At the end of 2016, more than 5% of insurance company admitted assets were held in Cash, Cash Equivalents and Short-Term Assets.1 Assuming these assets could be worked harder, a conservative estimate adds an incremental 40 basis points of yield, meaning the industry could earn another $1+ billion of additional annual income. Much of the damage wrought upon fixed income investments during the Financial Crisis was centered on “cash equivalents” such as Structured Investment Vehicle notes, Auction Rate Securities, and securities lending programs. While it is prudent to focus on capital preservation with cash assets, these 2007 bogeymen do not need to haunt investors forever.
WHY SHOULD YOU CARE ABOUT YOUR CASH?
Cash is a strategic allocation. It is necessary for the day-to-day operations of an insurer in taking in premium and paying out claims. It is also a frictional result of longer-term investment strategies.
An active approach to cash management reduces the income drag of passively sitting in sweep programs or money market funds, while minimizing the liquidity risks of blindly chasing yield. We seek to enhance performance without compromising liquidity and stability. Our history has shown this goal can be achieved.
Payden & Rygel was founded in 1983 on the premise that companies can do more with their operating cash than buying money market funds and rolling Treasury bills. We have successfully navigated the ups and downs of the market, through good and bad cycles.
We have shown that by taking well-managed incremental interest rate and credit risk, companies can earn an attractive return on cash while maintaining adequate portfolio liquidity. Today, Payden manages more than $30 billion of assets in this strategy for insurers and more.
HOW DO WE THINK ABOUT YOUR CASH?
The basis of our operating cash strategy is that the portfolio needs to be liquid, but not every security needs to be available to function as daily liquidity. Money market securities have less price risk and lower trade costs than corporate bonds, but both can be sold to generate funds, and over certain holding periods the corporate bond can earn enough return to overcome the higher cost of transaction. Rather than viewing all operating cash balances as needing immediate liquidity, tiers of liquidity requirements allow for an optimized combination of return generating and highly liquid investments. Re/insurance companies are particularly well suited to optimizing their cash balances ahead of claims payments. Using estimates for the size and timing of outflows, cash set aside for claims settlements can be invested with some flexibility.
With an understanding of these relative liquidity requirements, the stable portion of a cash allocation can be invested in an income and return generating strategy, the so-called ‘core’ portfolio. Investments in the ‘core’ portion of the portfolio are available to be invested in a broad set of opportunities, subject to regulatory considerations and investment guidelines, which typically include 1-3 year investment grade corporates, asset-backed securities, and mortgage-backed securities. Active sector and duration themes will be reflected in this portion of the portfolio. Layered on top of the ‘core’ portion is the so-called ‘flow’ portion of the portfolio. Typical investments include repurchase agreements, commercial paper, Treasury bills, agency notes, and short corporate bonds, securities with very low transaction costs.
Isn’t it prudent to segregate cash needed for different purposes? Not necessarily, mainly because cash is fungible; there are efficiencies gained in aggregating cash and viewing it as one comprehensive portfolio. Securities that were purchased as income generating investments can be used for liquidity when they generate coupons, mature or become overvalued. For example, a three year corporate bond may be purchased as a ‘core’ investment but could be considered a ‘flow’ asset after two years have passed. In a classic low duration portfolio, that bond would likely be sold and rolled out the curve. This constant cycle of securities rolling into the liquidity bucket or maturing to fund outflows reduces transaction costs and improves the total return of the portfolio.
In addition to dedicated operating portfolios, Payden has developed bespoke structures to facilitate the combination of cash across separate portfolios, legal entities and domiciles. These allow for maximum utilization of active and fallow cash for improving the overall liquidity and return profile of an organization—an holistic approach.
Advantages of the Payden Enhanced Cash Strategy
- Higher yield by 59bps – net!
- Capital efficient (statutory and SII) – low RBC
- Greater diversification of corporate credit
- Higher allocation to US government securities
- Ability to take advantage of steep yield curve
- Participates in syndicated corporate markets
SO WHAT’S THE BIG DEAL?
In addition to structural benefits mentioned earlier, extending your cash investment universe out the maturity curve and down the credit spectrum has multiple benefits. The primary benefit is the increased diversification of credit exposure. While prime money market funds with a maximum maturity of 397 days have large allocations to financial risk through repurchase agreements, certificates of deposit and demand deposits (Chart 1), a diversified enhanced cash portfolio can access asset-backed securities, industrial corporate issuance and even generate returns from government securities (Chart 2).
The inclusion of government securities also reduces the overall Risk-based Capital (RBC) for the portfolio, allowing for additional BBB-rated credit to be utilized without incurring a higher total RBC than current cash, cash equivalents and short-term investments. The example portfolio in Chart 2 carries only 0.35% RBC for Health and P&C companies.2
How does the portfolio generate returns from government securities? Recognizing the positive slope of the yield curve can add yield and capital appreciation to a portfolio in many environments. This also applies to the incorporation of fixed coupon corporate debt and asset-backed securities beyond the money market universe.
WHAT ABOUT THE RISKS?
Any time one moves away from a deposit at the bank or a government money market fund there is a potential for negative mark to market. With the understanding our strategy takes on additional risk, we believe the higher returns, nominal and risk-adjusted, reflect the benefit of taking these incremental moves out the curve. The pull-to- par characteristics of short maturity securities can result in very low volatility of returns, and infrequent negative returns. The scenario analysis in Table 1 illustrates this feature. Using the sample portfolio from Chart 2, we look at the return experience over six months, under various stresses. In this example, the portfolio could withstand rates moving higher by 100bps and credit spreads 50bps wider without generating a negative return.3
Using our enhanced cash composite as evidence, our experience over the past 34 years has avoided negative returns over any six month rolling period (see Table 2). The negative returns over shorter periods primarily occur during periods of rapid rising rates (ie. 1994) and are quickly recouped by higher portfolio yields moving forward.
Esoteric assets, lower rated credit, and longer durations have been the trend in insurance portfolios looking for higher returns in a low yield environment. Cash balances are often dismissed as a necessary drag on investment performance. Payden & Rygel believes there is an opportunity to better utilize this strategic asset and increase the overall nominal and risk-adjusted return profile of an insurance balance sheet.
1. snl.com, Cross Sector Industry, Financials, U.S. Statutory, NAIC Format
2. NAIC Investment RBC Charges (05/10/2016) and Payden & Rygel Calculations
3. Bloomberg Barclays and Payden & Rygel Calculations, as of 9/30/17