Before the summer of 2007, most cash investors felt little need to ask questions about the specific holdings within their money market and enhanced cash investments. Money market and enhanced cash strategies were doing what was expected of them. Money markets provided liquidity and principal preservation with consistent returns and enhanced cash strategies had moderate price volatility with stable returns over money markets. 

Investors were also comfortable because they thought they were taking little risk in their money market and enhanced cash strategies. These strategies had high average credit quality and yields were at reasonable levels compared to Treasuries and LIBOR rates. Money market and short-term bond investments were a stable corner of the fixed income universe, and investors presumed it would remain that way.  Unfortunately for many, that perception turned out to be far from the truth and the results have been quite painful for some investors.

What Happened and Why?
In recent months, some enhanced cash strategies have experienced significant volatility and a decline in value, even those with an average credit rating as high as AAA. While money market sponsors have stepped in to prevent similar declines in value, uncertainty about money market investments has increased. Suddenly, investors awoke to the fact that there is a potential for a loss of principal in strategies where the primary objectives are preservation of capital and a reasonable level of liquidity.

How has this happened? Over the past few years, the securities that money market and enhanced cash strategies traditionally invest in have provided low yields and low risk premiums compared to historical levels. This led many managers to search for alternative sources of high quality yield in cash portfolios. Asset-backed commercial paper (ABCP) offered just that: higher yields with AAA credit ratings. Until recently, ABCP routinely yielded 1-2 basis points more than traditional commercial paper, a staple of money market and enhanced cash portfolios. ABCP is a classic case of borrowing short to lend long — in essence, arbitraging the investment time horizon but outside of the banking system. Although the underlying assets in ABCP were not transparent, investors did not scrutinise them because of their high credit ratings. And while the underlying assets were presumably diversified, about 12-15% of the ABCP market was backed by subprime debt in structured investment vehicles (SIV) or collateralised debt obligations (CDO).

When rising concerns about subprime loans prompted a liquidity crunch this summer, the ABCP market stopped dead. Investors did not care if the ABCP was rated AAA; if there was an association to SIVs or CDOs, investors did not want to extend credit. As a result, ABCP spreads have widened to historical levels and some money market and enhanced cash strategies have been forced to write down the value of their assets.

What happens now? Enhanced cash strategies could continue to experience pain. Most of the underperformance in ABCP to date is the result of market-driven price changes, rather than actual credit deterioration. Headlines are likely to remain negative, leading to continued deleveraging and the potential for even wider spreads in ABCP. While we expect money market sponsors to continue to support the value of their money market strategies in order to protect larger franchises, there are no guarantees.

Is Your Manager Taking Excessive Risk With Your Cash?
For many investors, the unexpected volatility that some money market and enhanced cash strategies have experienced has brought the realisation that managing cash is not as simple as it may seem. At PIMCO, we believe this is a very positive development. Investors should review their investments and make sure their manager can answer some fundamental questions about philosophy and process to determine whether their manager is taking excessive risk in investments that should be stable. Key questions include:

• What is your philosophy for managing cash?
• What is the investment process?
• How do you analyse and pick credits?
• How and why have you been impacted by recent market events?
• Do you own any ABCP? How much credit support is there?
• SIV or CDO exposure? What tranches do you own? 

How would PIMCO respond to these questions?

Our philosophy is that money market investments are the equivalent of cash, which means that protecting principal is paramount and it does not make sense to take on risk. Enhanced cash strategies, as a substitute for cash, differ from money markets since investors expect the manager to take on some risk in order to generate a return. Nevertheless, even in these strategies, our philosophy is that liquidity and principal preservation are extremely important objectives, so significant risk taking is not prudent.

Our philosophy dictates that our process emphasises risk management in money market and enhanced cash strategies. One way we manage risk is to employ a very senior team of portfolio managers to oversee our money market and enhanced strategies. Our portfolio managers have experienced many market cycles and understand cash equivalent instruments and securities and the risks associated with them. As a result, they stuck to the firm’s longstanding philosophy: focus on the long term, strive to produce consistent results and do not allow market changes to influence our belief that investors should always be fairly compensated for the risk embedded in securities, even those in the money markets.

A second way we manage risk is to employ an internal team of credit analysts so that we do not have to rely on the rating agencies. Our analysts recognised the risks involved in ABCP due to the lack of transparency in the underlying assets, and we avoided the sector because we could not quantify those risks.  In fact, our risk management process led us to make a policy decision years ago to avoid any meaningful exposure to ABCP and debt associated with SIVs.

A third way we manage risk is to employ a broad opportunity set, which allows us to diversify our portfolios and help us to avoid excessive exposure to any one sector or issuer. Our philosophy and process has helped us to avoid any meaningful exposure to ABCP, SIVs or CDOs.

Conclusion
As investors continue to realise that managing cash is no simple task, we expect that they will take less risk in these portfolios and increase their level of scrutiny. At PIMCO, we welcome this development. Cash management is not an area where investors need to take on significant risk. Investors should take risk in other portfolios and keep their cash portfolios focused on the key objectives of liquidity and principal preservation.