Certain assets are quite liquid — such as cash held in a checking account or a savings account. Others are not — such as property or inventory.
The liquidity of your business is a key metric that banks and other financing sources use to determine how much to lend. Liquid assets also support day-to-day operations and can serve as emergency funds if the unexpected occurs, such as the COVID-19 global pandemic, which may cause direct or indirect impacts on your business including loss or insolvency of a major client.
The Three Liquidity Buckets
Think of your cash as being in three buckets: daily operating cash, reserve cash and strategic cash.
- Daily operating cash is what you need to operate your business on a daily or monthly basis. Generally, this bucket of cash is held in the most liquid products, for example checking accounts and sweep products.
- You need reserve cash on hand to manage through a disruption in your operations. A range of products may be used here depending on your organization’s ability to forecast cash flows on a daily, weekly and monthly basis.
- Strategic cash is typically invested for the long-term. It may be accumulated over time for a specific use, like a capital expenditure or an acquisition. Or, you might plan to support the strength and overall objectives of your organization through longer-term investments. Given that the investment horizon is much longer, you might consider using fixed income securities, or mutual funds, CDs, bonds or separately managed accounts to deliver improved results.
Managing the Three Buckets
The chart below is a visual to help you think about these categories and your money.
|Daily Operating Cash||Reserve Cash||Strategic Cash|
|Description||Daily inflows and outflows of deposit balances||Excess cash outside daily operations (a cushion)||Longer-term liquidity that may be dedicated towards a specific purpose|
|Key Objectives||Safety and ease; conservative investments||Convenience and efficiency; short-term liquid investments||Yield and diversification; may be willing to marginally increase risk|
|Typical Management Strategy||Passive management||Self-directed management||Active customer or managed solution|
|Tradeoffs||Lower liquidity yields, but highest capital preservation||Intermediate principal risk, intermediate yield||Higher principal risk for highest yields|
|Typical Products||Checking accounts or sweep products||Money market funds or Certificates of Deposits (CDs)||Mutual funds, bond funds, CDs, or fixed securities|
Today’s Rate and Economic Environment
Today’s interest rate environment has Treasury yields at historically low levels. When the Federal Reserve cut interest rates from 1.25%-1.50% to 0.00%-0.25% during early March 2020, both short-term and long-term yields declined and compressed. As of April 2020, major economists and forecasters expected the entirety of the Treasury yield curve out to 10 years to remain below one percent through the first quarter of 2021.
Yields on other interest-earning instruments have also come down on top of each other, with U.S. Agency securities, A-1/P-1 commercial paper, and government and prime money market funds offering historically low returns. If the Federal Reserve maintains low interest rates as expected for the foreseeable future, there is a chance that these yields will not appreciate significantly.
Given that all three liquidity bucket instruments provide minimal difference in yield pickup between options, companies must ask themselves: “Is the incremental yield I am earning worth the associated increased credit, principal, and duration risk?”
Corporate Reaction and Product Risk-Reward Trade-offs
In the current and foreseeable environment, rates are projected to remain low (relative to historical levels) and compressed across the entirety of the yield curve. Given this, many organizations have chosen to forego the principal and liquidity risk generally associated with traditionally higher-yielding investment products - such as fixed income securities and CDs - in favor of highly liquid, capital-preserving investment vehicles like money market mutual funds and bank products (interest bearing DDA, non-interest bearing DDA, sweep services, and money market demand accounts).
These money market mutual funds and bank products provide zero minimal principal risk, same day / next day liquidity, and offer yields minimally different from floating NAV investment products and securities.
In addition, for organizations looking to offset their treasury management fees, an earnings credit rate has proven to be a useful tool. Earnings Credit Rates traditionally decline more slowly than interest bearing rates in a low or declining rate environment, allowing organizations to pick up additional “yield” in the form of offsetting more notional dollars of fees than they would be paid in interest.
Options to Increase Yield on Strategic Cash
Should an organization find itself with excess Strategic Cash, the current market does present an opportunity to increase yield on cash holdings. As general interest rates have come down, A-rated corporate bond yields have increased with added pressure placed on the credit markets. While yields from historically strong, stable issuers peaked during March 2020, many issuers are still experiencing the need to access the debt capital markets at rates higher than previously established. Should an organization have the appetite to accept credit risk, the opportunity to enhance yield by investing in the corporate bond market is available.
Important Questions to Consider
It is important to remember that every organization is different, and the best investment vehicle for one company may not be the best for another. Important questions organizations should be asking themselves when bucketing their cash are:
- Given the current environment, how much operating and reserve cash do I need on hand?
- What are my projected cash flows and cash needs?
- What does my investment policy statement allow?
- How much time and energy am I able to devote to cash management?
- How much risk am I comfortable with accepting?
At PNC, we combine a wider range of financial resources with a deeper understanding of your business to help you achieve your goals. To learn more please contact your Relationship Manager or visit pnc.com/businessresiliency.