With new regulations and the US on the verge of moving off zero interest rates, investment managers are looking for ways to measure liquidity risk and add yield to the investment portfolio.
Will the Fed move on interest rates by the end of the year – or should we be watching for the nod any time they meet? This and other anticipated changes to the market landscape, such as money market reform, has investment managers focusing on optimizing their companies’ portfolios, taking a hard look at what should be in the mix, how they manage offshore cash, and measuring the success of their investment programs. Some key takeaways from the meeting include:
1) Global Macro Overview: Strong GDP growth gains in the labor market and low but stable inflation is expected to prompt the Fed to raise rates in 2015.
2) Managing Liquidity Through Evolving Regulation: Cash-flow management is the critical first step in optimizing the corporate cash portfolio.
3) Portfolio Optimization – Getting the Right Mix: Corporate yield spreads provide investors with multiple benefits in the current market environment. This includes spread to buffer interest-rate risk and a steep credit curve in the short- duration space that offers embedded spread tightening from rolling down the curve.
Sponsored by:
Educate Management When Securing Approval for New Investments
As current events seem to influence the structure of the portfolio, getting buy-in for new investments will require you to educate management.
One member walked members through his company’s investment policy review. The policy had not been changed since 2008. The goal was to pick up yield and update minimum average AA- to A+. When discussing changes with the board it is important to mention corporate names the board would be familiar with that they would now be able to buy. The investment management team also requested allowing 144a issuers that are technically private placements that are not in the Merrill index, and they requested a 10 percent maximum allocation to these issuers.
Asked what resonates the most with senior management, the practitioner noted: “We did a little of everything. We showed that we were leaving money on the table and where [the company] stood relative to its peers.” He also suggested moving in small increments, for example, from 5 percent to 10 percent, and similar increases. The increases are not too drastic but incremental enough to the portfolio to increase diversification.
Global Macro Overview
The Fed is on the move, but whether it will happen before the end of the year remains to be seen. Jeffrey Cleveland, principal and chief economist at Payden & Rygel, provided an overview focused on macro factors, GDP, and inflation in the US, Europe and the rest of the world. The outlook was interspersed with thoughts on what this means to investment opportunities and risks.
Key Takeaways
1) The Payden & Rygel team expects rate hikes in 2015. Mr. Cleveland explained: “Strong GDP growth, gains in the labor market and slow but stable inflation will bring the Fed to hike in 2015, at a slow pace.” He noted that investment managers need to look at the big picture and find signals to see what will happen next, especially GDP and inflation.
2) Global interest rate yields are very low. Rates are very low in the US and negative in Europe, with very flat yield curves. Mr. Cleveland noted that lower rates have resulted from supply and demand being out of equilibrium. Corporates are holding more cash than ever, and there is not enough supply to accommodate the demand, thus driving down yields. US Treasuries have been in huge demand by overseas investors. “This low interest-rate story will be with us for some time, even once the Fed starts raising rates.
3) The Fed will be the big driver of rates in the next few months. The Fed keeps giving subtle hints of rate hikes; every meeting going forward should be considered a live meeting, with the Fed raising rates. Mr. Cleveland explained that he believes raising rates in December will be too late, since the economy has seen sustained improvement on the labor front.
4) Focus more on payroll data. Ignore Q1 GDP data. Labor force participation has bottomed out and is slowly rising—a great indication the rate will continue to rise. People are coming back into the labor force, not back at pre-crisis levels of 66 percent, but maybe 63-64 percent.
5) Mechanism to hike rates. So many reserves means the Fed has to invest other policy tools to manage interest rate hikes. Tools the Fed can use are:
- Raise interest paid on reserves and the reverse repurchase rate
- Cease reinvestment of cash flows from the current portfolio
- Sell Treasuries
6) Hike once and be done with it? “This is the current market philosophy and what the market has priced-in to the futures market. Once and done would mean no growth. I think that is wrong; there is growth in the marketplace,” Mr. Cleveland said. He predicts the Fed hikes will be lower and slower than in the past. “I think 10-year yields will go to 3-4 percent, higher than now, but not back to where we were,” he noted.
7) Unlikely to repeat 2004-2006 cycle. Historically, following what the market has predicted has been a better indicator for rate movement than following guidance from the Fed. The 2004-2006 cycle was a bit of an escalator. Mr. Cleveland does not believe we will repeat this cycle of hikes. “We might see a 1994 scenario with hikes and pauses; the Fed wants it to be data-dependent,” he added.
Outlook
Mr. Cleveland made the case that the data-dependent Fed might see data to encourage a move sooner than market expectations of December hike. Once the Fed starts moving, expect the rate increases to be slow and gradual, with little movement in the long end of the yield curve, all very data dependent. Especially given the current supply and demand imbalances in the market, expect lower rates for the foreseeable future.
Evaluating Managers and the Investment Program
Members say management always asks, “What do other corporations do?” Through peer benchmarking, The NeuGroup is working to develop a model derived from the TIMPG-2 that members can use in evaluating their asset managers, investment funds and investment results. Here are some of the highlights uncovered through member discussion:
1) The return against other managers with similar mandates and the ability to position the portfolio relative to a benchmark both rank as very important to members when evaluating a manager.
2) Some members are seeing success moving away from traditional benchmarks. One member warned that traditional benchmarks could be used as security blankets.
3) All treasury benchmark forces managers to make their own sector allocations. One member company does not dictate allocations or sector weights, but it limits managers to a maximum of 20 percent per sector.
4) Use results to evaluate managers. Some group members use scorecards that rank managers (some are blind rankings; others allow managers to see each other’s names). Metrics shown include: standard deviation, Sharpe ratio, total return and gap net income (similar to book yield).
5) Regular meetings with managers are important, but the more frequent touch-base meetings can be conference calls.
When possible, members have found that using a scorecard, preferably with some type of risk or income metrics in addition to total return is the most effective evaluation tool. Benchmarks are helpful and can be used as “smoke alarms” to alert moving into danger; however, benchmarks do not always accurately represent the actual investment mandate.
Managing Liquidity Through Evolving Regulation
Managing very short liquidity pools has never been more complicated. Money market funds have been the one reliable place to manage liquidity with no volatility. As this changes we explored how members are handling their most-liquid pools of assets.
Key Takeaways
1) Opinions vary on money market funds. According to the TIMPG-2 pre-meeting survey, members are taking a variety of approaches to money market funds.
- 21.4%: Opted to stay in prime funds.
- 14.3%: Opted to move to or are already in government funds.
- 21.4%: Considering a separate account.
- 42.9%: Other (includes evaluating, using SMA, and looking at a mix of funds.)
2) Floating NAV is less of a concern. One member company is trying to utilize an enhanced cash fund but is uncertain how easy this will be administratively. “The floating NAV is less worrisome than if in a crisis we got money stuck in a money market fund,“ the practitioner from the company.
3) Liquidity is first; then capital preservation. A practitioner in the pharmaceuticals industry noted that his company’s first priority is liquidity and then capital preservation. The company does have a fair amount of cash on the balance sheet to support business development, so its priorities might have to shift a bit with the changes in the marketplace. The company’s investment management team estimates that 20-60 percent of investors in prime funds will consider pulling out. Where is everyone going to go?
4) Trying to use money-market demand deposits as a prime fund option. Another member company uses money-market demand notes in the investment portfolio. However, this instrument is less liquid than the prime funds and less flexible when you need the money.
5) Build an internal portfolio. Some member companies are deprioritizing money market funds. One member company looks at on- and offshore cash and uses some money market funds and government funds, although money market funds are not a big focus. The company has built an internally managed trading portfolio with one-year target duration. Another member company has also brought investments in-house. For this portfolio, the company is sticking to US government and agency issues along with commercial paper. It does use separately managed accounts for the credit portion. Yet another member company has three dedicated credit people managing about $10 billion in-house.
Outlook
Regulation in money market funds will change the dynamics of the short-term market. Many members have already seen the decreased supply in bank deposits. Members have gotten creative when it comes to decreasing reliance on prime money market funds, from reviewing alternative funds or deciding to manage the funds internally. When all else fails, there are always government money funds.
Changing Landscape of Corporates
For many members, the corporate bond portfolio is the largest sector component. How do corporates add value in a short-duration portfolio? Will the regulations designed to prevent a liquidity crisis put pressure on the short-term market that will result in a liquidity crisis?
Corporate yield spread provide investors with multiple benefits in the current market environment.
1) Higher odds of avoiding market losses associated with interest-rate increases (spread as a buffer to rate duration risk).
2) Yield enhancements in a stable spread environment.
3) Robust new issue market continues to offer investors concessions to existing bonds and new issuer opportunities.
When investing in the corporate market, members need to manage liquidity. Good credit research has never been more valuable. Prepare for periods of illiquidity and view them as an opportunity to find value. Also continue to increase diversification and look for value within sectors.
Portfolio Optimization – Getting the Right Mix
TIMPG-2 members explored portfolio optimization given guideline constraints and managing the various types of risk.
Key Takeaways
1) Most people have too much liquidity earning very little. The goal of an optimization program is to build an all-weather portfolio, especially with stormy weather ahead. Mary Beth Syal, managing principal at Payden & Rygel recommends tiering the short-term portfolio for relevant time horizon, return expectations, and risk tolerance.
2) Credit ratings have migrated lower. The market has responded by increasing the universe of allowed assets. “There is some comfort in knowing that everyone else is migrating their investment policy to allow lower-rated credits,“ noted one member practitioner. There is a systemic change in how corporates invest money. Her company de-risked, adding more non-financials, and are more diversified by allowing lower credits.
3) Determine how much loss you can handle. Ms. Syal recommends members think about a tiering concept from a duration standpoint. When reviewing the tiering, ask yourself how many negative months in the last five years you could have handled? Bloomberg does a gap break-even analysis using the GA3 code. The opportunity cost is keeping the money short to try to earn more later if we think a hike is coming. A positively sloped yield curve can provide higher total return, not just higher yields. The higher return potential can also provide more protection from rising rates despite having a longer duration.
4) Use floaters to balance interest rate risk. Most guidelines have a duration focus and do not restrict total credit exposure. Utilizing corporate floaters allows for a higher yielding portfolio; however, spread duration is longer, so you will have more exposure to changes in credit spreads.
5) Sector diversification provides improved risk metrics. Over a 10-year time frame that ended on 3/31/15, a blended corporate and government portfolio has a lower standard deviation and higher Sharpe ratio than a US Treasury mandate or corporate-only mandate.
6) The addition of BBBs has improved portfolio risk measures. Adding BBB issues to the investment portfolio has improved both average annual returns and Sharpe ratios (based on 10-year trailing returns as of 3/31/15).
Outlook
Building an all-weather portfolio for stormy seas ahead requires portfolio optimization that focuses on sector, duration, and quality. Reviewing investment policy for additions through quality or sector is as important as optimizing the existing opportunity set.
CONCLUSION
Preparing for rising interest rates and an expected drop in corporate liquidity seemed to be the themes for the meeting. Sponsor Payden & Rygel made an excellent case for why the Fed will consider a rate increase at any of the upcoming meetings and walked members through portfolio optimization, focusing not only on sectors that should be in the mix, but also reviewing quality and duration inputs to optimization. Money market reform, when first presented by the SEC, seemed light years away, but as we move closer, members are preparing for the change by taking a hard look at how they manage cash and measuring the success of the investment program.