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Jerome M. Schneider, Andrew Spottiswoode
Ongoing market and policy developments could pose new challenges for not only short-term investors looking to exit money market funds or insured bank deposits, but also longer-term investors worried about increasing rates. Yields are excruciatingly low and may remain so for an extended period, leading many to explore short-term active management strategies that have the potential to offer compelling risk/reward opportunities as a supplement to traditional short-duration liquidity-oriented strategies. PIMCO offers a range of solutions designed for these investment objectives. It may be time for those investors considering short-term strategies to boldly take the next step.
Key developments out of Washington The expiration of the Federal Deposit Insurance Corporation’s (FDIC) temporary provision to insure unlimited deposits in non-interest-bearing transaction accounts had a major impact on investors in U.S. money markets. On 31 December 2012 the limit reverted to the permanent $250,000 level. Upon expiry, deposits totaling more than $1.5 trillion became uninsured (FDIC estimates as of 30 September 2012), creating potential for a supply-demand mismatch for high-quality front-end assets as investors migrate to other alternatives beyond traditional options.
Additionally, look for forthcoming guidance from the Financial Stability Oversight Council (FSOC) and the Securities and Exchange Commission (SEC) to better articulate the updated requirements that regulated 2a-7 money market funds may need to adopt. One potential reform is a transition to a floating net asset value (FNAV) for money markets, which would be a radical departure from the current $1-per-share fixed NAV structure and would likely motivate many investors to explore other higher-returning options. Recently, numerous money market strategy managers, including PIMCO, began to disclose FNAVs on a daily basis. The portfolios still strike a $1 NAV, but this disclosure provides more timely market valuation transparency for investors.
Money market investors may find the benefits of these industry reforms bittersweet at best, as they are still tolerating borderline zero percent yields in a persistent low rate environment, likely to extend at least until unemployment drops below the Fed’s 6.5% target level.
Of note, the Fed’s new target language and its strong commitment to loose monetary policy may suggest that price stability – one of the Fed’s dual objectives – has become, at least for now, less critical than the goal of maximum employment. That, in turn, could mean investors may need to prepare for higher inflation (and eventually, higher rates) on the horizon, and consider strategies for keeping up with even modest levels of inflation while seeking additional yield in ways that are less sensitive to interest rate changes.
We believe the need to balance risk against reward is as pertinent as ever given short-term investors are seeking low volatility strategies that aim to preserve liquidity while defending against even a modest erosion of purchasing power due to increases in inflation. However, without creative strategies for liquidity management, many investors are finding themselves in the “dire straits” of actual negative real returns on their cash allocations even with modest current levels of inflation.
Investors concerned about real returns, or the prospect of higher levels of rates as future inflation expectations edge upward, may want to consider structurally lower-duration bond strategies: They have the potential to weather a rising rate environment better than long-duration strategies. As such, we’d expect front-end investment products to remain in high demand for the foreseeable future.
Active short-term management at PIMCO We’ve seen many changes in cash management in the past few years, including major regulatory reform. But we have found that cash investors – whether they’re individuals, corporate treasurers or pensions, asset allocators, anyone – are generally seeking the same objectives they always have, except today they may be even more important: capital preservation, liquidity and attractive returns, while doing so at an acceptable level of portfolio volatility.
PIMCO aims to help investors achieve these objectives. Our cash and short-term strategies draw on the firm’s experience, discipline, in-depth research, market access and risk management capabilities. Market access, for example, can be a real challenge for many cash investors, but because PIMCO manages $2.00 trillion in assets (as of 31 December 2012; this includes $1.62 trillion in third-party client assets), including a significant allocation to liquidity-conscious strategies, we believe PIMCO has the scale, resources and relationships needed to access and properly evaluate the full spectrum of opportunities in short-term fixed income. Additionally, our dedicated credit research team may afford PIMCO a competitive advantage by helping to identify situations or other trends underappreciated by the broader market, which will likely become even more important as we expect increasing demand for this sector to continue to overwhelm supply of these short-term opportunities in 2013.
PIMCO’s cash and short-term strategies aim to preserve capital while generating more attractive yields than investors can earn from traditional money market strategies. Our investment process canvasses similar high quality short-term instruments found in typical money market strategies, but may also consider the relative value opportunities that being invested in a different structure or part of the interest rate or credit curves may offer, albeit with additional risk.
We address the challenge of the persistent low-yield environment by working to construct robust, diversified portfolios. We believe there is an abundant opportunity set just beyond the money markets that may help reduce portfolio volatility while potentially offering higher returns than a short-term (one- to three-year maturity) Treasury index or government/credit index, though likely with higher risk as well. Given our secular outlook for low yields in the coming years, we’ll continue to seek a diversified set of return-generating investments, while actively managing the downside risks that spread products often present.
In 2013, we expect carry (i.e., estimated returns given our expectations about yield curve, and spread levels and other variables) will be only a modest contributor to performance in short-term portfolios, so we have become more active in our trading strategies to seek capital gains benefits as well. Traditional buy-and-hold strategies, which don’t transact actively, and also passive index-tracking strategies may miss out on many of the opportunities and returns ahead. Early adopters of these actively managed strategies could potentially benefit for several reasons: Existing investors in active strategies may benefit from continued interest and the potential for increased demand for the short-term investments in which such strategies typically invest; this incremental demand may present future opportunities for capital appreciation as well. Also, active short-term strategies may offer a lower volatility profile due to their flexibility to manage downside risks in many corporate and spread products.
‘Walk’ around concerns of zero yields and increasing rates In money market strategies, short-term Treasury index ETFs and other short-term strategies, near-zero nominal yields likely translate to negative real (inflation-adjusted) yields: a painful price for perceived “safety.” We believe too many investors essentially are giving money away in exchange for perceived “safety” and liquidity. On the flip side, many times investors looking to earn a more meaningful yield may face undesirable volatility, more concentrated risk exposure (which can exacerbate volatility), and unforeseen limitations on liquidity.
Investors concerned with the eventuality of rising rates as a result of inflation, positive growth or both, can consider allocating their bond exposures to structurally lower-duration fixed income strategies, which may hedge against rising rates while simultaneously providing positive yield potential with a low correlation to higher-risk investment allocations.
This is where a structural shift away from traditional money market strategies may benefit liquidity-minded investors. Short-term strategies can look to invest in a wider set of asset classes beyond money-fund eligibility criteria (such as the SEC Rule 2a-7 limitations on credit quality and maturity), and this diversification could help short-term investors seek higher yields while potentially diminishing concentration risks and volatility. But many investors are fearful of taking this step in an effort to reduce volatility as they may lack the in-house research capacity and market access required to assemble a diversified portfolio of short-term securities. But through partnerships with investment managers, like PIMCO, who employ active portfolio management alongside rigorous credit research, these investors may be able to diversify their risks and encounter attractive return opportunities. Active management strategies could potentially counter the challenge of a zero nominal yield environment by offering liquidity-minded solutions that seek yields closer to a positive real (inflation-adjusted) return.
In light of today’s low yields and longer-term inflation potential, considering a walk beyond the traditional money market confines has never been so compelling, in our opinion. Doing so might help a liquidity-oriented portfolio avoid the ongoing dire straits that may befall traditional approaches to short-term liquidity management.
Jerome M. Schneider
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, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2015, PIMCO.
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