Liquidity Lowdown: What has happened to spreads in cash markets?

Money markets, by design, do not tend to exhibit significant price volatility. The instruments held in Money Market Funds (MMFs) typically have ultra‑short maturities — generally less than 397 days, which provides a high degree of certainty around near‑term price behaviour, especially when contrasted with longer‑duration and more volatile asset classes such as bonds or equities.

Within this context, six‑month and one‑year maturities sit at the longer end of what MMFs typically purchase. While spreads on these instruments have widened relative to the Sterling Overnight Index Average (SONIA) over the past year, these remain well below both historical highs and long‑term averages. Several factors may help explain this, from changes in supply dynamics, to shifts in demand for high‑quality, short‑dated paper, to evolving monetary policy expectations. All these factors help rationalise why spreads in a market typically defined by stability have compressed so noticeably from their highs. This trend is not limited to cash instruments; it is reflected more broadly across the wider credit market as well.

Floating Rate Certificates of Deposit (FRCDs) remain less common than traditional fixed‑rate certificates of deposit, but the market has grown substantially in recent years. Their protection against interest‑rate fluctuations and inherently low price volatility have made them increasingly attractive to MMFs, which now use FRCDs more actively in portfolio construction. Although FRCDs are often viewed primarily as tools for a rising‑rate environment – offering a hedge against inflation and policy shifts – more sophisticated investors tend to focus on their relative value. This includes comparing current spreads to historical averages or highs and evaluating FRCD pricing against equivalent fixed‑rate CDs.

In today’s market, most FRCDs reset daily against SONIA, in contrast to older structures that reset every three or six months against the London Interbank Offered Rate (LIBOR). Historically, FRCDs were relatively difficult to trade in the secondary market due to operational and system limitations. Over the last few years, however, technology has largely removed these barriers, and trading in FRCDs has become far more mainstream. The combination of shorter duration and increased secondary‑market liquidity has made them even more useful to MMFs.

Modern SONIA linked FRCDs have minimal impact on WAM, allowing funds to purchase longer dated assets without extending portfolio duration

MMFs operate under strict regulations requiring their weighted average maturity (WAM) to remain at or below 60 days. Modern SONIA‑linked FRCDs have minimal impact on WAM, allowing funds to purchase longer‑dated assets without extending portfolio duration, while still capturing attractive spreads. Extending WAM is achieved through purchasing fixed‑rate assets, which typically carry greater duration or interest rate risk.

Spreads on FRCDs have remained relatively stable since the start of the year, with one‑year maturities typically trading around 35–38 basis points over overnight SONIA. While FRCD spreads can widen in response to short‑lived credit events, the broader trend has been one of tightening. Increased demand for instruments that allow funds to capture attractive spreads without adding duration may be one factor preventing spreads from returning to the higher historical averages seen in prior years.

Looking at the wider credit market

Looking at the wider credit market, spreads are tight relative to historic levels. Corporate and bank balance sheets remain strong, and default expectations are low. When credit risk is perceived to be low, investors require less compensation for holding credit exposure, naturally tightening spreads. Easing monetary policy also supports credit markets by reducing refinancing risk and increasing the value of carry. While some money‑market instruments – such as repurchase agreements – have very low correlation to credit conditions, CDs and commercial paper exhibit a greater degree of sensitivity, as counterparty risk is a key driver of their spreads, alongside other market factors.

We do not expect spreads on FRCDs to widen significantly beyond historical norms, and they may continue to narrow absent a meaningful catalyst. Examples of potential catalyst include the FCA’s proposed increases to MMF liquidity buffers, or a significant credit event that pushes the cost of credit higher. However, given their unique ability to immunise portfolios against interest‑rate risk – combined with improved secondary liquidity – we believe FRCDs remain a valuable tool in MMF portfolio management.

For professional investors only. This material is not suitable for a retail audience. Capital at risk. This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.