Cash Management in a Zero Interest Rate Environment

Cash Management in a Zero Interest Rate Environment

Money market funds have long been the default choice for cash management in organizations not large enough to house their own treasury operations. Indeed, many health care organizations fall into this category and are increasingly frustrated by the lack of any return at all on money market funds today. The average prime money market fund today has a yield of just a few basis points. The obvious reason for the lack of yield is that the low level of short term interest rates is completely devoured by management fees. The less obvious reason has to do with the difficulties experienced by money market funds during the crisis of late 2008 and early 2009 and the policy response to those difficulties.

Money market funds are mutual funds whose stated objective is to maintain a stable Net Asset Value (NAV). The idea is that your principal should not fluctuate; you should always be able to draw out what you put in. Up until September 2008, there had been only one instance of a money market fund “breaking the buck” or failing to return 100 cents on the dollar to investors. In September of 2008, the oldest money market fund in existence, the Reserve Fund, broke the buck in part as a result of holding Lehman Brothers securities. The fallout from this shattering event included changes to SEC regulations governing money market funds. The changes included requiring that funds have a minimum of 10% “overnight” liquidity and 30% 7 day liquidity. The weighted average maturity limit has been reduced from 90 days to 60 days. In addition, funds have stricter limits on lower quality investments and will be required to consider counter party risk in repurchase agreements. All of these changes serve to improve the safety of the funds, in return for lower yields than under the old regulations.

 How can financial managers improve returns on cash in this environment while managing risk prudently?

 There are generally 2 ways to improve yield in a non-levered fixed income portfolio. One can either increase credit risk or increase interest rate risk. Many had been playing the credit risk game leading up to the debacle in 2008, with disastrous results. Whether you held WAMU bonds or Lehman bonds or you had invested in auction rate preferred bonds, you were not a happy camper. Given the current environment of austerity and deleveraging, this is hardly the time to go back to that strategy.

 Tier 1 Cash

 Consider, then, a different mindset in terms of cash management. Start by calculating the immediate needs for cash. In other words, what are needs for daily liquidity? Call this your first tier of cash management and continue to use whatever you are currently using for these funds.

 Tier 2 Cash – Semi Permanent Allocation

How much of your cash position represents a “semi-permanent” allocation? Perhaps this number is some margin of safety above and beyond your average daily balance. You may need this cash, but you may not. There is a need for liquidity, but not an absolute need. The key to your strategy for this 2nd tier of cash is the trade-off between the additional return you will receive vs. the risk of principal diminution related to the modest incremental interest rate risk of the strategy. If the yield curve is steep enough, it may be that the additional return will outweigh the risk of a small decline in principal.  

Consider a fixed income strategy with a target duration of less than a year, 8-9 months for example. Given the steepness of the yield curve over the short term (see Attached “Yield Curve May 2010”), it is possible to construct a diversified portfolio that will have a yield of .70% with an approximate .85 (ten month) duration. Duration is a mathematical measure of the volatility of a bond portfolio at any given moment in time. A portfolio with duration of 1 will increase or decrease in value by 1% for each immediate change in interest rates of 100 basis points. Please note that interest rate changes that occur over longer periods of time will have a muted impact due to interest payments and yield curve “roll”.

 If interest rates rise 100 basis points, this portfolio will lose .5% of its value. On the other hand the yield at .70% is .68% higher than the average money market fund. The reward of a higher interest rate appears to trump the interest rate risk in this scenario. In reality, interest rate increases occur over time and not all at once, thereby reducing the principal reduction related to higher rates. In addition, an actively managed short term portfolio can begin to take advantage of higher rates more quickly than a longer term portfolio by reinvesting at higher rates.

 We took a look at an “ultra short” portfolio’s record of performance during periods of rising interest rates to further illustrate these points.  From May 1999 until December 2000, the Fed Funds rate rose from 4.75% to 6.50%, while the ultra short strategy had total return of 6.50% annualized. Clearly the strategy outperformed money markets during this time, partly due to the relatively modest increase in interest rates (a 36% rise).

 From May 2004 until August 2007, the Fed Funds rate rose from 1% to 5.25% (more than quadrupling the original rate), while the strategy produced total return of 3.41% annualized. Despite the large rise in rates the strategy performed well due to the long period over which the increases occurred.

In summary the smaller the rise in rates and the longer it takes for rates to rise, the better the strategy performs vs. a money market solution.

 The Federal Reserve under Ben Bernanke has been very clear regarding its intentions on Fed Policy.  In its latest round of Quantitative Easing, the Fed has said that it will continue to buy bonds until the unemployment rate comes down. By all accounts, this could be a long time. These observations lead us to believe that any increase in short term interest rates will be reasonably mild and will take some time to achieve, thereby enhancing the viability of the extension strategy.

 Tier 3 Cash – Permanent Allocation

Many organizations have allocated a piece of their investment portfolio to cash. Others have created “buckets” that hold cash before it is released to the unrestricted portfolio. This “more permanent” cash position can be thought of as Tier 3 cash, and may be afforded a slightly longer maturity profile than Tier 2 cash in this zero interest rate environment. Referring again to the Yield Curve attachment, we see that the curve remains quite steep out through 3 years. A low duration strategy designed to capture this segment of the yield curve may also benefit from a “go-slow” Fed Policy towards short term interest rates. Obviously this strategy represents an increase in risk related to higher interest rates, but offers a fairly big boost in yield as compensation. The target duration of this strategy might be in the 2-3 year range, indicating that there might be a 2.00% to 3% loss of principal in the event of an immediate rise in rates of 100 basis points. As an offset, this strategy would currently offer a yield in excess of 1%.


With the Fed funds rate stuck at or near zero, liquidity comes at a steep price. Financial managers can reduce the cost of liquidity by carefully analyzing the nature of their cash balances to create different “buckets” of liquidity need. In doing so, they assume increased interest rate risk. Managers can decide if the risk is worth taking by comparing the yield on an ultra short or low duration portfolio to the potential price volatility of the portfolio. They may also want to factor in some reasoned guesstimate of the outlook for short term rates.

About Jim Jeffery, CFA

Jim Jeffery, the founder and principal of Jeffery Asset Management has joined Solaris Advisors LLC as Managing Director where he will lead the non profit senior living effort. Jim is a Chartered Financial Analyst (CFA) with more than 20 years experience in the financial services industry. Have a question about your financial plan? ASK JIM

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