Most investors in short-term and money-market strategies appear poised to take a more defensive posture now that the credit situation in Europe is back in the headlines. While the final fallout has yet to be determined, we observe the initial response of many money-market and liquidity investors has been muted.
Although many investors have optically trimmed exposure to European bank names, especially those in the peripheral European countries, we have seen renewed interest in the short-dated commercial paper (CP) obligations of these issuers now that we are past the June quarter-end reporting period. Over the past year, many U.S. money-market funds, which are governed by the Securities and Exchange Commission’s Investment Company Act of 1940 regulatory Rule 2a-7 investment constraints, have continually purchased these names for the incremental yield they can offer above the near-zero levels of many cash equivalents. While perhaps attractive given the limited set of investment alternatives in this area, these low nominal yields may not necessarily offer sufficient return potential given the level of credit risk involved.
At PIMCO, we believe that by looking outside the strict confines of Rule 2a-7 governing money-market funds and employing alternative short-term strategies, investors can potentially find better risk/reward metrics, liquidity, capital preservation and total return. In other words, investors can be better positioned to earn the “extra credit,” or higher yield potential, they seek in exchange for stepping further out on the risk spectrum.
Studying the Current European Debt Crisis
It is crucial to study past episodes of stress in the credit and liquidity markets to understand the current European debt situation. While the credit dynamic in Europe now bears some similarities to that of both 2008 and 2010, the liquidity dynamic is different in significant ways.
First and foremost, central banks have indicated they are currently prepared to provide liquidity to the marketplace. The European Central Bank (ECB) offers unlimited Long-Term Refinancing Operations (LTROs), which allow European banks to obtain term three-month and one-year liquidity, while the Federal Reserve, in coordination with four other major central banks, has arranged to provide emergency U.S. dollar liquidity “swap” arrangements until August 2012. In addition, many non-U.S. financial institutions have a significant base of U.S. dollar cash, unlike in 2008 and 2010, as shown in the first chart, providing them with a significant liquidity cushion in dollars. Finally, certain indicators of financial stress remain contained for the moment, such as LIBOR and LIBOR/OIS spreads which remain well below the peak levels of summer 2010, as Chart 2 illustrates.
During the financial crisis in 2008, liquidity issues transformed into credit concerns, as in the case of Lehman Brothers. Today, as sovereign and corporate credit appear to have become increasingly intertwined in Europe, it is important to understand and track the evolving issues that we believe could easily make credit concerns become liquidity problems. Fortunately, institutional backstops, such as the government-sponsored refinancing operations and liquidity swap agreements discussed earlier, are in place to help support market liquidity. So credit, ultimately solvency, is believed to be the overriding current concern and focal point for investors.
Focusing on Credit in 2a-7 Money Market Funds
Recently, the press has provided details on the European financial names that prime 2a-7 money-market funds currently hold. By now, many investors may be aware that CP issued by Yankee banks (non-U.S. banks with U.S. operations) makes up a growing percentage of 2a-7 money market fund assets. We do not believe the motivation is to take more credit risk; rather, it likely is to make up for the lack of other investable assets as the supply of U.S. Treasury bills and government agency discount (“disco”) debt has declined over the past year, as Chart 3 shows.
The growth in Yankee debt holdings in itself is not a great concern to us. Investors may show interest in certain of these bank names when they are in more opportune places on the credit curve. In our opinion, many money-market funds fail to adequately focus on this differentiation due to structural guidelines and resource constraints. When evaluating the holdings of 2a-7 money-market funds, we have found that certain issuers comprise a large percentage of their credit holdings, mostly via commercial paper. Simply put, the money-market funds appear to be providing cheap short-dated funding to these institutions without adequate compensation for the credit profiles they represent, in effect taking mispriced or under-researched credit risk.
This is not a proposition we advocate for investors. Rather, we believe certain large U.S. banks whose international exposures tend to be in Asia or the emerging markets offer high-quality credit alternatives in the financial sector at more attractive premium levels per unit of risk. And while we do not seek to criticize all of the credit risk that many regulated money-market funds are holding, we at PIMCO do strive to deploy our clients’ capital more efficiently and through strategies that offer greater total return potential.
PIMCO has more than 40 credit analysts around the world independently assessing the credit worthiness of all issuers. Each day, they review their credit assessments in light of new information they have obtained first hand. With input from our credit analysts, portfolio managers allocate risk based not only on the fundamental credit risk determined (i.e., capital preservation), but on relative value of the potential reward given the investment thesis. We apply this process in all of our strategies, from mutual funds and ETFs to short-term accounts and total-return strategies.
ABCP: Still Alive and Kicking
Equally worth highlighting, 2a-7 money-market funds continue to invest in non-sovereign sponsored asset-backed commercial paper (ABCP). While below the peak of 2007, ABCP outstanding has found its footing again, and many money market funds seem to be flocking to it as a viable yield alternative – once again. The siren song can be alluring for sure, but the presence of a bank credit facility provided by a highly rated institution can often obfuscate the embedded credit risk in ABCP. Although many of the more aggressive ABCP issuers (e.g., structured investment vehicles or SIVs) have exited the market, the shadow-banking system remains a healthy segment of the overall CP market at approximately 34% of all U.S. CP outstanding, according to the Federal Reserve’s data as of July 6.
We reviewed the holdings of the top 10 prime 2a-7 money market funds (as determined by assets under management) and found they held approximately $20 billion, or 3.7% of their assets under management, in ABCP products at the end of June, as shown in Chart 5. That in itself is not what we consider to be a problem; when these assets are structured appropriately, they can present attractive risk/reward propositions. However, by examining the individual ABCP programs held by the funds, we found exposure to the peripheral countries of the eurozone lurking within some European bank-sponsored ABCP programs. PIMCO examined approximately 64% of U.S. ABCP outstanding, excluding quasi-ABCP issued with sovereign support, and determined that the asset pools within this sample contained about 5.6% aggregate exposure to the European periphery. Investors should be mindful that the European banks sponsoring these ABCP issuers provide the majority of structural support mechanisms that ensure timely repayment of the ABCP and may hold more exposure to peripheral debt outside the ABCP pools.
Thus, we believe investors in asset-backed commercial paper in general need to look under the hood to determine not only the quality of the credit they are purchasing, but the structure of the collateral or assets behind the credit. The potential for unintended and obscured credit exposures has kept us wary of corporate-sponsored ABCP programs since well before the 2008 crisis. We work to distinguish and understand this type of risk in order to better serve our clients and differentiate ourselves from the competition.
Finding “Extra Credit” Today
Many money-market fund managers claim to have done their credit homework, trimming risk and attempting to find attractive yields for investors in today’s market. Nevertheless, PIMCO believes “extra credit,” or higher yield potential, can be found in investments that present more compelling risk/reward metrics. There is no such thing as riskless reward, but there is reward-less risk. While a credit might be “money good,” or repay principal, this should not be the sole motivation for investment; the relative value of yield compensation vs. other “money good” options that also preserve capital should be considered. To put it simply, is earning a few basis points over zero by investing in financial commercial paper worth the risk when there may be other options that can offer better return potential for similar credit profiles?
We believe investors need to look beyond the “old normal” assumptions, metrics, and expectations that money-market investments have historically provided and toward “new normal” short-term strategies that offer disciplined active management. Short-term structures are designed to adapt to change, not only in credit conditions but also in liquidity conditions. Looking beyond one narrowly defined category and seeing the world of possibilities to manage short-term cash can be a logical – and necessary – response to the ever-changing landscape the new normal presents.
Investors should have immediate liquidity options, but demand deposits come at an inherent cost of (near) zero returns. Intermediate liquidity needs, however, can be met and managed in many ways and through various strategies. Many short-term strategies present not only attractive risk-reward metrics but also the potential for strong liquidity profiles compared to many more highly regulated money-market funds.
Capital preservation should mean more than $1 par net-asset-value (“NAV”) structures, and we believe attractive yield combined with active risk management can potentially mitigate mark-to-market volatility. The world has changed since 2008, and investment strategies to manage and preserve capital need further evaluation. By considering actively managed short-term strategies, investors can find strategies that seek to both preserve capital and properly compensate investors for risks. And many of these strategies may share similar risks to those they may already be taking in their current “par” liquidity vehicles – but offer the “extra credit” investors desire.