Jing Jia
8 minutes reading time
- Fixed income, cash & hybrids
Peek under the hood of “cash” funds
With the growing number of ETFs and managed funds labelled as “cash” or “cash plus,” it is not always easy for investors to determine whether a fund can reliably be treated as a “cash equivalent” for their portfolio construction purposes. What a fund is called or how it is marketed does not necessarily guarantee the underlying instruments will be consistent with what an investor may expect from a cash allocation.
Fortunately, there is well established guidance to help make the assessment:
- AASB 107 Statement of Cash Flows (equivalent to IAS 7) defines cash equivalents as “short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.” The standard adds that an investment normally qualifies only when it has a maturity of three months or less from acquisition.
- The IFRS Interpretations Committee (July 2009) clarified that for money market fund units, “known amounts of cash” means the redemption amount must be determinable at the time of initial investment, it is not sufficient that units can be converted at a prevailing market price.
- FSC Guidance Note No. 35 (2017) establishes naming conventions for Australian money market funds. Only funds meeting specific criteria around instrument quality, liquidity, and maturity are permitted to use “money market,” “cash,” “liquid,” or similar terms in their name.
- SEC Rule 2a-7 (US) provides the most prescriptive international framework, with a maximum WAL of 120 days and a requirement that every security present “minimal credit risks.” Subordinated instruments are not held by any 2a-7 fund.
Two portfolio metrics are central to this assessment.
Weighted Average Maturity (WAM) measures a cash fund’s sensitivity to changes in interest rates. For floating rate instruments, WAM is calculated to the next coupon reset date (not final maturity), reflecting the fact that the coupon resets to current market rates at each reset. A lower WAM means the portfolio is less sensitive to interest rate risk.
Weighted Average Life (WAL) measures the average time until principal is repaid across a cash fund’s portfolio, using each instrument’s final maturity date. WAL indicates the portfolio’s exposure to credit spread risk and liquidity risk.
For a cash fund, both WAM and WAL should be short: a WAM of 90 days or less indicates minimal rate sensitivity, while a WAL of 120 days or less indicates low exposure to credit or liquidity risks.
Where cash ends and credit begins
The instruments typically held by cash funds and short-term credit funds (sometimes also known as ‘enhanced’ cash funds) can generally be grouped into three categories.
- Cash equivalent instruments that meet the AASB 107 definition: final maturity of 90 days or less, known redemption amounts, and “insignificant risk of changes in value”.
- Money market instruments that are high quality, senior securities with final maturities under one year, as per market convention.
- Short-term credit instruments that include securities with maturities beyond one year, as well as subordinated debt and securitised products at any maturity.
Matrix of instrument classifications
The below table sets out our view of how various instruments used by cash funds and short-term credit funds should be classified under the three categories described above.
| Cash equivalent | Money market | Short-term credit | |||||
| <91 | 91–365 | >365 | <91 | 91–365 | >365 | All maturity | |
| At-call deposits | ✓ | — | — | ✓ | — | — | ✓ |
| Term deposits | ✓ | ✗ | ✗ | ✓ | ✓ | ✗ | ✓ |
| Government Treasury notes | ✓ | ✗ | ✗ | ✓ | ✓ | ✗ | ✓ |
| NCDs / Bank bills | ✓ | ✗ | ✗ | ✓ | ✓ | ✗ | ✓ |
| Commercial paper | ✗ | ✗ | ✗ | ✓ | ✓ | ✗ | ✓ |
| Senior FRNs | ✗ | ✗ | ✗ | ✓ | ✓ | ✗ | ✓ |
| T2 Subordinated FRNs | ✗ | ✗ | ✗ | ✗ | ✗ | ✗ | ✓ |
| ABS / RMBS | ✗ | ✗ | ✗ | ✗ | ✗ | ✗ | ✓ |
Maturity bands: <91 = less than 91 days | 91–365 = 91 days to 1 year | >365 = over 1 year
Should T2 FRNs and RMBS/ABS be included in a ‘cash fund’?
We consider Tier 2 subordinated debt and residential mortgage-backed securities (RMBS)/asset-backed securities (ABS) should be categorised as short-term credit regardless of their remaining term to maturity because their risk profiles do not seem to be consistent with a ‘cash equivalent’ classification for the reasons noted below.
Tier 2 subordinated debt (FRNs):
- Non-call and extension risk. T2 FRNs are often issued with final legal maturities 5 years after the first call date. There is no legal obligation for the issuer to call. If an issuer elects not to call, whether due to market conditions, capital pressures or regulatory constraints, the investor (or fund) is ‘locked in’ until legal maturity.
- Subordination and loss absorption. T2 FRNs rank below all deposits and senior unsecured obligations. Under APRA’s APS 111, they include a Point of Non-Viability (PONV) trigger allowing APRA to write down or convert the instrument at its sole discretion if APRA determines the bank would become bankrupt without intervention. While the probability of such an event for major Australian banks is low, a binary, discretionary regulatory action that can wipe out 100% of principal is qualitatively different from the credit risk of senior bank paper.
- Liquidity. T2 FRNs tend to trade with materially wider bid-offer spreads than senior paper, and liquidity tends to deteriorate significantly in stress events, precisely when a cash fund needs to access liquidity.
RMBS and ABS:
- Uncertain repayment timing. RMBSs have no fixed maturity. Amortisation depends entirely on the prepayment behaviour of the underlying mortgage pool, which is inherently uncertain and model dependent. An RMBS tranche with an expected WAL of 18 months could extend significantly if prepayment speeds slow. Final maturities are based on the loans in the pool, which can often be 30 years at issue. This uncertainty seemingly contradicts AASB 107’s requirement that the cash receivable be “known at the time of initial investment,” and makes it difficult to calculate a reliable WAL for cash fund purposes.
- Spread volatility and illiquidity. AAA Australian RMBS spreads widened from around 30bps to over 100bps during March 2020, and to over 150bps during the GFC, driven primarily by liquidity dislocation rather than credit losses. Bid-offer spreads for RMBSs tend to be materially wider than for senior bank paper, and in stress events RMBS liquidity can effectively disappear. This level of mark-to-market volatility arguably exceeds the “insignificant risk of changes in value” threshold stipulated by AASB 107.
What else a ‘cash fund’ should consider
Beyond instrument eligibility, in our view a ‘genuine’ cash fund should maintain robust portfolio level risk limits to ensure its net asset value (NAV) remains subject to only “insignificant risk of changes in value”. All issuers should be investment grade, with appropriate aggregate exposure limits by credit rating band, security type, and individual issuer concentration. A meaningful portion of the portfolio should be held in highly liquid, short-dated instruments to ensure the fund can meet redemptions under both normal and stressed conditions.
These limits, together with regular scenario and stress testing across interest rate, credit spread, and liquidity dimensions, should be documented in the fund’s investment guidelines and monitored on an ongoing basis.
Final thoughts
In our view, for a fund to be appropriately labelled as a ‘cash fund’ and classified as a ‘cash equivalent’ under AASB 107, three conditions should be met:
1. Eligible instruments should be limited to the cash equivalent and money market categories only.
A fund that includes subordinated debt, RMBS or ABS introduces risks that are qualitatively inconsistent with the cash equivalent definition, regardless of whether those instruments carry floating rate coupons. Low rate duration is different from low overall risk.
2. The portfolio’s aggregate risk characteristics must be consistent with guidance.
- WAM of 90 days or less, consistent with the AASB 107 presumptive threshold.
- WAL of 120 days or less, consistent with international benchmarks such as SEC Rule 2a-7.
- NAV subject to “insignificant risk of changes in value”, as required by AASB 107 and clarified by the IFRS Interpretations Committee.
3. Appropriate credit quality and portfolio risk limits must be in place.
The fund should hold senior debt issued by investment grade issuers only, with tiered exposure limits by rating, security type, and issuer. Scenario and stress testing should demonstrate that, under adverse market conditions, the portfolio’s change in value remains insignificant.
It may be reasonable to consider funds that include short-term credit instruments for short-term credit (enhanced cash) strategies, and they can play a valuable role in portfolio construction. However, they should be considered and classified accordingly, not as cash equivalents. Precision in labelling and categorisation matters, particularly for superannuation trustees who rely on asset class labels for member reporting and APRA’s performance testing framework.
References:
- AASB 107 Statement of Cash Flows
- IFRS Interpretations Committee Agenda Decision: Investments in Money Market Funds (July 2009)
- FSC Guidance Note No. 35: Naming of Money Market Funds (2017)
- SEC Rule 2a-7 (17 CFR 270.2a-7, as amended August 2023)
- APRA Prudential Standard APS 111, Capital Adequacy: Measurement of Capital
- Banking Act 1959, Section 13A (depositor preference)