Why do nonprofits maintain operating reserves, even if they have endowments or other long-term investments? In a word: volatility. You never know when volatility may spike and markets may tumble, effectively reducing the size of distributions, and perhaps disrupting fundraising efforts. In the economic environment of the last 10 years, that volatility rarely mattered. Nonprofits were able to borrow at low costs to fund short-term needs, so reducing the size of reserves made sense for many organizations. But today, the environment has changed, and reestablishing appropriate policies for managing operating reserves is prudent. Organizations need to decide how much to set aside, and what asset classes make the most sense for those funds in today’s environment.
The Last Few Years Were Low Risk…
Historically low interest rates pushed many organizations to stray from the traditional all-cash or short-duration bond allocation for their reserve funds. They took on additional risk—longer-duration bonds or more exposure to credit risk and equities—to maintain pace with inflation. This strategy worked as returns for a portfolio allocated 80% to intermediate bonds and 20% to equities returned 10% more than an all-cash portfolio over the last five years (Display).
But Today Is Different
This year, that trend reversed. Rising interest rates and fears of inflation have contributed to heightened equity market volatility and underperformance of longer duration bonds. Those investors that moved up the risk spectrum are left with unexpectedly low returns and perhaps even losses on their reserve portfolios.
The Path to Normal
The Federal Reserve began raising interest rates in December 2015 and has increased its target rate seven times since then, including three this year, plus another expected in December and two to four more in 2019. Rising short-term rates mean both higher cash yields and higher borrowing costs as the Fed continues to raise short rates toward normal, long-term levels of 3%—4%. Organizations that fund operating shortfalls by using lines of credit or margin will face higher financing expenses going forward. As rates move higher, cash becomes more attractive, and now it offers a competitive alternative to taking on duration, credit, or equity risk. Yields on cash have moved to 2.2%, much higher than the roughly 0% rates seen since the financial crisis and in line with inflation expectations (Display).
Spectrum of Choice
The appropriate allocation for reserve funds depends on the specific goals and circumstances of each organization within the context of the current market environment. There are many factors that may cause an organization to increase or decrease the risk in their reserve funds including but not limited to spending needs, time horizon, stability of revenues, likelihood of immediate need for capital, covenants or other restrictions, and knowledge of a significant near-term capital expense.
When deciding on asset allocation for a reserve fund, we advocate matching the investment horizon or holding period until the funds are potentially needed, with the duration of the investments.
- Short-term needs: Funds should be invested in the less risky investments—cash and cash-like strategies. We define cash as investments that have no or de-minimis volatility and daily liquidity.
- Budgetary support: Funds should be invested over a relatively short to intermediate time horizon, especially if it is possible for budgetary shortfalls to coincide with periods of rising risk aversion in the capital markets.
- Unexpected circumstances: If a reserve is meant for unexpected spending needs over an unspecified period, the portfolio could include intermediate- and longer-duration bond strategies, and even equities to generate higher returns.
“Just in Case” Funds Deserve a Second Look
Over the next several years, we expect the investment environment to be more challenging. It’s prudent to prepare today for that “what if” scenario. That means taking a fresh look at reserve fund policies to ensure that reserves are appropriately allocated and optimally sized. When borrowing costs are high and volatility is elevated, lending to oneself (from reserves), rather than negotiating with a lender or spending from more volatile assets, may be a safer, less costly way to meet cash flow needs.
The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.