The cash that companies carry on their balance sheets is typically divided into three categories: working capital, liquidity, and strategic cash. Working capital is the cash needed to fund day-to-day operations. Liquidity is cash that an organization keeps on hand to meet an unexpected shortfall in working capital. Businesses traditionally have held their working capital funds in bank accounts and held the cash designated for liquidity in prime money market funds, which deliver low yields but offer withdrawal at any time.

Strategic cash is the cash left over after the first two buckets are filled. Strategic cash is typically held as a buffer against unanticipated needs like a major acquisition or facility build-out, as well as to strengthen the balance sheet. Liquidity is definitely a concern for strategic cash holdings, but companies tend to seek out somewhat higher returns than they get on their working capital and liquidity. So cash in the “strategic” bucket is usually invested in bonds—typically corporate or agency securities with maturities inside five years.

Before the 2008 crisis in the financial markets, many companies worked to minimize the amount of cash in their working capital and liquidity accounts, in favor of higher-yielding strategic cash accounts. Then, in the immediate aftermath of the financial crisis, preferences experienced a dramatic reversal. The bankruptcy of Lehman Brothers and the subsequent failure of the Reserve Primary money market fund caused corporate investors to flee strategic cash, which was suddenly perceived as unacceptably risky, for the safety of bank deposits. According to the Federal Reserve, institutional money fund balances declined by 30 percent between August 2008 and the end of 2012.

Today, the pendulum is swinging back in the other direction. Strategic cash reserves are growing as companies are again pursuing returns on their cash holdings. Several factors have been driving this trend; they all start with financial regulations.

Regulatory Response to the Crisis

Among the many responses to the 2008 financial crisis from government entities, both domestically and abroad, two in particular have impacted corporate cash investments. The first is money market fund reform. When losses caused the Reserve Primary fund to “break the buck”—i.e., for per-share net asset value (NAV) to drop below $1—money market investors panicked. Many funds were forced to turn to their parent companies for cash infusions as assets went out the door. So the Securities and Exchange Commission (SEC) changed the rules for money market funds. Starting on October 14, 2016, institutional prime and municipal money market funds will no longer trade at a fixed $1 per share value; instead, the NAV will float, directly reflecting the value of the underlying assets.

The second major regulatory change is the liquidity coverage ratio (LCR), which came into existence as part of the Basel III banking sector reforms. To quote the Bank for International Settlements: “The LCR promotes the short-term resilience of a bank's liquidity risk profile. It does this by ensuring that a bank has an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted into cash easily and immediately in private markets to meet its liquidity needs for a 30-calendar-day liquidity stress scenario.”

This impacts corporate cash investing because of the way the new regulatory regime treats certain bank deposits. Large demand deposits made by institutional investors are essentially considered “hot” money. The Bank for International Settlements assumes these will be the first funds out the door if a bank runs into trouble. As a result, the new rule requires that banks hold a large amount of high-quality liquid assets, such as Treasuries, to back institutional investors' demand deposits—scaling up from 60 percent of these deposits' total value in 2015 to 100 percent by 2019. Thus, the liquidity coverage ratio makes corporate deposits very expensive for banks to hold.

The combination of money fund reforms and the liquidity coverage ratio is resulting in a cash crunch for corporate liquidity accounts. Many corporate investment policies stipulate that the only mutual fund investments that are permissible for corporate cash are shares of a money market fund with a fixed, $1-per-share NAV. Frequently, this language is echoed in control agreements, debt covenants, and a host of other legal documents that govern what a corporation can do with surplus cash.

Amending these legal documents is a difficult and time-consuming process, so a common response to the new structure is to seek an alternative to prime money market funds, a different type of fund that can guarantee the company a $1-per-share NAV. One possibility is investing in certain government or Treasury-only funds. The problem with these funds is that demand for short-term Treasury and agency paper is extremely high right now, which has driven rates down to the floor. At best, most Treasury and government funds are now yielding 1 basis point (0.01 percent).

If the money fund reforms were the only regulatory change companies were facing, many corporate investors would turn to bank deposits to stash their cash. However, because the Basel III liquidity coverage ratio has made corporate deposits costly for banks, banks no longer find these deposits very attractive. Banks have aggressively cut interest rates, and anecdotal evidence suggests that some institutions are actively seeking to discourage deposits of corporate cash.

The Fed: Changing Tack

Although the Basel III and money fund changes have been on the horizon for some time, many companies are just starting to grapple with their impact on corporate cash management. And now expectations about interest rates are further complicating the liquidity picture.

Since the fourth quarter of 2008, the Federal Reserve has held the overnight federal funds rate at zero. At the same time, the central bank has undertaken a series of “extraordinary measures” in order to bring down not just the overnight rate, but rates across the entire yield curve. The most significant of these programs appears to have been the three rounds of quantitative easing (QE) that the Fed ended in October of last year.

Now the Fed is issuing communications designed to prepare market participants for an increase in the federal funds rate. The Fed has clearly stated that its rate changes will be data-dependent, and most analysts expect the first rate hike to occur sometime later this year. The bond market already reflects this expectation: The yield on two-year Treasuries more than doubled over the past three years, from 0.20 percent on May 2, 2012 to 0.66 percent on July 31, 2015, while the yield on three-year Treasuries rose 68 basis points, from 0.29 percent to 0.97 percent, in the same period.

The rise in short-term rates (i.e., rates on bonds with a tenor shorter than three years) has steepened the yield curve and provided an incentive for investors to extend maturities. This underscores the fact that there is an economic cost associated with keeping cash in a liquidity account: forgone income.

According to Crane Data, the average annual return on a prime money market fund for the period December 31, 2012 through December 31, 2014 was 3 basis points. On a $100 million dollar investment, interest would have totaled roughly $60,000 for the two years. By contrast, the yield on two-year Treasuries on December 31, 2012 was 25 basis points. The same $100 million, invested in two-year T-bills, would have generated $500,000 in income over the same time period. So the cost of keeping cash in a prime money fund, instead of a two-year Treasury bond, was $440,000 over those two years. The difference is even more pronounced when money fund returns are compared with corporate bond funds; see Figure 1, below.

Investors Move

The convergence of these forces has triggered a change in behavior among corporate treasury managers. After years of moving funds away from strategic cash in favor of liquidity-focused accounts, corporate investors are becoming comfortable once again with investing for a longer term, primarily in corporate and municipal bonds, with some agency debt as well. For the most part, these changes are occurring within the context of companies' pre-existing investment policies; companies are electing to start funding strategic cash accounts again, drawing down money fund balances.

Most corporate portfolios fall into one of four categories in terms of investment type: They contain only U.S. Treasury bonds, a combination of Treasuries and agency bonds, only corporate notes, or only municipal debt. Because Treasuries are theoretically risk-free, the Treasuries-only portfolio is the most conservative option.

While some corporate investment policies allow only Treasuries, many more also allow investment in agency debt. Spreads for agency bonds remain attractive relative to Treasuries, especially for callable agency bonds. In fact, spreads are attractive enough that in some cases, a company may want to have agencies in its portfolio even if its investment policy allows for corporate bonds and institutional certificates of deposit (i.e., CDs that are not federally insured).

Municipal securities are typically purchased by investors seeking to maximize after-tax returns. The most significant difference between the pre- and post-crisis era is the virtual disappearance of bond insurance. Before the crisis, third-party insurance covering interest and principal payments on municipal debt was widely used to boost credit ratings and thereby widen the investor base. Now that this insurance is no longer widely available, the typical municipal investor is doing the requisite homework and so has paradoxically become more willing to add to its portfolio securities with lower—single- or double-A—ratings.

Portfolio Laddering to Increase Yield

Regardless of which vehicles a company's investment policy allows, the best practice in cash management requires the treasury function to ladder the portfolio. Laddering is a technique in which a portfolio is structured with funds allocated evenly to consecutive maturity tranches. So, for example, a $100 million portfolio might be invested so that $50 million matures within 12 months and another $50 million matures between 12 and 24 months from now.

This approach ensures that funds will be available, through natural maturities, to reinvest at higher yields if rates continue to rise. As rates begin to rise, we expect most portfolios to stay on the shorter-dated side, with weighted-average maturities of around 18 months and stated final maturities of 36 months.

The onset of the 2008 financial crisis was a tremendous shock to corporate cash investors. They responded to the shock in part by moving funds from strategic cash into liquidity accounts. Seven years later, memories of the shock have faded and been replaced by concerns about regulatory changes and forgone yields. The result has been a shift back into strategic cash. We expect this trend to continue throughout 2015 as short-term rates rise and regulatory changes bite deeper.

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Jerry Klein is a managing director/partner at HighTower at Treasury Partners in New York.

Brendan Jones is an executive director at HighTower at Treasury Partners in New York. He is the portfolio manager for the firm's Corporate Cash Management practice.

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Managing the High Cost of Liquidity

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