Enhanced yield strategies
New lows in global short-term interest rates have rendered investing problematic for yield-seeking investors. While declining rates are good for bond prices, they are not very welcome news for the many investors who rely on a stable or growing stream of income. Weak global economic growth, lurching equity markets and a new, post-September 11 age of geo-political anxiety have all contributed to the current rate decline. All of the uncertainty has been manifest in investor ‘flight to quality’. More pointedly, there has been a ‘flight to short maturity instruments’, as investors pursue principal stability in an otherwise volatile arena. Ironically, this flight to short maturity instruments is fueling further interest rate declines, as increasing amounts of money chase a limited supply of high quality, short-term investments.
The rapid retreat to short maturity instruments creates a quandry for investors. Pension fund managers, corporate treasurers and retail investors are among the many facing this challenging dilemma. While shortening portfolio maturity provides the sought after principal stability, it comes at the expense of diminishing yields, thus driving overall portfolio yields lower. This quandry is certainly not new, having come about in previous low interest rate eras. In the past, however, investors sought higher yields by relaxing credit quality constraints and by investing in lower quality, short-term instruments. This solution is simply not as palatable today in the current tumultuous credit environment. Fortunately, there does exist a viable alternative investment strategy that will be discussed later.
Investors’ short-term instrument of choice has typically been the money market fund, as illustrated by the recent rapid growth depicted in the chart. Money market funds are highly regulated and invest predominantly in high quality, short-term financial instruments such as government and quasi-government securities, commercial bank obligations and unsecured corporate obligations also known as commercial paper. These funds carry the stringent requirement that they invest in securities with a maximum final maturity of no more than 397 days.
The distinguishing feature of money market funds is their ability to maintain a constant net asset value of one dollar; meaning that for every dollar invested in a US money market fund, investors can reasonably expect to receive one dollar plus interest in return – ‘dollar in/dollar out’. The principal stability provided by money market funds emanates primarily from the onerous maximum maturity restriction mentioned above. Despite some brief occasions in past years when a few funds came perilously close to falling below the one dollar net asset value – “breaking the buck”, these funds have by and large offered investors principal stability. The principal stability comes at the expense of a considerable amount of reinvestment risk.
As previously mentioned, there is an attractive alternative investment to money market funds for short-term investors seeking principal stability, higher yields and protection from declining interest rates. Commonly referred to as ‘enhanced cash’ investment, this strategy focuses on modestly extending maturity, and in doing so, significantly broadening the universe of investable short-term securities. The result for investors: a better diversified, higher yielding and higher quality investment portfolio.
The table below shows a typical enhanced cash portfolio and a money market fund. Note that the enhanced cash portfolio has a slightly longer weighted average maturity and a more diverse range of investments, such as asset-backed and mortgage-backed securities as well as short maturity corporate bonds. Additionally, most of the aforementioned securities possess the highest credit quality rating of triple-A, thus contributing to the portfolio’s high quality orientation. Finally, note the attractive weighted average yield differential between the two portfolios.
Having discussed the relative advantages of enhanced cash portfolios, it is important to point out their main disadvantage. While the enhanced cash portfolio’s longer maturity usually provides a higher yield, the portfolio’s longer maturity changes the degree of principal stability. Changing interest rates will typically result in modest principal value fluctuations depending upon the maturity of the enhanced cash portfolio. Like any bond portfolio, the longer the average maturity the more volatile its value.
There are factors that mitigage this principal volatility, however. One such factor is the yield difference between maturities; another is the yield difference between traditional money market securities (ie, time deposits and commercial paper) and the alternative investments discussed previously. Generally, the higher the yield differences, the greater the principal value protection from rising interest rates. For example, currently yields can rise about 1.2% over a 12-month horizon before the total return (ie, interest plus price change) on the enhanced cash portfolio would fall below that of the money market fund.
Principal stability and yield advantage are certainly not the only considerations in deciding which of the two portfolios is more appropriate. Another consideration is the expected difference in total return. Enhanced cash portfolio returns have generously outperformed money market fund returns by 1.7%, 1.4% and 1.2% annually for the last three, five and 10-year periods ending September 2002, respectively1. Enhanced cash portfolios have exhibited this strong performance despite the considerable interest rate volatility over the last 10 years.
Structuring similar enhanced cash portfolios for European short-term investors is a challenge. The universe of short-term securities, other than money markets, in Europe is significantly limited, if not non-existent. European investors generally have choice between money market instruments or securities with a much longer maturity.
So what is a non-US investor to do? There is a creative solution that exploits the versatility of the US market by investing in short-term US dollar-denominated fixed income securities and hedging the currency exposure. In fact, the short-term interest rate differential between the US and most of Europe provides an attractive opportunity for investors in short-term sterling- and euro-denominated portfolios. For example, by using this technique, a UK and euro-based investor can achieve a currency hedged enhanced cash portfolio yield of approximately 4.1% and 3.7%, respectively, in today’s environment. This compares to respective sterling and euro-denominated money market fund yields of about 3.5% and 2.9% today. The enhanced cash strategy has therefore spawned a higher yielding portfolio for both the US and the non-US investor, while adding greater diversification and higher quality.
1 Payden & Rygel Enhanced Cash and money market fund composites
James P Sarni is managing principal at Payden & Rygel Investment Counsel in London