Fine-tuning cash portfolios through liquidity management.

• Author: Pan, Lance
• Position: Treasury

Financial executives often consider liquidity as a major investment objective for their excess cash accounts. Few, however, have a firm grasp of what liquidity means beyond daily access to a money market fund. This is especially so in a portfolio of individual cash assets. As the Federal Reserve aggressively mops up excess liquidity from the financial system, now could be a good time to fine-tune liquidity in your portfolio.

With marketable cash investments, liquidity generally means how easily and quickly one may exchange a security for cash with little price concession from its going rate. The two key factors in measuring liquidity are how long it takes to complete the transaction and how much of a price "haircut" must be taken on the sale.

Investors who intend to hold securities to maturity often make the mistake of downplaying the importance of liquidity. At a minimum, an unexpected cash need may force early redemption of an existing holding. Concerns with credit or interest rate risk may also require a sale to avoid future losses. Additionally, liquidity has economic value. In other words, a less-liquid security should carry a more attractive price than an otherwise identical, but more liquid security.

For example, a two-year floating-rate note with three-month interest rate resets may provide 0.05 percent to 0.10 percent more annual yield than a three-month commercial paper from the same issuer. The former may be less liquid, but is otherwise almost identical to the commercial paper in risk exposure.

Factors Influencing Liquidity

Portfolio liquidity results from many factors, including general financial market conditions and specific security features. Among the more prominent factors, listed below are five that may be relevant to treasury cash accounts:

1. Size and Breadth of Market Sectors: U.S. Treasury securities are among the most liquid bonds in the world. Aside from strong credit backing from Uncle Sam, they are liquid because they are widely held. Generally speaking, liquidity is better in large market sectors with higher debt outstanding and higher daily trading volume, such as federal agencies and corporate securities. The municipal, asset-backed and commercial mortgage debt markets may be less liquid by comparison.

2. Market's Risk Appetite: The general market's sentiment towards liquidity risk premium can be a significant factor. When interest rates are low, credit is easy and investors tend to demand a lower premium for...