Managing credit risk in money market funds

At the recent Local Authority Treasurers’ Investment Forum, J.P. Morgan Asset Management spoke about the importance of proprietary credit analysis in money market funds. We followed up with Jimmie Irby, the head of the credit and risk management team in J.P. Morgan’s Global Liquidity business, to find out more about how credit risk is assessed in the liquidity investment process.

Room151: How are you set up for managing credit risk?

Jimmy Irby: We have a dedicated credit research team that works closely with the portfolio managers of our funds. The team is structured by sector, with specialist analysts responsible for identifying the best securities to buy and sell, across the maturity spectrum. Ours is a research-driven organisation, and our credit analysts have a highly valued role. We strive to make credit research a real career path for our analysts, rather than presenting it as a stepping stone to becoming a portfolio manager. Continuity of cover and specialist focus on one or two sectors means that we can offer real in-depth knowledge of issuers, which we believe is very important for our funds and for our clients.

Room151: What metrics do you use to assess the creditworthiness of counterparties?

JI: We use a variety of information sources, including reports by the major rating agencies, external fixed income analysis reports, Bloomberg and other specialist systems. Most importantly, we conduct our own analysis using fundamental data, including company financial statements. When choosing a money market fund manager, it’s vital that local authorities look at those with the ability to carry out their own fundamental credit research – the lessons of the financial crisis demonstrate the risks of relying on credit ratings alone.

Room151: What are you looking for in a corporate issuer?

JI: We have a long list of criteria, including quantitative factors such as capital levels, asset quality and earnings – both current earnings and earnings history. More stable earnings require less capital, but if earnings are volatile companies need more of a capital buffer. We also look at how the business is working. Is management strong? What position does the company or its key product hold in its industry, and how is that industry performing as a whole? We assess the company’s liquidity position to determine its ability to pay, and examine how we would get our money back in the event of a default – could the underlying collateral securing the investment be sold?

Room151: And in a sovereign issuer?

JI: Credit analysis on sovereigns needs to assess both the country’s willingness and ability to pay its debtors. Willingness can be assessed from the strength, transparency and accountability of a country’s political system. Ability depends on a country’s economic strength and its debt ratio, as well as the scope it has to control that debt ratio – for example, by boosting growth or reducing spending. Our analysis is extensive and broad-ranging – from looking at the transparency of the election process in the issuing country to examining the diversity of sources of growth, the health of the financial sector and the effectiveness of tax collection.

Room151: How do you decide what makes it into portfolios?

JI: Each credit, corporate or sovereign, that meets our criteria is assigned an internal rating, independent of rating agency ratings. These quantitative ratings establish portfolio ceilings for firm limits, account concentrations and maturity restrictions. The team then develops an approved-for-purchase list, which guides the investment decisions of our portfolio managers. Only credits that appear on this list can be incorporated into a money market fund portfolio. The process doesn’t stop once securities are in the portfolios. Our credit views and exposures are constantly monitored and adjusted based on news and earnings, macro trends, valuation and other factors. We maintain a constant dialogue with portfolio managers to ensure that any change in our views is quickly reflected in our funds.

Room151: How would you characterise your approach to credit risk?

JI: Our approach has always been conservative. We have a strong track record of making the right calls at the right time, and always seek to be ahead of the story. The eurozone debt crisis serves as a good example as the benefits of this approach. We have dynamically managed our buy list throughout the crisis, and kept tenors short. We have had no peripheral eurozone exposure in our liquidity funds for a long time, and have stayed ahead of the market by removing the counterparties we are uncomfortable with very quickly. Ireland was removed from our buy list in February 2009, before being given a bailout in November 2010. Portugal was removed in April 2010, before requesting assistance a year later. All Greek names were removed from our approved list in February 2009. We cut our exposure to Italy and Spain long before they came under pressure as a result of the crisis, and removed them from the buy list entirely in July 2011. This conservative approach has ensured that our funds have fared well even in periods of extreme stress within credit markets.

Room151: What credit analysis capabilities should local authorities be looking for in a money market fund manager?

JI: The managers who have come through the recent market disruptions most successfully tend to be those that have invested heavily in proprietary credit analysis. Treasurers should familiarise themselves with the structure, expertise and resources of the credit team. The last few years will have served as a stern test of a firm’s credit analysis capabilities, and any RFP or due diligence questionnaire should ask for details of any security downgrades or buyouts that have affected the fund. In the current environment, we believe this thorough due diligence is more important than ever before. Investors can no longer simply look at the credit rating of a fund, and they need to make sure their managers are going beyond ratings too.