When we think of the most important components of our portfolio, it is easy to overlook cash. Investors seeking to diversify their investments will typically keep a portion of their funds in cash or enhanced cash funds to ensure a readily available funding source for expenses or to allocate to other assets. Despite the importance cash plays in our portfolio, we tend not to focus heavily on the risks that enhanced cash funds can pose during periods of market stress.

As the Covid-19 pandemic rolls on, with further lockdowns and more stringent social distancing measures in some parts of the world, it is critical that we learn the lessons of the dislocation that hit credit markets in March. This means taking a close look at the risks inherent in enhanced cash products and how to mitigate them to create a more robust portfolio, especially during bouts of volatility.

As a relatively low risk, defensive asset, investors typically expect their cash to provide regular income and capital stability within their diversified portfolio. Some investors, in order to generate enhanced returns relative to cash funds, invest in enhanced cash products that carry greater risks that some investors may not always be fully aware of. These risks have come to light in recent months and emphasized the need to carefully manage the cash component of your portfolio.

Enhanced cash products in the past few months have been impacted by the Covid-19 health crisis, which has caused financial market volatility the magnitude of which was last seen during the Global Financial Crisis (GFC) in 2008-09. This volatility has caused the Reserve Bank of Australia (RBA) to reduce the official cash rate to a record low 0.25% and hold the yield curve out to three years in a range around the same level.

Record low interest rates have significantly reduced the income received by investors, and this problem has been further compounded by capital stability concerns as financial markets turmoil has seen the price of some cash assets fall and yields rise relative to the RBA cash rate. As a result, some enhanced cash funds in this record low yield environment surprised unit holders by producing negative absolute returns during the March quarter, while other enhanced cash funds continued to produce positive returns, albeit with relatively low yields.

This has served as a timely reminder that you need to look at not only the returns but also the risk characteristics of individual enhanced cash products. This is critical in order to understand the impact of financial market volatility on the risk of your cash holdings.

Enhanced cash funds are exposed to credit risk, term risk, and liquidity risk. These refer respectively to the risk of losing capital due to default by security issuers, the changes in interest rates that adversely affect the price of the securities, and the inability to convert the securities into cash without any loss of capital. Given these risk factors, the returns for enhanced cash are sourced from each of these risks accordingly (i.e. credit premium, term premium, and liquidity premium). Among all the premiums, credit premium is typically the main contributor of enhanced cash fund returns when compared to cash fund returns.

Enhanced cash products typically invest in high quality investment grade securities and cash accounts with an average credit rating of A+ or A1, where the probability of losing capital or suffering delayed payments is very limited. These investments may include overnight cash accounts, bank bills, promissory notes, asset-backed securities such as registered mortgage-backed securities (RMBS) and floating rate notes (FRNs) issued by semi-governments, and corporates, all of which are common constituents of enhanced cash strategies.

Of these securities, RMBS and FRNs are assets that are sensitive to price movements, which in the current Covid-19 situation are at risk of becoming stressed if credit and liquidity conditions deteriorate. As a result of stressed market conditions, some of these security prices are adjusted lower. Enhanced cash fund unit prices become materially impacted and those investors looking to redeem their funds may find the fund product’s sell spread has widened or redemption price has risen materially.

This sell spread change considers the increased trading costs during such a volatile period, which is passed on to the investor redeeming their funds, rather than impacting unit holders that remain in the fund.

These lower unit prices and increased transaction costs caught investors unawares in March and caused some enhanced cash funds to achieve short-term negative returns. A stressed liquidity and credit experience with enhanced cash funds also occurred during the GFC. The severity and duration of the GFC was different to the current crisis, and many enhanced cash funds recaptured their underperformance relative to cash funds following the GFC. The lesson is that the search for additional return beyond cash rates, which comes with increased risk, must be done cautiously.

On average, enhanced cash products usually have within the fund securities with a longer weighted average life or maturity than traditional cash funds. This longer maturity profile exposes enhanced cash funds to greater interest rate risks and therefore an expected higher term premium. When interest rates are falling, enhanced cash funds with their longer maturities benefit from the rise in securities prices and receive a capital gain greater than a cash fund. However, when interest rates are rising, enhanced cash funds are at a slight disadvantage because of this interest rate risk when compared to cash funds.

Overall, given current financial market conditions, it is important to take a closer look at enhanced cash funds and make prudent assessments based on the different risks they are exposed to. Compare the credit risks, maturity profile (also known as duration), and liquidity, both across individual enhanced cash products and compared to cash funds and understand the trade-off that is being made to achieve a higher return. It is important to critically assess these differences, especially during downside scenarios and periods of heightened uncertainty.

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