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Jerome M. Schneider
We believe there are three “plumbing” issues short-term investors should constantly monitor during 2012 and beyond, because they will likely affect the performance of their cash management portfolios. The operational and funding components of our financial system – repurchase, or “repo,” agreements, collateral posting and funding transactions of collateralized and uncollateralized natures – are now important indicators of whether investors can expect to bathe in the warm waters of liquidity or suffer from unheralded waves of credit risk or ebbs in liquidity.
Repurchase agreements are usually over-collateralized borrowings, in which the holder of securities sells the securities to an investor with an agreement to repurchase them at a fixed price on a specified date. In the U.S., recent efforts by the Federal Reserve and the Securities and Exchange Commission to review the inner workings of the repo markets and money market funds only serve to highlight the importance of these pipes of liquidity and credit creation. However, this is a truly global problem that needs consideration and action by investors and regulators alike.
Monitoring global liquidity While the aftereffects of the two three-year long-term refinancing operations (LTRO) in Europe remain, the euphoric power of this elixir has begun to diminish as investors realize that while questions of near-term liquidity have been diminished, fears about operational solvency – whether corporate or sovereign – remain unanswered and are beginning to again weigh on sentiment. After a strong renewal of interest at the beginning of 2012, in recent weeks we have seen investors again begin to differentiate clearly among short-term investments and reduce their allocations to European financial commercial paper. If this trend should continue, similar to the second half of 2011, the market could again see renewed demand for liquid, high-quality, short-term liquidity assets – such as U.S. and German treasury bills – resume in earnest. A clear indicator of this would be the re-emergence of negative nominal yields on short-term debt as the menu of eligible collateral to meet margin requirements becomes more limited.
As such, a first point of concern for investors would be to vigilantly monitor the global marketplace for any changes in the liquidity markets, reviewing aspects and conditions in both the unsecured (commercial paper/CD/note) and secured (repo) markets. For secured markets, any changes in collateral and margin requirements, specifically with regard to altered collateral acceptance schedules by central banks, central clearinghouses or prime brokers are a tell-tale, real-time signal of a shift in global liquidity and credit risk preferences.
When collateral ratings and performance are reevaluated and migrate lower, dispersions in the quality of collateral typically begin to appear, forcing lenders of funds to alter their list of acceptable collateral and margin requirements. If the list of eligible collateral types dwindles, demand for eligible remaining collateral would likely increase resulting in a flight to quality as investors look to true up their liabilities with the highest quality assets available to purchase. This will undoubtedly remain at the forefront of indicators to watch in 2012, especially as it relates to Europe.
While many parties suffered losses in 2008 due to mark-to-market volatility, many more found the forced deleveraging through increased haircuts/margin requirements associated with collateralized funding transactions far more challenging. This “gearing” effectively acts not only as an obvious source of leverage, but also as an indicator of counterparty credit risk and collateral eligibility, both for institutional investors and participants of the intra-bank lending markets.
We believe market participants need to remain highly vigilant and react with urgency to any observed change in the aforementioned parameters – positive or negative. In our view, these oscillating risk preferences driven by defensive posturing, combined with growing needs for approved collateral to meet (Basel III) regulatory requirements for liquidity thresholds, could create a potential dearth of collateral in the markets. Furthermore, this may be the source of the next solvency and liquidity crisis over the multi-cyclical horizon.
Capturing liquidity premiumsThe second source of clogged plumbing is the capital market participants themselves. Reduced or reallocated dealer balance sheets have led to wider bid-offer spreads in the marketplace for cash bonds and reduced allocations to repo for customers. While this has increased transaction costs, it has also increased liquidity premiums. For investors who have to make an unplanned liquidation, this transformation might be costly. However, for those investors who can accurately forecast their funding needs, this new landscape creates an attractive opportunity for those who manage their liquidity and can effectively capture liquidity premiums by separating funds needed for immediate liquidity versus intermediate cash requirements.
Many investors of excess cash could be missing opportunities for higher yields and better liquidity profiles by remaining fully invested in so-called “liquidity” strategies. For example, today we see an opportunity to purchase assets with mispriced liquidity premiums in AAA-rated covered bonds, specifically those issued by high-quality Canadian banks and collateralized by a pool of high-quality assets, including assets that are guaranteed by the Canadian government (please note that the covered bonds themselves are not guaranteed by the government, only the collateral is guaranteed). Many of these bonds are attractive because they have maturities of three years or less, which may be ideal for short-term investors. Additionally, despite being over-collateralized, Canadian covered bonds tend to offer generous liquidity premiums which may benefit opportunistic buy-and-hold front-end investors.
Perhaps technical trends and opportunities will be made available to the market by the advent of QE3 and potential sterilization actions or continued fluctuations of short-term supply of investments. But the one important trend which one cannot overlook is the changing structural landscape beneath investors’ feet.
Anticipating regulatory developments The final evolutionary condition to monitor is the regulatory environment in the U.S. The SEC and the Federal Reserve have recently become more pronounced critics of the current structure of 2a-7 money market funds. In an effort to bolster these funds’ liquidity during times of stress, officials in recent weeks have outlined several proposals which suggest the establishment of a minimum capital requirement for such funds, liquidity back stops, or transitioning to a floating net-asset-value (FNAV) structure. Even though the public discourse on this subject has become more vocal, regardless of the ultimate outcome, investors should use this as a firm reminder to actively consider how prospective changes to the corral of regulation governing money market funds might alter their investment process, including liquidity needs. Once immediate liquidity investment needs are satisfied, typically via investments in Treasury bills, repos and insured bank deposits, excess monies can be deployed in actively managed short-term strategies that invest in risk assets and seek more attractive returns through proper liquidity management and fundamental in-house credit analysis.
Conclusion Some investors will defer to the comfortable route of the known status quo. Others will consider whether traditional money market investments still adequately fulfill not only their liquidity needs, but also their risk/reward profiles, considering the near-zero yields and embedded credit profiles. As some firms continue to incur costs in running these strategies while waiving fees to investors in the past few years, it is conceivable that some managers may seek the higher-yielding, credit-oriented risk investments in an effort to offset higher expenses associated with running such funds. Investors, for their part, could conceivably decide to head toward the safety of insured bank deposits instead. However, that “safety” is also obscured, as unlimited FDIC insurance for non-interest bearing accounts is set to expire at the end of 2012.
For investors seeking investments with more attractive risk and return characteristics, short-term strategies may provide viable alternatives to investments in money markets. In the current low interest rate environment, short-term strategies can aim to capture additional returns through liquidity premiums and capital appreciation via roll-down (holding bonds for a period of time and then selling as they near maturity to realize any price appreciation).
2012 will be a year of continued shifting in the tectonic plates of the short-term continent. Such shifts can create waves of changes, some small and difficult to observe and others that can potentially create catastrophic losses in the blink of an eye. We would urge investors to closely monitor the market for the small shifts, those little-noticed changes that may indicate rising risk.
In our view, the short-term markets will remain volatile, as periods of calm will be punctuated with periods of investor reflection and reaction to potential and actual ratings downgrade actions, changes to monetary and fiscal stimulus both domestically and abroad, and increased demand for more sources of low risk, liquid collateral in which to invest.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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