In the second part of Aviva Investors' article series on liquidity optimisation, Alastair Sewell investigates how investors can find the right mix of assets for their liquidity pools. Read this article to understand: how liquidity pools can be segmented, the importance of capital stability, yield, capital efficiency, and ESG in building liquidity portfolios, and the different liquidity asset classes
The topic of liquidity has come into greater focus in the wake of recent market events and regulatory changes. Regulators around the world are asking investors to hold more liquidity and are placing greater emphasis on existing rules. Recent liquidity risk events have pushed many investors towards higher liquidity allocations.
For many investors, a liquidity pool may just mean cash deposits with banks and/or government bonds. While such an allocation may be intuitive, it is not necessarily optimal. Investors need to consider whether the liquid assets they hold are the right assets for their needs.
We believe there are significant opportunities for investors across geographies and sectors to optimise their liquidity portfolios. This article explains how.
Segmenting liquidity
Segmenting a liquidity pool means slicing it up into sub-components, each of which can have a different asset allocation. This exercise can help investors diversify effectively, thus lowering risk, while potentially also increasing yield. Broadly speaking, we see three liquidity segments:
- Operating liquid assets: This category is for same-day liquidity needs, and hence will comprise daily accessible instruments. Yield will be at cash levels. In many cases, this will be the largest component of a liquidity portfolio because liquidity’s primary purpose is to be used on an ongoing basis.
- Reserve liquid assets: This is liquidity which may be accessed on a relatively frequent basis but does not necessarily need to be accessed same day. Stepping away from required same-day access is an important step because it opens the possibility of including a range of different asset types. The simple fact is that many securities and mutual funds settle at T+2 (i.e., two business days after the trade), thus making them unsuitable for same-day liquidity needs. In a reserve context, however, these assets can be useful.
- Strategic liquid assets: This is liquidity held in reserve for major events. As such, and like reserve liquidity, it does not necessarily need to be available same day but does need to be sufficiently liquid to be available when needed. Similar to reserve liquidity, strategic liquidity pools can access a variety of asset classes to allow for more diversification potential and the opportunity to access higher yields.
Historically, many investors have thought about liquidity pools as operating liquid assets only. For these investors, liquidity pool construction is relatively simple: it may comprise money-market funds (MMFs, offering same day or “T0” liquidity) and cash deposits at banks or domestic government bonds which can be "repoed-out” (i.e. sold under a repurchase agreement) to raise liquidity same day. The yield available on such a pool will be around the level of market cash rates. Unfortunately, there are potential issues with these allocations (see Figure 1).
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Author: Alastair Sewell,
Published August 2024
Recognising these issues, some investors have used short-term corporate credit as both a diversifier and yield enhancer in their liquidity portfolios. We would certainly agree that some allocation to corporate credit can be beneficial to liquidity portfolios. However, the volatility of these investments can be materially higher than other liquidity assets, due to potential exposure to lower-rated entities, among other factors. The risks of such exposure were brought into sharp focus for sterling-based investors in September 2022 (see Figure 2). The gilt-market dislocation negatively affected credit markets (as well as government bonds). Investors with these assets as the core of their liquidity positions were in a disadvantaged position.
Figure 2: ReturnPlus strategy – performance versus traditional indices during LDI crisis
Past performance is not a guide to future performance. Illustration shown net of fees.
Note: Indexed to 100, August 3, 2020 to April 26, 2024.
Source: Aviva Investors, Bloomberg. Data as of April 26, 2024.
The September 2022 event did not extend to banks or MMFs. Sterling MMFs experienced outflows, but these were met without serious problems. The fact that MMFs can diversify across high credit-quality issuers from multiple geographies reduced risk. In contrast, the failure of Silicon Valley Bank in March 2023 highlighted the risks associated with single counterparty exposures. While government action guaranteed deposits in the bank, the event brought significant uncertainty and historical precedent shows the time taken to resolve a failed bank means immediate liquidity provision is unlikely.
It is also worthwhile thinking about diversification in the context of liquidity. A liquidity pool which is diversified across multiple high-quality sovereigns is much better able to withstand a liquidity shock in each sovereign bond market than a portfolio concentrated on any one sovereign/asset type. Consider the experience of a liquidity portfolio comprising multiple different foreign “AA”-rated or better sterling-hedged bonds compared with a gilt-only liquidity portfolio in September 2022. The former would have experienced negligible price movements, the latter, especially for longer-duration bonds, severe movements.
Segmenting liquid assets based on the needs they are serving allows investors to take a more nuanced approach to building liquidity portfolios. This, in turn, enables investors to consider a wider range of asset classes and access potential diversification and yield benefits.
Factors to consider in building liquidity portfolios
Broadly speaking we see four overlapping factors most investors consider in designing liquidity portfolios. To this core set of four considerations some investors might also add environmental, social and governance (ESG) factors.
Some regulatory regimes can be prescriptive on liquidity portfolio characteristics. Where a regulatory regime is prescriptive, this will clearly be meaningful to the construction of the liquidity pool. Others will be more principles-driven, thus affording greater flexibility in liquidity portfolio construction.
For example, in Bermuda, the insurance regulation consultation outlines liquidity tiers.2 Tier 1 securities are limited to cash, deposits and high-quality government bonds, while other assets fall into lower tiers. There are limitations on the liquidity eligibility of each tier – Tier 3 assets can comprise a maximum of 30 per cent of the liquidity pool, for example. The Basel III high-quality liquid assets (HQLA) framework also applies a tiering system, and, like the proposed Bermudan regime, applies standardised haircuts to asset values. For less-liquid or more volatile assets, haircuts can be severe.
In practical terms, regulatory requirements may dominate liquidity pool construction. Nonetheless, these regimes may also afford asset-class specific benefits, as we discuss in the capital efficiency section below. In our view, simply allocating to domestic government bonds, even if coherent from a regulatory perspective, is not always the optimal allocation. Intriguingly too, regulatory requirements can provide liquidity support to certain asset classes by affecting demand conditions. Asset types in demand due to regulation should gain a liquidity benefit.
1. Liquidity
The first step for any liquidity pool is determining the stressed outflow the pool must be able to deliver. The higher the level of immediate, i.e., operating, liquidity need, the more the pool will need to be focussed on instant-access cash, MMFs and government securities. At lower levels of same-day demand, the flexibility to diversify the pool into other instruments is greater. In other words, the reserve and strategic liquidity segments can be larger.
In practical terms, our clients will typically express their operating liquidity needs in terms of daily and weekly access. That is, a minimum percentage of the portfolio which must be always accessible (daily liquidity), along with weekly liquid assets (i.e., securities maturing within a week, also known as weekly liquidity). In both cases, our clients typically assume securities cannot be sold for the purposes of these metrics. That is, these “natural” liquidity concepts are independent of market movements (barring defaults). In our view, this approach is conservative but prudent. Market circumstances can affect the liquidity – and price – of even the most liquid instruments, while more prosaic matters, such as settlement times, can be meaningful at points of high liquidity demand.3,4
These daily and weekly liquid asset allocations will typically meet the operating liquidity requirement. Beyond these allocations, a wider set of assets can be used to meet reserve and strategic cash needs. These can include securities with longer maturities, in a wider array of asset classes and potentially even in different currencies (hedged). To do so effectively, however, requires liquidity laddering.
Liquidity laddering
The concept of liquidity laddering is central to the construction of the reserve and strategic elements of a broader liquidity pool. A liquidity ladder may define the order in which assets are liquidated; equally, it can define how the sequencing of maturities in a liquidity portfolio will “top-up” daily, weekly, and potentially monthly, minimum liquidity levels in a pool naturally with the passage of time as securities mature and cash is reinvested.
A robust liquidity ladder will also enable the restoration of liquidity to target levels after a liquidity event. A well laddered portfolio will be able to restore target liquidity levels promptly, without the portfolio necessarily being topped up or rebalanced through an exercise involving sales/purchases.
Our clients will typically express a liquidity ladder to us in terms of how much liquidity they expect to need on any given day, week and month in stressed conditions. This sets the baseline characteristics for the liquidity portfolios. As stated above, we would typically expect most, if not all this liquidity to come from natural maturities, rather than assuming security sales are possible.
To be clear, we believe only liquid securities – that is, securities which can reliably be sold, with limited price impact – should be held in liquidity portfolios. However, not all those securities need necessarily be instantly available.
Trade receivables
Trade receivables offer the combination of short maturity dates, low default rates and, typically, relatively high yields. On the face of it, these characteristics make them attractive candidates for liquidity pools. There are, however, some complexities: first, they are typically non-tradeable. This means liquidity is not available until maturity – all well and good, unless there is suddenly an urgent need for liquidity. Second, they usually do not have public ratings from any of the major credit rating agencies.
This can be an obstacle for some investors, for example those needing to report rating-based metrics. Thirdly, “trade receivables” includes a wide array of different underlying asset types and classes, with potentially meaningful differences between them, for example in terms of their documentation or legal status. Understanding the asset class requires specialised knowledge.
2. Capital stability
Capital stability will almost always rank equally with liquidity when constructing liquidity portfolios. The key to doing so is to avoid defaults and minimise the risk of adverse price movements.
For most of our clients, this means investing in short-duration high credit-quality securities. Or, more specifically, securities with less than one year’s interest-rate duration and rated “AA” or better. By building diversified portfolios investing in short-duration, high credit-quality securities, investors reduce the risk of defaults and decrease sensitivity to price movements.
We do see a case for including longer-maturity fixed-rate instruments in the reserve or strategic segment of liquidity portfolios, provided the interest-rate risk can be neutralised (for example by using forward contracts) or where a specific rate view is being implemented. Our analysis shows that volatility is typically greater in interest rates than it is in credit spreads, a view supported by research from rating agencies showing losses from interest-rate increases are far more severe than from credit defaults.5 Therefore, the relative risk vs reward of holding credit spreads is typically smaller than that of being exposed to interest rates. Nonetheless, any such longer-dated exposure needs to be balanced against the liquidity requirements of the portfolio.
3. Yield
Most liquidity investors will think about yield in relative terms, i.e., expressing a yield target relative to prevailing cash rates. We recognise cash rates can vary meaningfully with policy rates and that therefore an appropriate target must be relative to the prevailing conditions.
To achieve higher yields on liquidity portfolios, investors will need to have relatively larger reserve or strategic segments in their liquidity portfolios.
Allocations to asset classes typically not included in operating liquidity assets can add both diversification and yield. Highly rated asset-backed securities (ABS), for example, are typically more suited to reserve or strategic liquidity segments in our view than the MMFs or government securities in the operating liquidity segment. We have identified multiple other examples of asset classes we believe are overlooked by many investors in constructing liquidity pools. All can play relevant roles in building optimal liquidity portfolios (see Figure 3).
Figure 3: Optimising liquidity by exploiting missed opportunities
Source: Aviva Investors, April 2024.
4. Capital efficiency
Many investors will also need to take capital into consideration when designing liquidity portfolios. Capital considerations will cut across all liquidity segments. All else being equal, government bonds will score most favourably under capital matrices, with other asset classes performing progressively worse (for example with increased haircuts or capital charges) or in some cases being excluded altogether. For example, the Basel III HQLA framework excludes bank issuance altogether, but can include equities, albeit subject to a large haircut (50 per cent) in addition to other limitations.6
Factoring capital into liquidity pool construction requires a change of perspective. A key metric for capital-aware investors is yield relative to capital. Yield relative to risk is also important, but may yield subtly different results to a yield-capital curve. Understanding both perspectives has been important to our clients in understanding and defining liquidity pool requirements.
For example, covered bonds (bonds collateralised against an underlying pool of assets) typically yield less than some other asset classes. However, they have favourable capital charges. In relative terms this may make them attractive holdings within a liquidity portfolio.
- Insurance (Solvency II): AAA-rated covered bond: 0.70 per cent spread capital charge.7
- Banking (Basel III): AAA-rated covered bonds are eligible for Level 1 and Level 2A high quality liquid assets (HQLA), which factors into the calculation of the Liquidity Coverage Ratio (LCR). They carry a ten per cent risk weight under the capital requirements regulation (CRR).8
Similarly, senior Simple, Transparent and Standardised (STS) ABS and mortgage-backed securities (MBS) carry materially lower capital charges than equivalently rated securitisations under the Solvency II regime for insurers.
Lastly, regulatory capital (and indeed liquidity) requirements can be meaningful to asset-class liquidity characteristics. The fact regulation favours some asset classes should increase demand for those assets. AAA STS residential-MBS, for example, are efficient for both European insurers and banks, which means these assets should have a strong, structural bid – an eminently desirable feature when it comes to constructing liquidity portfolios.
5. ESG
We see increased focus from investors on factoring ESG considerations into their liquidity portfolios. Investors will usually focus on this in the form of an assessment of the investment manager’s ESG capabilities and by defining specific ESG targets. Given the assets typically held in liquidity portfolios have short maturities, the types of ESG factors with the most influence will be different from longer-term strategies.
Governance will typically be the most important risk factor to consider. Liquidity portfolios can nonetheless engage effectively with longer-term issuers, thus rendering engagement an important consideration.
The liquidity asset classes
At a high level, we would divide liquidity pool construction into two primary approaches.
The fund-based approach
An investor allocates to a set of different mutual funds to build a liquidity portfolio. Typically, this will involve allocating to short-term MMFs for operating liquidity, and other funds for reserve and strategic liquidity. We would typically consider short-duration fixed-income strategies for ReturnPlus. These would include “standard” MMFs – that is, regulated MMFs with permitted longer duration than “short-term” MMFs and ultra-short bond strategies. These fund types can access some of the “missed opportunities” by investing in AAA ABS for example. Our ReturnPlus strategy fits the strategic liquidity segment well, due to its flexibility to invest across asset types and geographies, while neutralising interest rate risk.
Benefits: Simple to implement, but with sufficient breadth to build a robust overall liquidity pool.
Figure 4: Cash segmentation
Source: Aviva Investors, May 2024.
The securities-based approach
An investor provides a set of guidelines to an investment manager to build a bespoke portfolio. This will primarily comprise securities but may also include some funds. The fact short-term MMFs can provide same-day liquidity makes them useful in building the operating liquidity part of a liquidity portfolio, for example.
Benefits: Total flexibility in developing a bespoke liquidity solution, albeit with greater complexity than a fund-only approach. Can be tailored to specific capital requirements.
Figure 5: The liquidity sub-asset classes
| Domestic agencies | Transport for London (AA-/A3/A+15) |
| Global sovereigns | Japan (A/A1/A+) |
| Global agencies | ACOSS (AA-/Aa2/AA) |
| Financial institutions | Covered bonds |
| STS ABS and MBS – ABS and MBS may be offered in the STS format. | Typically AAA |
| Corporates | Varies |
| Trade receivables | Typically unrated |
| Government MMFs | Typically rated AAA on a fund rating scale |
| Short-term MMFs | Typically rated AAA on a fund rating scale |
| “Standard” MMFs – regulated MMFs with longer duration | Varies |
| ReturnPlus Strategy | Underlying average credit quality AA category |
| Short-term bond funds | Varies |
Source: Aviva Investors, April 2024.
We provide more detail on a securities-based liquidity portfolio construction in our forthcoming article “Liquidity optimisation for insurers: Building a bespoke portfolio solution”.
Conclusion
To conclude, we believe investors can build optimal liquidity portfolios by looking beyond traditional liquidity tools and broadening their perspectives to include a broader array of “cash” assets. To do so requires a deep understanding of pool requirements and the requisite expertise and knowledge to build suitably robust portfolios.
References
1. Alastair Sewell, “A bigger splash: How much liquidity do I need?”, Aviva Investors, July 2, 2024.
2. “Consultation paper: Proposed Enhancements to the Regulatory Regime for Commercial Insurers”, Bermuda Monetary Authority, July 28, 2023.
3. “Stress emerges again in Treasuries market”, The Financial Times, April 29, 2022.
4. Repo: How the financial markets' plumbing got blocked”, The Financial Times, November 25, 2019.
5. “U.S. corporate bond shock - risks and mitigants (examining investor and market sensitivities to rising rates)”, Fitch Ratings, November 18, 2021.
6. “LCR30 - High-quality liquid assets”, BIS, December 15, 2019.
7. “Official journal of the European Union: Legislation”, European Union, Volume 58, January 17, 2015.
8. “Covered bonds”, European Covered Bond Council, 2024.
