By Barb Shegog
Liquidity is about to get more expensive; time to turn rate hikes to your advantage.
Investors in the short-term fixed income market are facing a new investment challenge. Increasing regulation restricting a bank’s ability to issue short-term debt has decreased the availability of these assets while at the same time changes in money market fund regulations have increased the demand for them. Not a great environment for a short-term cash investor.
One solution is to shift funds longer in duration and invest outside this cash universe. But trying to sell this proposition to your management when the Fed is poised to increase interest rates is not an easy sell.
That’s because preconceived notions exist that fixed income is a loser when rates rise and investors can lose money. This could be the case for a longer fixed income, but is not always the case in short-duration fixed income. Predicting moves along the yield curve and the movement in the shape of the curve is humbling.
“Historically periods of rising rates have not meant negative returns,” notes Andrew Smock from Merganser Capital Management. “Don’t be afraid of short-term bonds and mis-timing.”
Why would an investor keep additional liquidity waiting for rates to rise? Isn’t this trying to time the market?
Structure portfolio to match cash needs
“Most people have too much liquidity earning very little [return],” notes Mary Beth Syal, from Payden & Rygel. Therefore, the goal of an optimization program is to build an all-weather portfolio, especially with stormy weather ahead. Ms. Syal recommends tiering the short-term portfolio for relevant time horizon, return expectations, and risk tolerance.
The goal would be to match timeframe and need with the investments, thus avoiding liquidity risk and giving investors more confidence to invest outside the traditional cash universe. Ms. Syal says investors should think about a tiering concept from a duration standpoint, and when reviewing the different buckets she suggests investors ask themselves, “How many negative months in the last five years could you have handled?”
Fixed-income markets have rewarded risk-taking
Looking at the past ten years’ worth of data, investors have gotten what they reached for, as the risk-reward graph (see below) demonstrates a very linear slope and an efficient market. Knowing your cash-flow needs and being able to take on as much risk as possible has paid off with incremental yield.
Time heals short-term pain
Rising rates should not be a major concern in this environment. As rates go up, the new higher yields can make up what is lost in price return. A short-duration core strategy’s (1.7 years duration) one-year expected return with a 100 basis point rate shock is only slightly negative at -0.10 percent; with rate shocks between 25-75 basis points, the expected total return moves positive.
Opportunity to test out data first hand
The long-awaited Fed hike is nearly here. Recently the thought was a December move but now it could be sooner, which demonstrates how unpredictable the timing and events can be.
“US economic data showed some signs of modest improvement after months of lackluster results,” notes Merganser’s Mr. Smock. “Retail sales were relatively robust for the first time in three months, first quarter GDP was finalized with a revision up to -0.2 percent and employment numbers remained robust. On the margin, a September hike looks more likely than it did a month ago, but is by no means assured.”
Mr. Smock adds that the market volatility resulting from the problems in Greece “has been well contained and certainly not enough to override the Fed’s focus on domestic data.” That said, “Data has been mixed,” he says. “If domestic economic data fall short of expectations then global geopolitical and market risks such as Greece and China will have a greater impact on decision making at the margin.”
These events further demonstrate that trying to time the Fed to shift investments from cash to short-term bonds is very difficult.
Whatever the uncertainty around the timing of a rate rise, what is certain is that liquidity will get more expensive to keep. And as a result, investors are going to have to think about their needs more carefully than they have in the past.
Interest rates have a track record for being fickle and unpredictable—some experts warn that market rates might not immediately follow the Fed’s hike—and investors cannot sit on the sidelines waiting for rates to increase to reinvest. Embrace the opportunity to turn rate hikes into a higher-yielding portfolio now.