By Barb Shegog
Anticipation of higher rates is forcing portfolio managers to be more proactive. No more waiting on the sidelines.
The fear of rising interest rates and of money market funds with fluctuating values has investors perplexed as to where to invest. Should they shift shorter to avoid principal price fluctuations with rising rates? On the surface, adjusting the portfolio’s duration makes sense. However, money market fund reform has changed the way investors use money market funds. These funds are not the automatic option for cash anymore, so where to? It’s a good time to see if there are any good answers to these questions.
Uncertainty principle
Markets aren’t supposed to like uncertainty. Brexit, the US elections, and unknown fiscal policy are all excellent examples of uncertainty. Historically, uncertain times are usually good for the bond market (lower risk) and bad for the stock market (higher risk). However, the US financial markets keep chugging along. The US stock market is breaking records daily. Some of the differences in today’s market are expectations around tax reform and lower corporate tax rates, changes to the US healthcare system, and a friendlier and less regulated administration. These items are good for risk-takers and have been good for the stock market. Not so good for the fixed income markets is investors’ fears that the Trump administration will encourage actions that promote faster job growth when the jobless rate is already low. Wage pressure could result in increased inflation.
When rates hover at all-time lows for years, it is easy to forget that what goes down will eventually come back up. Having worked with treasurers for years to prepare them for higher rates—and it seems every year higher rates are just around the corner—many believe now they really are just around that corner. Rates rise as the economy continues to rebound, and we are certainly seeing this. Now is the time to begin preparing for an upward shift in the interest rate environment.
As usual, the cost of doing nothing could be high. There is no more sitting on the sidelines to see how things play out. So waiting for rates to rise isn’t really an option anymore. As Jerome Schneider, head of short-term portfolio management at PIMCO points out: “Investors should take note of the low absolute yields which many of these ‘cash equivalent’ assets offer, in both absolute and relative terms.”
Mr. Schneider adds that although the Federal Reserve has begun moving toward higher rates beginning with last December’s hike, “some assets have not enjoyed the benefit of the march toward higher yields.” For example, yields on T-bills are structurally subdued, Mr. Schneider points out, with maturities less than three months trading below the lower rate threshold (the Fed’s reverse repurchase rate) of 0.5% established at the last meeting. And levels on repos “have caught the bug as well,” he says, (see chart below), and have spent much of December and the beginning of the new year at subdued levels well below the market “risk-free” rate (i.e., the overnight index swap rate, or OIS).
This means that investors should consider alternatives to MMFs such as SMAs if they choose to hold a higher-than-needed cash balance. “Holding very short liquid assets will be very costly in yield or income give-up,” Mr. Schneider says.
Laddered Structure Minimizes Interest Rate Volatility
When yields rise, fixed income securities will decline in price, and lose market value. However, this decline is only temporary; as the securities march towards maturity the security will mature at par. One option to minimize interest rate volatility is to build a laddered portfolio. Per Lance Pan, director of investment research and strategy at Capital Advisors, a portfolio of securities with laddered maturities “provides higher income potential in an upwardly sloping yield curve environment than government money market funds confined by maturity restrictions.” A laddered structure also allows reinvestment opportunities to adjust for unanticipated interest rate movements. One may adjust the “ladder,” meaning maturity distribution and weighted average maturity (WAM), as growth, inflation or Fed policy outlook changes throughout the year.
With the environment not looking good for rates, the entire fixed income market will face market pressure. Unfortunately, the fixed income sector tends to be highly correlated so there is no sector in which to hide. Some sectors will perform better than others in rising rates, for example the corporate fixed income sector. Rising rates can be a signal of an improving economy so corporate issues can experience positive price movement from spread tightening. The optimal portfolio is one that can be flexible and take advantage of a wide variety of fixed income investments.
Although there is no escape from rising rates, there are ways to minimize the volatility. Moving funds to very short term vehicles could be an option but will be very costly. Laddering the investment portfolio is also an excellent option for investors that have a good understanding of their required cash needs. Finally, being nimble and flexible when choosing appropriate sectors that do better in rising rate environments can help offset some price volatility from rising rates. Perhaps the best answer might be a combination of all three.