Managing Current Low Rates with an Eye Toward a Rate Increase

Investment managers must invest in a manner that is sensitive to today’s business climate and to the impact of future rate moves. 

TIMPG2 members marked their inaugural meeting, which was sponsored by Merganser Capital Management, by focusing on how to manage the investment portfolio in the current environment as well as in the long-term. Members also discussed where to go to add yield and how to manage interest-rate risk. Further highlights from the meeting included:

1) Deep Dive into Fixed-Income Relative Value. Prepare for higher interest rates in the form of a Bernanke Era interest-rate shift, noted sponsor Merganser. The firm noted that the number-one driver of total return in fixed income is yield-curve movements, and at the same time it is difficult to predict where the yield curve is going to move. Most members, like most of the market, feel a Fed rate rise is in the offing in the middle of 2015.

2) Asset Allocation and Portfolio Positioning. TIMPG members along with the rest of the financial world are wondering when rates will rise. Will it come in the middle of 2015 as many predicted or will global events force the Federal Reserve to stay its hand and raise rates later? Whatever the actual time and date, it is inevitable that rates will rise. So the big challenge is making sure the company’s investment portfolio is positioned properly. What assets should be considered? Should members assume a more defensive posture? Are TIMPG members changing their portfolios now or are they waiting? (They’re waiting, according to the pre-meeting survey.)

3) Changing Money Market Fund Landscape. After years of debate, the SEC has approved a series of reforms to money market mutual funds. Implementation of changes is two years away but members are starting to prepare. Some TIMPG2 members have decided to take the wait–and-see approach. Other members are more proactively looking at money market fund alternatives, such as separate accounts.

After reviewing a summary of the changes, options such as moving to government money market funds, separate accounts, and doing nothing were discussed. Concerns were also raised regarding the redemption fees and whether government funds accommodate an influx of demand. What new products for the marketplace might also be developed?

4) Trade Execution. In this session, members discussed how efficient managers are in executing through their broker network. How do you determine that managers are allocating fairly among their clients? Evaluating manager (internal and external) performance was also a main feature of the sessions, along with a look at how one member uses some of the tools the market has to offer as well as the advantages of doing the managing in-house.

Sponsored by:
 

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Deep Dive into Fixed-Income Relative Value

Members discussed interest rates and the broader implications of quantitative easing, which had just ended the month before. Sponsor Merganser then reviewed economic data that is critical to calculating not only the direction of rates but shifts in yield curve. Specifically, Merganser told members to keep an eye on specific economic inputs such as employment, both in the US and abroad, and GDP growth, which is inconsistent globally. Also discussed was the relative value of specific asset classes.

KEY TAKEAWAYS

1) Two periods of rising rates with very different yield-curve outcomes: The yield curve moved very differently during the Greenspan and Bernanke eras. One shift resulted in lower returns and the other in higher returns because of the shape of the curve.

2) Economic factors likely to keep the front end lower than expected. The largest impact to the investment portfolio will be the severity of the rate increases in the short term. We are better off in a rising rate environment because the portfolio is re-investing cash-flow in higher-yielding bonds and at a higher coupon.

3) Macro world impacts liquidity. It is important to follow key economic data to assess supply/demand as this is very important when managing a short-duration portfolio.

4) Floating-rate market is attractive for short-duration portfolios. There are several sectors that offer floating-rate issues, including the corporate market and the ABS (student loans) market. Merganser sticks to investment-grade only for this investment.

OUTLOOK

Several factors influence expectations on rates. When it comes to rate increases, not only is the rate and magnitude important to predict, but equally important to consider is the movement along the yield curve and the shape of a new yield curve. Members agree when it comes to the credit market; several members in addition to Merganser are favorable on this sector.

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Asset Allocation and Portfolio Positioning

Given where rates are today, an increase in rates is inevitable. But when? How long are companies expected to wait? Have members given up on the defensive posturing or have they continued to structure the portfolio more defensively in anticipation of rising rates? What are members’ thoughts on the spread sectors? This session included a discussion on how members are structuring the portfolio and preparing for changes in interest rates.

KEY TAKEAWAYS

1) Waiting game with no new moves. “No changes” was again the most popular response to the members’ survey question about changes made to the portfolio. However, the reason is not that everyone isn’t preparing for something; we are just already there. Currently all respondents to the pre-meeting survey are either neutral or short their duration targets, and are short wherever they can be.

2) View on the market is not the only driver of portfolio changes. Change in investment policy is the biggest factor in portfolio changes, as well as the view on credit and business operations.

3) The cash piles continue to grow. The biggest challenge noted by members has been, “Where are we allocating to this year? We are going to have lots of cash come in from offshore.” Members struggle with deployment knowing the offshore pool is the more stable pool. Some members are keeping excess liquidity for potential business purposes.

4) Suggestions for asset allocation. First, consider Commercial Mortgage Backed Securities (CMBS), noted Merganser. The onset of the CMBS market in the late 90s was done poorly and it tainted the market’s view of them. Currently CMBS issues are offering the most spread advantage of the credit sectors. Merganser sees value in the front end of CMBS (front-pay extenders specifically). The underlying mortgages are very strong properties. The firm has worked with several clients to add this sector as allowable investments to the investment policy. Despite spread compression Merganser still likes the ABS credit card space. Merganser noted that MBS issues do not have a place within an operating funds portfolio; it prefers the CMO market as these have a more appropriate paydown structures.

OUTLOOK

Members are finally starting to see higher rates out on the horizon. However, this does not mean large-scale rejiggering; we are already there. Members are continuing to seek yield through investment in many of the spread sectors and are focusing on taking more risks in the offshore accounts.

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Changing Money Market Fund Landscape

After four years of debate, the SEC in the summer of 2014 approved a series of reforms to money market mutual funds. Despite the fact that changes will not be implemented until two years down the road, members are starting to prepare. Members discussed the SEC changes and how they will impact the investment program going forward.

KEY TAKEAWAYS

1) Changes do not impact investments allowed directly.  

• Floating net-asset value (NAV) required for all Institutional Prime & Institutional Tax-Exempt/Municipal MMFs.
• Except for Government Funds, liquidity gates and redemption fees are required for all funds (including retail and institutional).
• The board is permitted to charge a liquidity fee on all redemptions if weekly liquid assets fall below 30 percent. If weekly assets fall below 10 percent then the board is required to charge a 1 percent liquidity fee on all redemptions.
• The board is permitted to impose a gate on all redemptions for a maximum of 10 business days in any 90-day period, once assets fall below 30 percent.

2) The world has not changed. Regulations do not alter the investments within the portfolio. Members questioned though if the floating NAV would alter the portfolio manager’s investment style and are less willing to take the risk.

3) When you consider the new regulations, consider the various risks. What in particular has you concerned? Is it liquidity, capital, or the investments? Breaking down the risk will help you evaluate possible next steps for the investment portfolio.

OUTLOOK

The best part about the change in regulations is that the change has been announced. Now we can plan. There isn’t anything that changes the investments, but will the managers manage differently knowing fees and redemption gates could be imposed? Can government funds handle the new demand, and is there even enough issuance?

Members raised some very good questions, most of which cannot be answered until the regulations go into effect. In the meantime, members should start to prepare for a change in the regulations and, more important, prepare for possible changes in the market.