Cash is king...again Cash is king...again\images\insights\article\chess-money-small.jpg January 21 2020 August 30 2019

Cash is king...again

How are rate cuts affecting liquidity products?
Published August 30 2019
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Podcast Transcript
Linda Duessel: Hello and welcome again to the Federated Hear & Now Podcast. I'm Linda Duessel, Senior Equity Strategist at Federated Investors. Today, I'm joined by Debbie Cunningham, our Chief Investment Officer of Global Liquidity Markets. Debbie, Liquidity Products saw record inflows in this year's second quarter. What drove that growth?
Debbie Cunningham: Well, there were three major reasons, Linda. First of all, interest rates are no longer at zero, so this has made cash an asset class again. Ultimately when we went through the decade of zero interest rates, people used cash because they needed to have liquidity for daily, weekly, monthly purchases, but other than that, it really wasn't something that was allocated because of the low return associated with it. But given that we no longer have those year interest rates and were at interest rates that are in the 2% range, that has worked well as a safe Harbor to some degree for those that are allocating. Money market rates also look very good versus other short term liquidity alternatives, especially deposit products. When you look at deposit betas, it's essentially the rate of change for bank deposit products versus what's happening from a rate of change in a markets rate basis. It's as low as it's ever been in a rising rate environment. Granted, we may be ending that rising rate environment now, but nonetheless, at 29%, that essentially means for every hundred basis points that the Fed raised, deposit products went up by 29 basis points, and that's the institutional side of things. The retail side of the market is even worse.
Linda Duessel: I see.
Debbie Cunningham: Ultimately, we've had very good growth because of the comparison to that deposit product. When we're looking at overall rates now, you're looking at something that from a government product standpoint in money market funds, it's about a 215 to 220 gross yield. Prime products are 233 to 235. Even when you're looking at tax freeze in the muni side of the equation, 140 to 150, all of which are much, much higher than those deposit products. The third major reason is basically what I mentioned before, that liquidity products, money market funds in particular, have been a safe haven in quite volatile times. If you go all the way back to 2018, it was the only one of the three major asset classes that actually had a positive return.
Linda Duessel: Wow, that's pretty spectacular.
Debbie Cunningham: It is. And with all the global issues and uncertainty that are happening second quarter, change in heart from a Fed perspective, what might be happening from an immigration standpoint, where we are with regard to trade wars, Brexit, how that impacts us and whether it's hard or soft or none, all of these things I think came to a crescendo in the second quarter and allowed people to take a safe haven approach, which put them into the liquidity markets.
Linda Duessel: I guess to put it in layman's terms, cash is now king.
Debbie Cunningham: Cash is looking pretty good. Even when we're looking at other types of fixed income securities. We've got a three month [inaudible 00:03:20] at 215, that's kind of a bellwether for where our prime product yields are. One year treasury is at one 72, that's pretty indicative of where treasury and government products will be going. Two year treasury is at a 160, 10 year treasuries and a 161. You're getting as much if not more of the yield and none of the volatility that's associated with longer term yields in the fixed income markets, so it's a great place to be.
Linda Duessel: Yes. Great. Well, you know Debbie, I'm an equity lady, and as an equity lady, we're still very, very interested in what the Fed's doing. Everybody's hanging on every move about the Fed. Not being a cash lady, I'm wondering from your perspective whether the Fed is in the midst of a mid cycle adjustment, or actually its first easing environment in a decade, what has been the effect on money market funds and what would one or two more cuts mean for liquidity products?
Debbie Cunningham: Sure. Well, the impact so far has been a direct one. The Fed lowered rates by 25 basis points in July, and if you look at our yields now in the money market industry, there are 25 to 35 basis points lower than where they were in the end of the first quarter, which is when the adjustments in the marketplace began to ring through. So 25 to 35 basis points lower now. Ultimately, if the Fed lowers rates by another 25 or 35 basis points or 25 or 50 basis points, you're going to see a same direct impact with about a month to six weeks sort of lag. From an asset growth perspective, that's basically been the second major impact. The asset growth has been tremendous. So when we look on an industry basis at total prime assets over the course of the last year ending at the end of the second quarter, June of 2019, the industry has had a 42% growth rate. Federated assets in the prime sector, up 55% government assets. On an industry basis, up 8%. Federated's government assets up 21%. And on the muni, side industry is only up 1% but Federated's up 25%, so the second major impact has been with regard to asset growth, so yield asset growth. Ultimately, I think from a yield perspective, the market grew lazy once interest rates went below 1% and it no longer proved cash no longer proved to be an asset allocation tool at that point. It was still a liquidity product and it was needed for daily transactions, but it was no longer an asset allocation. We're a long way off from that, and whether the Fed's most recent cut was an insurance cut or whether it's more programmatic to lower rates, I think nobody at this point thinks that they're going back below that 1% barrier.
Linda Duessel: Well, great, but in the event that we actually are in a declining rate environment, how do you see money market funds fairing when compared to bank products?
Debbie Cunningham: Definitely awesome in the current environment. Because of that deposit beta and the bank's lack of moving interest rates up over the course of the last two and a half years in the increasing rate environment, the markets had begun to move away from bank deposit products. Bank deposit products were the place to be in the financial crisis. 2008, 2009 they were 100% guaranteed for a period of time and the markets flocked to them. That larger growth and larger base of assets continued through the zero rate environment, and it wasn't until the Fed started raising rates at the end of 2016 that you actually started to see that reverse. Now at this point, you see deposit rates changing somewhere in the neighborhood of two to 10% over the last one to three years, versus money market rates changing anywhere from 10 to 20%, so larger growth having already happened. In a declining rate environment, that will even grow larger, because the banks have already lowered their rates. They don't follow interest rates up very quickly, but they do follow interest rates down very quickly. They want that increasing margin increasing spread on their books.
Linda Duessel: Very, very important.
Debbie Cunningham: Absolutely, and it's important to us as analysts, we like it as credit analysts that are using those banks on a continuous basis. But the underlying customers of those banks are getting lower rates because of that, and ultimately in a declining rate environment, they followed those lower rates down quickly. At this point, we've just begun to see that process occur, and we have seen an enormous amount of assets into the industry, that if future cycles follow past, will repeat itself with more of that happen.
Linda Duessel: This could be only the beginning of more and more than.
Debbie Cunningham: Exactly.
Linda Duessel: Excellent. Then finally, an area that's becoming a quite a lot of interest these days, ESG. We're seeing some liquidity products integrate ESG into their credit analysis. Can you explain what's behind this? And more fundamentally, how incorporating environmental, social, and governance factors into credit analysis works in the world of liquidity products?
Debbie Cunningham: Certainly. As a 2a-7 money market fund, we are required by the SEC to make sure that all of the issuers that we use within those 2a-7 money market funds are of high quality and represent minimal credit risk. That's the basis that forms our credit analysis process according to what the SEC mandates. The ability to do that requires us to look at both quantitative and qualitative factors associated with each of the issuers and the industries that we follow. The quantitative factors are generally very cut and dry: capitalization, what the profitability, how the liquidity of the product is leveraged, that sort of thing that we look at on an issuer basis. But on the qualitative side, it's much more touchy-feely. We tried to assess what's happening from a management perspective. We try to look at what's happening from an overall social perspective, how the product fits in with what trends are, how it might be losing favor. If it's not a product, if it's a service, how that service is regarded. That's the key to integration from an ESG perspective.
Debbie Cunningham: Federated has a 60% ownership of Hermes Investment Management as of July of 2018, so a little over a year at this point. And at that point, we took about a six month time period to assess and understand what exactly it was that Hermes Investment Management with their full integration in all of their products have ESG assessments, as well as something that they call EOS was, which is equity ownership services, whereby they are engaging their issuers, not only on how they currently are rated and ranked with regard to environmental, social, and governance issues, but where they might be going with those rankings, and trying to develop success stories with those issuers. We reviewed that and studied that for about a six month time period, and then beginning in 2019. we began to integrate the information that we receive from our Hermes counterparts in our London office, that information into what is basically the qualitative assessments that our investment analysts do to continue to help them in their minimal credit risk, high quality determinations. Much like having a new provider of inputs to our credit analysis process, that's essentially what we're utilizing from an ESG perspective, and trying to understand, and it's focused mostly on the qualitative aspects. The benefit that we think is flowing through from our Hermes acquisition is having that internal to us.
Debbie Cunningham: So, we understand their process. We have internal dashboards that are proprietary in nature. Yes, there are third party providers that we use MSEI, Sustainalytics to name a few, but Hermes is a proprietary tool that only Federated has at its disposal, and we think that that in fact allows us to improve our credit analysis process in a way that accepts the information from them into that qualitative associations and assessments. Our one through five rating scale, which is how we internally rank the issuers that we use within our 2a-7 money market funds can either be neutral, or positive, or negatively rated, or factored, when we look at the inputs that come from Hermes. Generally speaking, we've always used qualitative assessments and we've reviewed what's happening from an environmental, social, and governance perspective, but the unique aspects of the Hermes input has given us additional insights, and that's effectively how our process of integration has proceeded in our liquidity products at Federated.
Debbie Cunningham: What we haven't done yet at this point is begun a named ESG money market fund. We may, we may not. It will be driven by client requests, essentially. I think at this point when we see what's happening from our own client standpoint, the ESG assessments and integration are being driven by the coastal clients, so East coast, West coast, both have what seems to be more of a unique interest and need in understanding how environmental, social and governance aspects impact our credit analysis process. There may be some in the Midwest. And when we look at European and operations in Germany, in Dublin, and in the UK, those essentially are much more currently impacted by customers who want to, perhaps, have a named product. And what does a name product mean? ESG in the name versus an integrated product, which says nothing about ESG and it's name, but in fact has ESG integration into its credit analysis process. What's the difference there?
Debbie Cunningham: It's essentially, in our opinion, the ESG named product is exclusionary to some degree, so there has to be a way from an SEC requirement standpoint to cut off who we would use from an ESG perspective in a ESG named product. And rather in an ESG integrated product that doesn't have it in the name, we don't have to have a cutoff below which we won't invest and above which we will. And in fact, maybe we own some issuers that are below what would be sort of the natural cutoff in the marketplace, but if those issuers are trending upward and improving their ESG footprint, we look at that more favorably than maybe somebody that's currently on an issuer basis above that cutoff in the marketplace but trending downward. It allows you flexibility to have the integration approach, which is what we're taking, rather than the name to approach. We will take the name approach, however, if it's client demanded.
Linda Duessel: Well that's great. Thank you, Debbie, so much for explaining that. It seems that that your group is very far along in this evolving ESG landscape. It's great to have heard your comments today and your insights on the evermore interesting interest rate environment out there and how the environment may be shaping up very, very well for liquidity products. Thank you very much for the podcast this day.
Debbie Cunningham: Thank you, Linda.
Linda Duessel: Thank you for listening and we look forward to you joining us again on the Federated Hear & Now Podcast.
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Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Yields quoted are for illustrative purposes only and are not indicative of the past or future performance of any particular investment. Actual yields and principal value will fluctuate. Tax-free investments yielding the same as taxable investments generally involve a higher level of risk.

An investment in money market funds is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although some money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in these funds.

Bank deposits, unlike money market funds, are FDIC insured.

Deposit beta is the change in funding costs divided by the change in interest rates.

London interbank offered rate (Libor): The rate at which banks can borrow funds from other banks in the London interbank market. The Libor is fixed on a daily basis by the British Bankers' Association and acts as a benchmark for other short-term interest rates.

Rule 2a-7 is a rule under the Investment Company Act of 1940 regulating money market funds.  Rule 2a-7 imposes various requirements on the money market fund’s portfolio, including regulation related to maturity, credit qualification and diversification.

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