In a late-cycle environment where the return of volatility and concerns about rising rates have put investors on the defensive, cash and short-term investing is moving from an afterthought to an active allocation. But the old post-crisis liquidity tools may no longer be serving investors looking to put their cash to work while seeking to preserve capital and maintain a low risk profile – and tax reform has made it more critical to consider the implications of taxable versus tax-efficient investments, especially for those in the highest tax brackets.

PIMCO takes a holistic, tiered approach to short-term investing that seeks to actively align investment horizons with each investor’s immediate, intermediate and longer-term liquidity needs. Our broad solution set spans actively managed ultra-short and short-term bond funds, exchange-traded funds and tax-efficient municipal bond funds and other tax-aware investments, along with custom mandates for single-family offices (SFOs) and high-net-worth individuals. In this Q&A, Jerome Schneider, head of short-term portfolio management, David Hammer, head of municipal bond portfolio management, and Caleb Pitters, head of the U.S. nonprofit and single-family office practice, discuss how PIMCO’s tax-aware approach to short-term investing seeks enhanced returns for investors while aiming to preserve capital, maintain needed liquidity and help protect purchasing power.

Q: Why is it important to focus on liquidity management in this late stage of the economic cycle, and how should investors think about allocating their cash and short-term investments?

A: Interest rate concerns and increased volatility are part and parcel of late-cycle environments, and as investors increasingly seek to reduce risk, cash balances for many have grown to 10%–20% of portfolios or more over the past few years.¹ With more assets at stake, we believe it is critical for investors to approach cash and short-term investments as a true structural allocation. This process begins with considering how much liquidity is actually needed over various horizons.

We generally divide liquidity requirements into three tiers:

• Tier 1 – Immediate or daily cash needs
• Tier 2 – Intermediate needs, over the next few weeks or months
• Tier 3 – Longer-term needs, over the next few years

Tiering liquidity in this way enables us to target assets that best match a given investment horizon. PIMCO offers short-term asset management solutions for family offices for a variety of liquidity needs. For example, some may need to draw on funds within the next six to 12 months, but want to earn more than a traditional cash investment in the meantime; others might require effective liquidity management that will allow them to act quickly when needed, for instance to make an acquisition or meet private equity capital calls.

If an investor needs only 1%–2% of cash available for immediate use, for example, it may be favorable to allocate only a small portion of short-term investments to traditional cash investments and allocate the bulk to Tier 2 or 3 assets, including short-term bond funds or municipal bond strategies, which may offer higher income in exchange for a modest increase in risk and a balance of liquidity, return and risk.

Q: What are the drivers of the flattening Treasury curve versus the steepening muni curve, and how do these trends influence positioning in taxable vs. tax-efficient portfolios?

A: All told, while the Treasury curve has flattened to about 35–40 basis points of spread between two- and 10-year notes, and is even inverted between the one- and five-year points, the Municipal Market Data AAA muni curve has widened to about 124 basis points (between two- and 30-year bonds).

We attribute much of the recent Treasury curve flattening (see Figure 1) to a belief in the markets that the Federal Reserve is approaching the neutral policy rate and nearing the end of its hiking cycle. Indeed, the effective federal funds rate is now only slightly below the Fed’s range of estimates for neutral monetary policy (2.5%–3.5%) and is already within PIMCO’s New Neutral range (2%–3%). A pause in rates hikes appears likely in the first half of 2019, and market prices are in line with this expectation. Still, we believe investors should prepare for continued market volatility and higher costs of obtaining liquidity: Over the past few years, the cost of capital has risen not only in nominal terms, but in real terms as well.

The steepening of the muni curve, on the other hand, reflects a market that has yet to adjust to these realities, and we believe the primary reason is tax reform. The Tax Cuts and Jobs Act reduced the corporate tax rate from 35% to 21%, which in turn cut into demand for tax-exempt munis from banks and insurance companies (tax-exempt refers to federal tax-exempt income). These entities had owned about 30% of outstanding muni assets until recently, with a focus on the long end of the curve to match future liabilities. The current lack of support on the long end, combined with demand from retail investors at the very short end (where rates have moved up to their highest levels since the financial crisis), has created a much steeper curve (see Figure 2).

Given this dichotomy, in taxable short-duration portfolios we broadly favor floating-rate notes to take advantage of very short front-end rates, and these notes have tended to trade cheaper more recently relative to their fixed-rate equivalents for the same issuer. Additionally, we like structures that would benefit from a steeper Treasury yield curve in 2019 and beyond. In the tax-exempt muni market, the steeper curve presents an opportunity to earn roll down and carry by purchasing longer-dated maturities, which have cheapened due to the impact of corporate tax reform and may benefit from potential price appreciation. Such a barbell approach may provide a greater downside hedge against inflation or a sell-off on longer-dated Treasuries.

Q: Can active short-dated strategies deliver attractive positive returns during periods of rising rates and heightened volatility?

A: We believe active short-dated strategies may not only navigate through but benefit from increases in front-end rates, with compelling total return potential relative to traditional liquidity vehicles. In an environment of reduced systemic liquidity and lower return expectations, we believe investors should consider capital allocations in terms of risk-adjusted returns – specifically, whether expectations for an asset class are sufficient to stomach the potential volatility. In this context, we believe allocations to front-end assets are particularly appealing.

Short-duration strategies have tended to benefit from periods of volatility on a relative basis, given their diversification to high-quality assets and limited exposure to the interest rate or credit risks that may unsettle broader markets. Active short-duration strategies may help hedge against rate increases by holding assets such as floating-rate notes, and their lower interest rate exposure allows these strategies to reinvest in potentially higher-yielding assets as opportunities arise. Active management enables us to take advantage of dislocations and opportunities arising from volatility, such as what we saw in the fourth quarter of 2018.

We believe the ability to move beyond the limits of financial and commercial paper enhances return potential relative to traditional cash investments, with some additional risk. In our view, the distinction between an active and a passive approach in many ways boils down to the difference between simply earning yield (by holding assets to maturity) and earning a total return, or yield plus the potential incremental returns from active management. As an active manager with deep credit research capabilities – including a team of more than 60 bottom-up credit investment professionals to seek the most attractive opportunities in global credit markets – PIMCO is able to be highly selective about the credit risks we take and to be opportunistic when we perceive pricing dislocations.

The ability to maneuver to take advantage of opportunities while helping mitigate risks in rising-rate environments may offer an attractive value proposition to investors when compared with traditional liquidity vehicles.

Q: Where are you seeing the best after-tax opportunities in the short-term space, and how is PIMCO positioning portfolios to take advantage of those opportunities?

A: Broadly speaking, municipal bonds have tended to outperform other credit asset classes when rates are rising. We attribute this primarily to an increase in the value of the tax-equivalent yield in such environments, particularly for investors in the higher tax brackets. For instance, a two-year short-duration muni portfolio currently has an implied after-tax yield of about 2.42% (based on Morningstar U.S. Fund Muni National Short category data as of 31 December 2018); a U.S. investor in the highest tax bracket (40.8%²) would need to find a roughly 4.09% taxable yield to earn the equivalent after-tax income stream. We have seen this dynamic drive performance over the past year, with the Bloomberg Barclays Municipal Bond Index outperforming the Bloomberg Barclays U.S. Aggregate Bond Index and Investment Grade Corporate Bond indices on a pretax basis.

Our current muni positioning takes a three-pronged approach to benefit from these trends. One, we seek to take advantage of rising SIFMA rates by investing capital at the short end of the curve, in variable-rate demand obligations (VRDOs), which reset daily or weekly and whose prices tend to remain near par. Two, we look to assets with maturities exceeding 13 months for the bulk of muni investments. Because money market funds cannot buy outside of this window, we have observed attractive structural steepness on the curve between 14 months and two years. And three, we rely on bottom-up credit research and credit selection to determine specific allocations. Given the decline in monoline insurance on municipal bonds since the financial crisis, and with an opportunity set of more than 70,000 credits, we believe an active approach to credit selection is key to seeking to avoid drawdown risk.

We emphasize that for U.S. taxpayers, the higher tax-equivalent yield potential on municipal bonds may create attractive after-tax carry as these investors wait to deploy capital elsewhere.

Q: What is the outlook for muni market supply, and how does that influence your views on the asset class?

A: Unlike other U.S. fixed income markets, the muni market has not grown significantly over the past decade; most of the roughly $11.5 trillion in new fixed income issuance has consisted of Treasuries and corporate bonds. The primary reason for flat growth is that increases in muni market liabilities (from unfunded pension liabilities, other post-employment benefits, etc.) have generally occurred off-balance-sheet and have not led to new issuance. Moreover, in the past year alone, tax reform – specifically the cap on state and local tax deductions – has led to a 17% decrease in muni supply just as investors in high-tax states like California and New York increasingly looked to munis for their relative tax advantages. We are also seeing a secular rise in demand from retiring baby boomers, who are increasingly looking to convert riskier portfolios to higher-quality, income-producing tax-efficient assets, such as munis. Taken together, we view tight supply and growing demand as a solid tailwind for muni performance.

That said, throughout a given year there tend to be periods when more new bonds are being created than are maturing, and this net positive supply can create opportunities for active managers. Upticks in supply at the front end of the curve tend to occur around tax season as investors tap liquidity to pay their taxes, as well as in the fall months, when we tend to see weaker technicals and wider spreads.

Q: What differentiates PIMCO from competitors in the short-term space?

A: PIMCO has been actively managing short-duration strategies for more than 30 years, with a distinctive top-down, bottom-up investment process that has been tested across market cycles and environments. Our award-winning investment team³ manages some of the largest actively managed funds by asset value and brings expertise in managing short-dated risks spanning areas including credit, structured products and funding/collateral management. PIMCO draws from this broad and deep resource set to actively manage the dynamics between capital preservation, liquidity management and total returns across more than $125 billion of dedicated short duration mandates (as of 31 December 2018).

PIMCO brings the further advantage of a tax-aware investment perspective from our municipal team. With $37 billion in municipal assets under management,⁴ PIMCO takes an active forward-looking approach to uncovering opportunities and risks often overlooked in the marketplace, while leveraging economies of scale in an effort to reduce transaction costs for clients.⁵

PIMCO’s top-down macro forecasting paired with a rigorous credit rating process allows for “apples to apples” comparisons between municipal bonds, corporate bonds and other types of credit risk, with shared analytics that enable us to compare and evaluate investments across sectors with a common framework – including liquidity premiums, adjusted duration and option-adjusted spread factors. We believe this provides a key benefit over many competitors. Moreover, a real-time dialogue among portfolio managers across the trade floor helps to quickly communicate opportunities and potential risks in the short-term markets.

PIMCO offers an array of solutions to meet individual investors’ liquidity needs, including ultra-short and short-term bond funds, exchange-traded funds and tax-efficient municipal bond funds, along with custom separately managed accounts for SFOs and high-net-worth individuals. Our approach draws on this opportunity set to help defend investors against rising rates while also providing important diversification benefits to their overall portfolios and a hedge against credit drawdowns. In short, we bring the full force of PIMCO to an approach that targets enhanced tax-efficient returns for investors while focusing on needed liquidity, capital preservation and purchasing power.

For more of PIMCO’s views on tax-aware investing, visit our Muni page.

ACCESS NOW