traders expect the Fed to keep jacking up rates in a stairstep strategy of 25 basis points each month, and potentially 50 or even 75 basis points if inflation keeps running hot. Those expectations get built into what’s known as the term structure of interest rates so that longer maturities pay more, in expectation that rates will keep going up in coming months.
Consequently, yields on Treasury bills, jumbo bank CDs and corporate commercial paper that mature later this year and in 2023 have risen to levels high enough that watchful public cash managers are coming out of dormancy and locking in some positive yields that beat the puny rates that they earn on the liquid investment vehicles offered by money market mutual funds, state and local government investment pools (LGIPs), and transactional bank accounts. We call this disintermediation — essentially, bypassing the middleman. It’s a predictable process when rates are rising, and it’s a challenge for the liquidity pools’ portfolio managers, who must retain a high level of overnight and one-week paper to cover liquidations as investors yank their money for juicier products. Right now, such overnight money is the lowest-yielding on the money market’s totem pole.
The Securities and Exchange Commission just announced new proposals for “2a-7,” the principal rule governing money market mutual funds, that will require even more liquidity (and hence lower yields, relatively) in those commercial-fund products as a protection against a “run on the fund,” which is the industry’s bogeyman. An abrupt increase in federal funds rates and other money market instruments would drive cash managers to seek higher yields elsewhere and leave the money market funds at risk of holding longer-maturity prior investments that have lost market value because of escalating interest rates. That could “break the buck” — the presumably stable $1 share price convention.
Outside of the mutual fund industry, the same general problem applies to investment pools operated by state treasurers as well as the LGIPs that are typically operated by a private portfolio manager under contract with an intergovernmental consortium that qualifies for exemptions from SEC regulations. Although many of these pools try to operate by a “2a-7-like” rulebook to qualify for lower-risk categories in governmental financial reports, a number of pools have higher average maturities in their underlying portfolios than the commercial money market mutual funds. The performance of such pools can lag competing vehicles when rates move upward faster than markets had expected. That is precisely the scenario today, and a potential warning flag.
What the Public Fiduciaries Need to Watch
In a regime of persistently rising interest rates, which is the high-probability scenario for 2022 and likely in 2023, local government cash managers need to pay close attention to two concepts: the average maturity of any investment funds and pools they still use, and the “breakeven reinvestment rate” on fixed-term investments when investors reach for a higher yield by locking into a longer maturity as rates are rising. The latter is especially relevant to public treasurers and cash managers who are now tempted to string out their portfolio maturities into 2023 or even beyond in a quest for slightly higher yields — on paper. These are the two most important issues that oversight officials on public agency governing bodies should now be surveilling, as public fiduciaries.
The average maturity of a money market mutual fund, a state investment pool or an LGIP should be readily available to cash managers and their overseers. Regulators require this information for money market funds, and the portfolio managers of governmental investment pools also typically provide transparency for theirs. When average maturities extend beyond 90 days and interest rates are rising rapidly, the pool’s performance risk increases as a function of its average maturity.
Now, as long as nobody yanks their cash, there is no crisis. But when disintermediation gathers steam and participating investors run for the exits, there could be a headline-grabbing nightmare unless the fund has enough “bottom-towel dollars”: Like the seldom-used towels stacked at the bottom of a laundry cabinet, those include compulsory deposits with no other place to go by law or policy, as well as a state’s, city’s or county’s cash reserves that are pulled out only for genuine emergencies. Such stagnant money can match the pool’s laggard investments so that the fund won’t break the buck. In that case, the yield would stink but principal would remain intact.
Lately the gap between today’s overnight rates and anticipated future overnight rates (which are now reflected in longer maturities) keeps expanding, so public cash managers can easily go elsewhere with money that they don’t foreseeably need to pay bills for a few months or longer. Quotes on three-, six-, nine- and 12-month Treasury bills and jumbo bank CDs today offer increasingly higher yields to compensate for the risk of escalating interest rates. Disintermediation is a predictable outcome, and its scale could be unprecedented. In coming months, investment-pool and liquidity-fund managers will be playing defense at best and damage control at worst. This will be true especially for pools that were persistently running average maturities over 180 days as we entered 2022, some of which now hold unwieldy large blocks of inferior low-yielding paper that is a deadweight hindering their catch-up game.
For local governments and agencies that have hired external money managers, this would be a good time to revisit with them their portfolio structures and strategies. Some may have underperformed their benchmarks in recent months if they were over-extended in their portfolio maturity structure. Also, it’s a sure bet that external managers who waived or discounted their fees when rates were low will be re-imposing full fees quickly as rates increase, so their clients should make sure they are getting what they pay for.
Avoiding Rising-Rate Risks
Pools and funds with average maturities over 90 days will likely struggle with outflows in coming months. Even highly liquid, super-safe and easily marketable Treasury bills and notes are now offering attractive yields that exceed most liquidity pools’ by a long yard. Until the Fed eventually raises its overnight rate closer to 2 percent, a pool-investor exodus becomes a performance and headline risk worth avoiding. This is not to disparage most investment pools, only to explain that a few may bear such risks while making note of greener pastures in the months ahead.
On the other end of the maturity spectrum, however, there is also a mirror-image problem lurking ahead for cash managers who jump too quickly into longer-term paper that is not fairly priced for the risk that interest rates could move up even more abruptly than the market now expects. The Fed now has to rein in its high-powered money supply by cashing in its bond portfolio, and that augers for higher yields across the maturity spectrum, not just the overnight paper. A few cash managers who naively invested in short-term bond mutual funds are already feeling the pain and fearfully holding the bag, wondering whether to take their losses and confess to failed strategies or to try to ride out a full market cycle and explain their misjudgment and unrealized paper losses in the next financial report.
So, how does a public cash manager avoid losing principal on investments of supposedly idle cash? First, don’t invest beyond the dates when cash is needed to pay bills. Then, conduct a break-even analysis of how high interest rates would have to go in 2023 before an investment today in longer maturities would begin to suffer price losses (sometimes called the implied forward rate).
For cash managers toying with longer maturities today, I encourage this analysis, and further recommend a re-read of my February column explaining why rates could still go well above levels now reflected in today’s intermediate-term (one- to five-year) maturities. Finally, be especially wary of brokers peddling “step-up” securities that promise to pay higher yields in the future if rates increase, unless staff has carefully done its upside/downside homework. There is no free lunch in the money market.
Of course, nobody can predict the future, so these are all educated judgments that should be paired with the future dates when today’s cash will be needed for operations and scheduled obligations. Just remember the venerable cash managers’ adage that it’s never wise to pick up nickels in front of a streamroller — going for small gains while ignoring a bigger risk. In today’s markets, persistent inflation and resultant Fed tightening remain the clear risks lurking in longer maturities.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.
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