Benchmarking Your Cash: Part 1 Navigating the Evolving Landscape
With interest rates at levels not seen for 10+ years, the question ‘what's a good yield on my cash?’ is top of mind for many investors. Understanding how to benchmark and compare your cash investments is crucial for optimizing returns, assessing risk, and making informed decisions in a changing market.
“You can’t improve what you don’t measure.” – Peter Drucker
Since 2015 the Fed has moved interest rates by almost 1,000 basis points: up, down, back up and most likely back down this year. With the emergence of new liquidity products (deposits, DEI share classes, earnings & tech credits) and the evolving rate environment, institutional cash investors are faced with a difficult question, “Is my approach to managing our organization’s liquidity competitive?”. We at SSGA receive this question continuously and work closely with our clients and prospects to help them benchmark their cash based on liquidity type, whether that be operating, core, or strategic.
Using Benchmarks for Cash Investments
The overarching goal of a traditional cash product is to preserve principal and provide liquidity. As such, they do not tend to have benchmarks in the more traditional sense, where a portfolio’s aim may be to match or exceed the performance of its benchmark index. The benchmark rate or index chosen for a cash product is more indicative in nature, and can help to measure a portfolio’s performance over a risk-free rate of return or against a pool of similar products. Commonly used benchmarks in the cash space include:
- SOFR (Secured Overnight Financing Rate): The leading replacement for LIBOR, SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. It's considered risk-free, as it's based on actual transactions rather than estimates.
- T-Bill Rates (U.S. Treasury Bills): The yield on short-term U.S. government debt serves as a benchmark for risk-free returns. Investors often compare their cash yields to the relevant T-Bill maturity to gauge whether they're being adequately compensated for credit risk.
- Fed Funds Rate: The target rate set by the Federal Reserve for overnight loans between banks. It influences other short-term rates, including those on bank deposits and money market funds.
- BSBY (Bloomberg Short-Term Bank Yield Index): A credit-sensitive index designed to reflect the average borrowing costs of banks. It had been considered a potential replacement for LIBOR in certain markets although US regulators have requested the index not be supported.
- Money Market Funds and Money Market Fund Indices: Relevant money market funds or money market fund indices which track average yields can be a reliable way to measure a market rate of return. Indices are categorized by asset type (e.g., government, prime) or share class (e.g., institutional, retail). Providers include: Crane Data, iMoney, S&P, and others. Note that these options may not perfectly align with your specific portfolio strategy.
Pros and Cons of Different Benchmarks
| Benchmark | Pros | Cons |
|---|---|---|
| SOFR | Risk-free, reflects actual transactions | Backward-looking with no credit component or term market |
| T-Bill Rates | Risk-free, easily accessible | May not fully reflect credit risk taken by other cash instruments |
| Fed Funds Rate | Widely followed, influences other rates | Doesn't directly reflect yields on most cash investments |
| BSBY | Credit-sensitive, potential LIBOR alternative | Regulators not supporting the index |
| Money Market Fund Indices | Easy to compare against your fund | May not be perfectly aligned with your fund's specific portfolio |
A Note on the Transition from LIBOR to SOFR
LIBOR's phase-out resulted in a number of market-wide changes. In advance of the switch, millions of contracts referencing LIBOR needed to be transitioned to new benchmarks, with SOFR being the dominant benchmark for many financial products. In addition, the dissolution of LIBOR also forced investors to use alternative methods to gauge risk in the absence of the legacy LIBOR/OIS spreads. The absence of a term structure and the lack of a credit component to the SOFR replacement have created a void, and the difference in its calculation methodology has made risk assessment more complex. Today, investors must take a multi-faceted approach to measuring portfolio risk, with metrics including:
- Credit spreads: The difference between the yield on a credit-sensitive instrument (like commercial paper) and a risk-free benchmark (like a T-bill).
- SOFR term rates: While not yet as developed as the LIBOR curve, SOFR term rates are emerging and can be used to assess risk (term premium) across different maturities.
- Credit rating analysis: Investors continue to rely on credit ratings to assess the creditworthiness of issuers and the associated risk of their cash investments. This is a backward looking measure and should be applied with caution.
- Understanding interest rate duration and credit duration. Commonly referred to as weighted average maturity (WAM) and weighted average life (WAL), these measures are essential in recognizing how a fund could lose value in a stressed market environment.
Benchmarking Beyond “Cash”
Ultra-Short Bond Funds invest in short-term bonds and can offer higher returns than money market funds, albeit with greater credit and interest rate risks. If benchmarked to a traditional money market fund or money market fund index, one could easily compare the incremental risk to the associated returns over a full economic and credit cycle.
Things to Consider when Choosing a Cash Strategy
- Competitiveness: Compare yields to relevant benchmarks and similar products from other institutions.
- Safety and Liquidity: Prioritize globally systemically important financial institutions (GSIFI) bank deposits or government money market funds for maximum safety.
- Peer Comparison: Industry surveys and reports can provide insights into yields for different types of cash investments.
- Proactive Adaptation: Stay informed about regulatory changes and market trends to adjust your cash strategy as needed.
- Performance During Stress: Choose highly liquid investments with minimal credit risk to weather market volatility can be a top priority.
- Analyzing Returns: Comparing returns over a full economic and credit cycle is important when considering the full range of cash and short term investment options.
Key Takeaway
Benchmarking your cash investments is an ongoing process that requires staying informed about market developments and adjusting your strategy accordingly. By understanding the available benchmarks and their nuances, you can make informed decisions to optimize your cash returns while managing risk effectively.
In part 2 of this series we will explore the various types of returns that are available to cash investors in the cash and short term fixed income universe and how those returns have performed over time and through various economic and credit cycles.