The properties of pyrite – fool’s gold, as it’s commonly known – are worryingly similar these days to the characteristics of many short-term portfolios investors are using these days for maintaining defensive liquidity-minded cash positions. Investors have in recent weeks sought refuge from volatility by delving into the mines of “cash equivalent” portfolios in search of greater stability. While many money-market strategies, especially those that favor credit, look like valuable commodities, their appearances may prove deceiving and may even, like pyrite, blow up if left unmonitored in the wrong environment.
We believe investors need to be more cautious than ever when considering allocations to short-term strategies. Traditional money market liquidity strategies often advertise easy access to the cash in the portfolio. However, investors need to dig a little deeper to accurately determine whether the minerals they hold will be valuable – both in terms of liquidity and credit performance – over a range of market scenarios.
Just as minerals show up on a periodic table, money market securities provide relative levels of liquidity across a broad spectrum. However, when market conditions change, the liquidity embedded within securities can change, too, as liquidity preferences themselves change. The recent volatility over the past two months has supported this dynamic again, as dealers and investors become more defensive in bidding for securities in an ever more stressed marketplace. Securities that are perceived to have high value because of liquidity or relative yield can look a lot different once investors start worrying about, say, the possibility of Greek default or broader credit concerns in Europe.
The latest volatility – and volatility looks to be with us for a while – has investors asking questions about the securities they own, in particular probing any exposures to European issuers. Since 2010, some investors have migrated from strategies containing commercial paper (CP) and certificates of deposit (CDs) to those focused on only purchasing government debt. Yet, as we saw in the 2008 and other recent crises, there has tended to be less willingness to provide liquidity to holders of commercial paper – the bid-ask spreads for financial and other high-beta issuers have widened greatly – so what typically might be deemed money-market worthy instruments in better times may be anything but sources of marketable liquidity.
In times of stress, we believe only Treasury securities, over-collateralized repurchase obligations and insured demand bank deposits will be able to withstand the stress of a liquidity vacuum and continue to provide portfolios with adequate access to cash in a variety of market environments. The cost of this “purity” can be quite expensive though: near zero percent yields, currently.
None of this is meant to alarm investors. Rather, we are suggesting that liquidity focused investors exercise prudence and insist on 1) rigorous, ongoing analysis of their actual liquidity needs and the true value of their holdings and 2) active liquidity management that continually searches for value to help preserve returns in a low-yielding environment.
With proper liquidity management, we believe investors are able to make more prudent selections with their intermediate cash balances and find more favorable and proper risk-reward metrics for their portfolios in the process. Put another way: Why own commercial paper from an issuer paying 0.10% if you can own the same credit except only six months longer in maturity and offering yield in excess of 2%? This is an example of one of the inconsistencies in the money markets that may make them less-than-compelling investment alternatives for liquidity provisioning.
Mining for Yield as Supply Dwindles and Volatility Soars
Additional monetary policy options are being implemented combined with a hope for more fiscal solutions to address the current global economic malaise. Still, until these solutions are clearly implemented, there will likely be uncertainty regarding immediate demands for liquidity and the oscillating valuations of credit. In the short-term markets, virtually the only variable we can feel confident in is that the Federal Reserve expects not to raise rates before mid-2013.
Meanwhile, issuance of eligible assets in the money market arena has dropped considerably, driving down yields even as demand for money-market instruments grows. This can and has led to less desirable risk/return options as many money-market portfolios are forced to diversify into short-dated credits they would likely have avoided if other alternatives were available. We are often seeing these funds forced into a corner of the world that is growing more and unattractive due to dwindling supply mechanics. Evidence of this is the high percentage of CP/CD assets that still make up a large percentage of assets under management for these regulated funds: more than 40% as of September 30.
Cash investors often over-allocate to money market and bank investment vehicles, while the most attractive risk-adjusted opportunities might fall just outside of this space. In the past, we have suggested that when an investor has an abundance of excess cash that they should look at short-duration and enhanced-cash strategies. Investors can move excess liquidity out of traditional money markets often for incremental adjustments in risk, and with active portfolio management that is not constrained by traditional money market fund regulatory guidelines, dynamically adjust their positioning to liquidity changing conditions while seeking to produce more attractive risk-adjusted returns. To be able to do so, however, their managers must be able to continuously and consistently analyze credit and manage their portfolios accordingly.
When investors develop a logical framework and determine that some of their cash can instead be invested in strategies that exist beyond money markets, they may discover a new world of liquidity and higher return potential that they hadn’t seen before. Market volatility that causes portfolio losses may be uncomfortable for some cash investors, but daily volatility does not always equate to longer-term losses. While it might create losses for the money-market portfolio looking to sell CP below par, for strategic short-term portfolios it can create opportunities to capture liquidity premiums by acquiring positions at discounted levels or purchasing assets that offer compelling yields and may have a high probability of being called or maturing in full. The poorly positioned investors who are being forced to sell to generate liquidity are helping to create these opportunities.
Where We See Value
Investors should look deep into the mines of investment opportunities to find glittering value. To cite just one example, we currently see compelling opportunities in short-dated, non-financial BBB-rated corporate bonds. The ratings alone might discourage some investors from pursuing such an opportunity, but our macroeconomic insights and credit analysis allow us to identify companies with stable cash flows and profitability. So we can pursue opportunities for our clients that differ from those seen in strategies constrained by traditional money market fund regulatory frameworks alone.
Other examples of where PIMCO sees value in cash equivalents include buying bonds and bills issued by sovereigns with solid balance sheets (think Australia, Mexico, and Japan, for example) and hedging them back to the U.S. dollar.
Putting it all together, PIMCO believes that pursuing better-than-zero returns in an actively managed, short-term cash strategy – and doing so with an eye toward proper risk management – requires actively reassessing both your immediate versus intermediate liquidity needs, while allocating quality credit risk to your portfolio at proper risk-reward metrics. Failure to do both may cause you to end up holding fool’s gold.