The current market environment continues to confound cash investors, who face low yields and limited supply for many short-term securities, along
with ongoing regulatory reform affecting money market funds and bank deposits. Complicating these issues are the questions surrounding the
longer-term interest rate trajectory at the Federal Reserve (Fed) and a range of uncertainties across the global economy.
Universities investing cash to meet operational needs already face certain unique limitations; these market issues only complicate the decision-making
process. Against this backdrop, it is important to construct a concrete investment framework to not only navigate these challenges but also be positioned
to take advantage of opportunities.
Challenges with cash investing …
Some themes have shaped the cash investing landscape for years, while others are new and evolving:
Low yields: Short maturity (front-end) securities have offered investors minimal yields since the Fed dropped its policy rate to a range
of 0%–0.25% in 2009. The result is that money market funds – the default choice for most cash investors – are offering near-zero returns, well below
- Limited government supply: Front-end securities are seeing supplies dwindle, especially within government space (in part because the
U.S. government is issuing less short-term debt). With yields already compressed, a supply-demand mismatch will likely constrain the extent to which yields
will rise in line with the gradual rise of the fed funds rate. (Our recent blog post offers a closer look at the changing shape of the front-end
- Limited availability of bank deposits: Another default cash management option, bank deposits offer modest yields, but given new
regulations, many banks are seeking to reduce the level to which they accommodate deposits.
- Money market reform: Announced in 2014 and going into effect in October 2016, regulatory reform of U.S. money market funds will have
investors examining what a floating NAV (net asset value) or potential fees and gates will mean for their portfolios.
… unique to universities
The treasury staff of a university has different needs and limitations relative to many other types of cash investors. While many individuals, for example,
can rely on twice-monthly paychecks or monthly interest income when planning expenditures and investments, universities’ cash flows are more cyclical,
generally tied to semiannual tuition payments but not with any definitive regularity. Therefore the amount and composition of an operating cash portfolio
tends to vary dramatically over the course of the year, and ensuring consistent liquidity is challenging.
Many universities also issue debt, meaning the treasury team is tasked not only with accommodating large inflows, but also with implementing strategies for
cash outlays that include interest payments on debt and (ultimately) principal paydowns. Moreover, there may be unanticipated liquidity needs over the
course of a given cycle.
Lastly, there may be a question of what to do with an excess cash balance (whether temporary or likely to be permanent). This balance could be a portion of
operating capital that serves as a “buffer” beyond the funds needed for daily liquidity, but for which there is no pre-specified outlay. Or these excess
cash balances may be earmarked for a known outlay, but one that is several months or even years in the future.
The task facing the university treasury team becomes identifying the right amount of liquidity for a given time period in light of all the variables, while
balancing the need to escape near-zero returns in many short-term investments.
Cash tiering approach – the first step is crucial
Although liquidity needs and external factors are always in flux, a strategic framework for managing university operating cash can help treasury teams
navigate the shifting landscape. One time-tested framework implemented by universities around the country is a cash tiering methodology.
The basic idea is to differentiate operating cash into tiers based on the timing and liquidity profile, and invest each tier in a corresponding strategy:
Tier I represents the most liquid (daily) tier of a cash portfolio, typically held in money market funds, bank deposits or a combination
- Tier II represents a still-liquid portion of the portfolio, but for less immediate cash needs. Strategies in this space remain focused
on capital preservation while incorporating a longer liquidity timeline, often six months to a year.
- Tier III represents a longer-term portion of the portfolio, typically focused on growth of the cash balance and with an investment
horizon of one year or more. Some universities will not have an outlay to this tier depending on their position.
The main focus in developing a cash tiering approach should be on identifying the portion of the overall portfolio needed for Tier I immediate liquidity.
The majority of the potential return enhancement involves that initial “step out” from Tier I strategies into other options. Also, this is not a static
process: A cash tiering approach may evolve over time along with the portfolio objectives and market environments.
What do cash tiering solutions look like?
Here are three hypothetical scenarios for universities tiering their operating cash.
- University A held the bulk of its operating cash in highly liquid but low-yielding investments, and was looking for ways to get more
yield on its cash balances. A careful assessment to differentiate tiers of needed liquidity and acceptable volatility resulted in a multi-tiered solution
to invest a portion of operating cash in a combination of short-term fixed income strategies in different amounts over the tuition cycle.
- University B wanted slightly higher returns in its daily liquidity (Tier I) cash portfolio than its current investments were providing.
A highly liquid strategy that offered return potential above money market funds targeted the dual objectives of liquidity management and investment
- University C wanted to outsource some of its Tier II liquidity. A fixed income strategy targeting duration of up to 1 year offered the
desired capital preservation benefits while significantly enhancing the yield versus Tier I options.
Is now the right time to engage a tiered approach?
At a minimum, a thoughtful exercise around cash tiering can help universities better understand their operating capital needs, regardless of whether they
implement a different investment approach. Money market funds and bank deposits continue to offer yields well below historical norms and their
inflation-adjusted returns may well be negative in the long run. We believe these trends will continue for some time.
Like many investors, university treasurers may be concerned about the effect rising rates could have on their investment portfolios, including operating
cash. A tiered approach may make sense in this environment, and PIMCO’s range of strategies can offer capital preservation even in the face of rising
rates. They seek to provide positive yields in several ways:
- De-emphasizing U.S. Treasury duration, especially in the front end
- Emphasizing floating rate securities
- Investing in high quality credit sectors and names, which we believe will benefit from an ongoing economic recovery in the U.S.
Over time, these strategies offer the potential to generate positive returns – even in a low interest rate environment – while remaining focused on
providing capital preservation, or “clipping the left tail” of risks.
Many investors are facing continuing challenges related to their cash investments. For universities, these issues are complicated by a unique set of
cyclical cash inflows and often uneven outflows. There is no one-size-fits-all approach, but an important first step is to establish a consistent framework
that matches the investment objectives and risk tolerances every day, and over the longer term.