Looming reforms and rate hikes join sluggish and volatile markets to drive portfolio shakeups.
The Treasury Investment Managers’ Peer Groups 1 and 2 (TIMPG and TIMPG2) met April 26 and 27 in New York City, sponsored and hosted by Goldman Sachs Asset Management. This is the first time both groups have met for a TIMPG Summit. Members are grappling with upcoming money market fund reform, dislocations resulting from the short-term fixed-income market, income policy statements that need to be changed, and the threat of rising interest rates.If they’re going to win, investment managers will need to do the following:
Watch the New Horizon for Global Bond Markets. Banking and SEC regulations are affecting the short-term markets and have market implications, so stay nimble.
Find New Ways to Invest Cash. Despite continued spread tightening in the corporate markets, spreads are still wider than pre-crisis markets and still offer value.
Manage Risk — Top Down and Bottom Up. With portfolios changing, risk management requires clear metrics and benchmarks.
A New Horizon for Global Bond Markets
The current state of the fixed-income market includes very aggressive monetary policy around the world and negative interest rates in a large percentage of the government bond market. With the help of Goldman Sachs Asset Management (GSAM) team members, the group reviewed how to prepare the investment portfolio for what’s ahead in the fixed-income market.
Key Takeaways
1) Fed will continue to tighten slowly. Jonathan Beinner, Chief Investment Officer and Co-Head of Global Fixed Income and Liquidity Management for GSAM, believes that the US will see another couple of years of 2%-type growth and a continuation of inflation pressure. He estimates the Fed will tighten and risk upside inflation to avoid downside risk to growth. When inflation goes past the 2% threshold they can put the brakes on tightening.
2) Europe is pretty grim compared to the US. Andrew Wilson Chief Executive Officer, GSAM International, EMEA, and Co-Head of Global Fixed Income, noted that if Europe was experiencing even the “lackluster” growth of the US, they would be having a party. The non-US markets have experienced extreme volatility which shows central bank action can drive markets. When thinking about investing in a world where central banks are so active, they are buying to stimulate economies, not for yield, and this has implications for corporate spreads.
3) How do you handicap Brexit, and what are the implications for the economy and markets? Mr. Wilson sees the chances of Britain voting to leave the EU as a 25% chance, currently the lowest Brexit case yet. The consequences of an exit are very hard to assess but a downshift in economic activity would be expected. There would be a mandated two-year exit plan if Britain should vote to leave.
4) China addressing policy missteps. Mr. Wilson noted that policy efforts are now backing away from some reforms and focus is more on economic stability. He noted that sooner or later China will have to move away from their central case of a soft landing with 6-6.5% growth. But eventually that has to come down to something more sustainable.
5) Liquidity becoming tighter. Liquidity has become challenged, explained Mr. Beinner. The bond market is an OTC market; the corporate bond market has never been highly liquid, even in normal times. To prepare for money market fund reform, GSAM is positioning the portfolio more conservatively as the October implementation date approaches. During this transition period GSAM expects to be very conservative.
Outlook
A slow, steady recovery is expected. Balancing all of the global volatility and Fed moves can be tricky. It looks like investors may have another year to wait before seeing additional rate hikes, or at least more than one hike.
When Did Cash Get Complicated?
Money market fund regulation and other changes to the market are altering the dynamics of supply and demand, as well as making historically simple and safe investment places far more complicated.
Money market fund reform may increase demand for government securities, and the liquidity coverage requirements may increase the demand by banks, custodians, and financial institutions for high-quality assets. Several members have noted their corporations’ desire to transfer to government money market funds. The GSAM team says there’s enough supply to meet the increased demand for short-term product in the government market, but the timing around moving from a prime fund to a government fund is hard to predict. GSAM is preparing for money movement on both sides of the platform.
As we move toward regulation changes in money market funds it is important that all prime funds and government funds be reviewed and investment policies adjusted to reflect what the funds will look like starting in October.
How Are You Investing Your Cash?
With money market fund regulation taking effect this fall, customized short-duration strategies can play a role in managing strategic cash needs. Members explored the evolution of managing liquidity.
Key Takeaways
1) Build-up in cash positions and low yields have forced corporations to look beyond money market funds. The low-yield environment has resulted in an evolution of the cash portfolio. The process begins with moving to a slightly longer duration, then adding additional asset classes, and eventually tiering the portfolio into liquidity buckets.
2) Good forecasting model is critical to taking the next steps. A group member explained that one risk he faces is business risk and internal management. He relies heavily on a good forecasting model to set up the investment portfolios. His company has three “tiers.”
3) Separately Managed Accounts (SMA) can provide liquidity. Investors are feeling more comfortable about being able to get liquidity from separate accounts. The high-quality front end paper is in very high demand. A member noted that communication is critical — and the more notice you can give, the better. Although one member commented that his company had a large SMA liquidated in a matter of days when a surprise acquisition took place.
4) “Alternative” cash investment products are starting to emerge. Investors are starting to consider alternatives to money market funds. Limited term repos and private placement funds weren’t even considered a few years ago, and now they are emerging as alternatives to money market funds. Members are still finding availability in bank deposits at Japanese banks or smaller banks. MMF portals are now including deposits within their systems and can also help consolidate counterparty risk. Some members raised concerns around transparency and these newer funds being unregulated and unregistered.
Outlook
Money market fund regulation changes have forced members to revisit cash investment options. SMA products are being considered more as an investment option to add yield and diversification to the investment program. Understanding the corporation’s cash-flow needs to maximize the tiering of the portfolio will be critical.
Getting Management Comfortable with Emerging Markets
In order to have his management get comfortable with this sector, one member asked the GSAM team how they get comfortable with all the names they invest in. One of the keys is learning on the ground. GSAM’s credit group covers 60-70 countries, and they are very integrated as a team, with the hubs in New York, London and Singapore. Roadshows are very helpful to give them a glimpse into the names in-between data releases. Over time they have also built up relationships in the group to provide constant color, and they “learn by listening.” GSAM takes a skeptical approach: If the issue starts to deteriorate, “move out of it fast” and avoid the jump to default risk.
Low yields force investors to look to the higher-yielding sectors. Members that can invest in emerging markets agree that this is an area that should be given to an external manager. Members were encouraged to use these managers as an extension of their own staff. Also for the higher-risk cycles, make sure strong communication lines are set up between you and the managers and the supporting team is deep and experienced.
Managing Risk — Top Down and Bottom Up
Taking a look at risk from a top-down perspective, Bill McMahon, Head of Risk Management for GSAM’s Investment Management Division, shared how the team assesses risk across client mandates.
Key Takeaways
1) Make sure you know where your margin is. Mr. McMahon explained that his division looks at both market risk (prices up and down) and credit risk. They also are being asked more often to report on liquidity risk.
2) Liquidity risk measured in three dimensions. In GSAM’s three-tiered approach, the team first reviews market liquidity. Liquidity will not always stay the same, and at any point, you will be able to get out; however, you might not like the price. A second measure is looking at redemption liquidity. GSAM does an extensive profiling of all its funds (assets and liquidity on a daily basis). The third component is fund liquidity. When derivatives are used on the fund level, they always make sure they have enough cash set aside under stressed market conditions.
3) Align risk management process with the investment process. It’s important to ensure that there is a level of transparency and understanding of risk metrics. This would include how the risk metrics are calculated and what people are going to be held accountable to. It is important to integrate the risk management team and the portfolio managers.
4) Performance can be an early indication of risk metric success. Looking at performance can be an early and good indicator of what risk metrics may not be showing. Both positive and negative side performance and standard deviation of performance movements can be helpful. Performance is reviewed outright or against a benchmark that GSAM has established.
5) Where is the benchmark-hugging coming from? “Since 2008 I’ve never seen such hugging of benchmarks,” one member noted. “Where is that coming from?” GSAM takes the benchmark as your risk expectations, so the benchmark is used to set the risk budget. If you believe the investment manager is hugging the benchmark too much, it is important to make sure that it is understood when you set up the portfolio how much out-of-benchmark risk you are willing to take. Tracking error and out-of-benchmark holdings are two levers to measure risk, explained a GSAM team member.
Outlook
Transparency, understanding, ownership and accountability are the keys to a successful risk management program, explained the GSAM team. Well-communicated risk profile and tolerances can help the portfolio manager in setting up the portfolio and taking on enough risk.
Risks and Opportunities in the Fixed-Income Market
Although interest rates are low, options exist to add incremental yield to the investment portfolio. Members examined some key asset classes, including emerging markets and municipals, and assessed whether the risk is worth the reward.
- Emerging markets are performing well after a three-year drought. Drivers of this better performance are global liquidity and commodities bouncing off the lows. A structural driver also in emerging markets and a bright spot is the improvement in government policies.
- Market technicals in the municipal market are extremely important. A big outflow in funds has been met with strong demand in the face of moderate-to-low supply. Credit fundamentals remain strong (except Puerto Rico). In general the market has experienced two upgrades for every downgrade.
- The securitized market offers attractive carry. One opportunity right now is to lend via the repo market secured by non-government assets for three months to a year and get spreads over LIBOR. Where investment policies don’t allow this trade, floating-rate instruments, such as student loans or CLO issues, may be worth a look.
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