Recent weeks have seen significant market volatility. With decades of cash investment expertise and experience, the J.P. Morgan Global Liquidity investment team navigated through the recent market volatility and, with the help of our clients, weathered through the market storm.
Q1. What caused the widening of front-end spreads in March? How is the credit profile of global banks currently?
The Covid-19 story started in January as a relatively contained event in Asia, but rapidly evolved into global lockdowns. Realizing the severity of the crisis, short-term fixed income investors started to de-risk and limited (or stopped altogether) investments in debt instruments maturing longer than one week. Issuers that were seeking funding further out the curve were forced to cheapen their offered levels to as they sought to enhance their liquidity profiles and roll maturing securities. This quickly triggered a negative cycle, raising liquidity concerns about the short-term markets in general and causing spreads to widen across the board.
However, this situation was very different compared to the global financial crisis (GFC) which was driven by fundamental credit issues in the banking and financial sector. Since GFC, significant reforms have taken place in the banking and money market fund (MMF) industry across the globe. Banks possess much stronger balance sheets from both a liquidity and capitalization perspective and MMFs have also seen numerous structural enhancements. The volatility in March was centered on market liquidity, which was quickly repaired by aggressive central bank action.
Q2. The Federal Reserve has rolled out numerous measures & programs over the past months. How does that impact credit spreads, and offshore USD liquidity funds?
The speed at which the Federal Reserve (Fed) intervened and restored market liquidity was impressive. The Commercial Paper Funding Facility (CPFF) was the first program targeted at short-term fixed income markets and provided liquidity for commercial paper (CP) issuers, relieved some of their funding pressures, and put a ceiling on spread levels in the domestic U.S. CP market.
The Primary Dealer Credit Facility (PDCF) soon followed and provided liquidity to broker-dealers, but its usage was constrained by balance sheets implications. The subsequent Money Market Mutual Fund Liquidity Facility (MMLF) was a real game changer. The MMLF enabled MMF managers to sell CP, Certificates of Deposit (CDs), and other instruments to the Fed through banks and broker-dealers at amortized cost. With balance sheet constraints removed for the banks and broker-dealers that facilitate these transactions, liquidity has greatly improved for MMFs.
The Fed programs have successfully repaired market liquidity and restored investor confidence in the function of short-term fixed income markets. In particular, the CPFF and MMLF have stabilized MMF cash flows and spreads in U.S. domestic market. While the offshore USD liquidity fund market does not have direct access to the various Fed programs, there have been clear secondary benefits and therefore cash flows in those funds have stabilized as well.
Q3. According to U.S. and European regulations, what are the requirements on cash holdings and weekly liquid assets (WLA) in MMFs?
Regulations in the U.S. and Europe are broadly the same with some nuances. In general, a MMF should possess at least 30% of weekly liquid assets (WLA). In the U.S., falling below the 30% threshold will trigger a required obligation for a fund’s board to meet in order to discuss the liquidity profile of the fund and to better understand what drove the WLA below the 30% requirement. It is at this time that the Board can decide to just to let the fund’s liquidity repair naturally through maturities or they can choose to impose a gate and/or a fee, if the circumstances justify such a response. For European funds, the same will be triggered only if simultaneously the fund’s daily outflows exceed 10%.
30% WLA represents an extremely robust liquidity position. However, some investors preferred to redeem from funds that saw WLA drift toward 30% given the uncertainty around a board decision if that threshold was crossed. As the Fed stepped with the various facilities targeted at liquidity in the short-term markets, fund WLA levels recovered and cash flows turned positive for most funds.
WLA is a critical threshold for MMFs providers. MMF providers should actively manage this metric and ensure a healthy liquidity buffer above and beyond the regulatory minimums. In some scenarios, this may involve selling securities in the secondary market to ensure liquidity, but fund managers need to be mindful of investor concentration risk and the term structure of their portfolios, both of which can help limit the impact of redemption activity.
Q4. USD liquidity solutions are available for onshore and offshore investors respectively. What are the major similarities and differences between their underlying investments? What should investors focus on when evaluating a strategy or fund provider?
Similar to the regulatory requirements for WLA, onshore and offshore strategies are fundamentally the same with some relatively minor nuances. Fund managers typically apply the same management process and constraints on underlying investments to both strategies. The same regulatory requirements of 60 days weighted average maturity and 120 days weighted average life carries across both strategies. A notable nuance is that offshore strategies are subject to tighter regulations on the use of repo and typically can only use U.S. Treasuries as collateral with a maximum maturity of two business days on the repo transactions.
Now more than ever, cash investors should carefully examine their asset manager’s approach. First and foremost, consider the fund’s size and scale. This is not only important for diversification of investments and clients, but also tends to be correlated to the asset manager’s ability to raise and manage liquidity in times of stress. A manager with scale can typically tap into deeper secondary market liquidity with a broad array of core trading counterparties. Furthermore, WLA and mark-to-market net asset value (NAV) are good indicators of the fund’s liquidity and risk profiles, as well as its asset manager’s ability and track record in navigating through market volatility. Last but not least, review the asset manager’s experiences and approach during recent market events including the GFC.
Q5. What are the key criteria to successfully manage adequate liquidity?
Manage a portfolio’s liability structure and understanding client cash flows needs and trends are key aspects of any liquidity strategy. An asset manager should conduct extensive quantitative analysis to fully understand client cash flows, ensure the flows are within an acceptable tolerance range and review any outliers on a regular basis. Also, an asset manager that has a dedicated global distribution team typically maintains better relationships with clients and therefore have deeper insights into cash flow needs and timelines. This does not only mitigate portfolio risk, but also can help the manager better accommodate significant flows needs from clients.
Q6. Looking ahead, what are your views on U.S. rates and the credit outlook?
Under normal circumstances, yields of MMFs typically fully reflect the impact of a Fed cut four to six weeks after the Fed changes its rate due to the product’s short duration nature. The emergency 150 basis point rate cut by the Fed has brought the Fed Funds target range back to 0%-0.25%. However, the unprecedented fiscal stimulus in the U.S. has shored up supply in the front end, kept U.S. Treasury bill rates elevated and therefore MMF yields will take more time than usual to fully reflect the Fed’s rate reduction. This creates an opportunity for investors from a yield perspective. Moreover, the spread differentials between government funds and credit funds is approximately 40 bps in the domestic market in U.S. and as high as 60 bps in offshore market which is another historically compelling opportunity.
The range of yields in credit funds is wide across the various funds and providers in this space which is an indicator of how some have been more successful in managing through the recent volatility than others. Funds that experienced more muted outflows and benefited from stronger liquidity management are generally offering higher than average yields.