Relatively low global short-term interest rates continue to challenge investors. Rates declined precipitously in the US and throughout Europe and the UK in response to geo-political fears, tepid economic growth and concerns regarding the deteriorating credit market over the last 19 to 24 months. While rates have rebounded somewhat this year in response to more favourable economic news and credit markets, declining income streams making earnings targets more difficult to achieve have plagued yield-seeking investors.
Short-term investors typically fall into two categories: those that are required to invest in short-maturity securities such as money market mutual funds and those that strategically choose to invest in short-maturity securities. Examples include corporate treasurers and investors with uncertain portfolio time horizons. Investments of choice for these investors, regardless of category, have typically been bank time deposits, commercial paper and government securities such as one-to-three-month maturity US Treasury bills. Money market mutual funds have also been popular short-term investment vehicles.
Principal stability (a constant net asset value) is the primary attraction of money market funds. This stability is derived from money market funds’ stringent restrictions on the maximum maturity (397 days) of the securities in which they are allowed to invest. There are opportunity costs associated with limiting investments to money market funds, to be sure, namely lower yields and less diversification.
Today’s yield environment as depicted in the government yield curve chart is particularly attractive for investors who seek ways to optimise the tradeoff between yield and principal stability. An ‘enhanced cash’ investment strategy focuses on moderately extending maturity, and in doing so, broadening the universe of investable securities. The result is a more diversified portfolio with a higher yield and credit quality than a typical money market fund. Is this a ‘free lunch’? The answer is yes and no. By slightly extending maturity, for example, from one to two years (see government yield curve chart), US and European short-term investors can increase their annual portfolio yield by approximately 0.50% to 0.75% without sacrificing credit quality. From a credit quality perspective, this certainly looks like a free lunch.
There is a cost, albeit a minor one, to the lunch, however. While the enhanced cash portfolio’s longer maturity provides a higher yield, the longer maturity changes the degree of principal stability. As rates change, the portfolio’s value will fluctuate inversely with the rate change. As rates rise, the portfolio value will fall, and vice versa. Like any bond portfolio, the longer the average maturity, the greater the principal fluctuation.
There are, however, factors that mitigate this principal volatility such as the slope of the yield curve, or the yield difference between maturities. Generally, the higher the yield differences, the less the fluctuation in principal. For example, in today’s steeply sloped yield curve environment, yields can rise by about 1.0% to 1.2% over a 12-month time period before the total return (ie interest plus price change) on the enhanced cash portfolio would fall below the money market fund return.
Access to a wider universe of securities, and hence, greater portfolio diversification, is another important benefit of the enhanced cash strategy. While money market fund-eligible securities are limited, the universe of short-term securities with maturities of three years or less is broader. The universe includes high quality corporate notes, asset-and mortgage-backed securities in addition to the traditional money market securities mentioned earlier. It is important to note that the breadth of short-term investments differs by geographic market. The US short-term market, for instance, is the broadest, with ample supply of short maturity asset-backed securities (ABS); while the short maturity UK and European asset-backed markets are still developing.
The key to achieving higher yield with greater diversification in today’s environment is to invest with a global perspective. A UK or euro-based investor could take advantage of the higher yielding US ABS market, for example, by investing in US ABS and hedging the currency exposure. Current interest rate differentials between the US and Europe make it possible for UK and euro-based investors to achieve higher yields by investing in selected currency-hedged international securities. Table 1 provides a current summary comparison of short-term portfolios and their currency-hedged yields.
Enhanced cash strategies, therefore, present a compelling alternative to money market funds for short-term investors. By modestly extending the duration of a money market strategy, an active portfolio manager can take advantage of a broad universe of global short-maturity securities to construct a high quality portfolio that provides added yield without adding a significant amount of risk, especially in today’s market environment.
Jim Sarni is a managing principal with Payden & Rygel IM in Los Angeles