Article from PIMCO
Australia
Additional monetary policy options are being implemented combined with a hope for more fiscal solutions to address the current global economic malaise. Still, until these solutions are clearly implemented, there will likely be uncertainty regarding immediate demands for liquidity and the oscillating valuations of credit. In the short-term markets, virtually the only variable we can feel confident in is that the Federal Reserve expects not to raise rates before mid-2013.
Investors should look deep into the mines of investment opportunities to find glittering value. To cite just one example, we currently see compelling opportunities in short-dated, non-financial BBB-rated corporate bonds. The ratings alone might discourage some investors from pursuing such an opportunity, but our macroeconomic insights and credit analysis allow us to identify companies with stable cash flows and profitability. So we can pursue opportunities for our clients that differ from those seen in strategies constrained by traditional money market fund regulatory frameworks alone.
Viewpoints
October 2011
- The latest volatility has investors
asking questions about the securities they own, in particular probing any
exposures to European issuers.
- Cash investors often over-allocate to
money market and bank investment vehicles, while the most attractive
risk-adjusted opportunities might fall just outside of this space.
- We currently
see opportunities in short-dated, non-financial BBB-rated corporate bonds,
along with dollar-hedged bonds and bills issued by sovereigns with solid balance
sheets.
The properties of pyrite – fool’s gold, as it’s commonly
known – are worryingly similar these days to the characteristics of many
short-term portfolios investors are using these days for maintaining defensive
liquidity-minded cash positions. Investors have in recent weeks sought refuge
from volatility by delving into the mines of “cash equivalent” portfolios in
search of greater stability. While many money-market strategies, especially
those that favor credit, look like valuable commodities, their appearances may
prove deceiving and may even, like pyrite, blow up if left unmonitored in the
wrong environment.
We believe investors need to be more cautious than ever when
considering allocations to short-term strategies. Traditional money market
liquidity strategies often advertise easy access to the cash in the portfolio.
However, investors need to dig a little deeper to accurately determine whether
the minerals they hold will be valuable – both in terms of liquidity and credit
performance – over a range of market scenarios.
Just as minerals show up on a periodic table, money market
securities provide relative levels of liquidity across a broad spectrum.
However, when market conditions change, the liquidity embedded within
securities can change, too, as liquidity preferences themselves change. The
recent volatility over the past two months has supported this dynamic again, as
dealers and investors become more defensive in bidding for securities in an
ever more stressed marketplace. Securities that are perceived to have high
value because of liquidity or relative yield can look a lot different once
investors start worrying about, say, the possibility of Greek default or
broader credit concerns in Europe.
The latest volatility – and volatility looks to be with us
for a while – has investors asking questions about the securities they own, in
particular probing any exposures to European issuers. Since 2010, some
investors have migrated from strategies containing commercial paper (CP) and
certificates of deposit (CDs) to those focused on only purchasing government
debt. Yet, as we saw in the 2008 and other recent crises, there has tended to
be less willingness to provide liquidity to holders of commercial paper – the
bid-ask spreads for financial and other high-beta issuers have widened greatly
– so what typically might be deemed money-market worthy instruments in better
times may be anything but sources of marketable liquidity.
In times of stress, we believe only Treasury securities,
over-collateralized repurchase obligations and insured demand bank deposits
will be able to withstand the stress of a liquidity vacuum and continue to
provide portfolios with adequate access to cash in a variety of market environments. The cost of this “purity” can be quite expensive
though: near zero percent yields, currently.
None of this is
meant to alarm investors. Rather, we are suggesting that liquidity focused
investors exercise prudence and insist on 1) rigorous, ongoing analysis of
their actual liquidity needs and the true value of their holdings and 2) active
liquidity management that continually searches for value to help preserve
returns in a low-yielding environment.
With proper
liquidity management, we believe investors are able to make more prudent
selections with their intermediate cash balances and find more favorable and
proper risk-reward metrics for their portfolios in the process. Put another
way: Why own commercial paper from an issuer paying 0.10% if you can own the
same credit except only six months longer in maturity and offering yield in
excess of 2%? This is an example of one of the inconsistencies in the money
markets that may make them less-than-compelling investment alternatives for
liquidity provisioning.
Mining for Yield as Supply Dwindles
and Volatility Soars
Additional monetary policy options are being implemented combined with a hope for more fiscal solutions to address the current global economic malaise. Still, until these solutions are clearly implemented, there will likely be uncertainty regarding immediate demands for liquidity and the oscillating valuations of credit. In the short-term markets, virtually the only variable we can feel confident in is that the Federal Reserve expects not to raise rates before mid-2013.
Meanwhile, issuance
of eligible assets in the money market arena has dropped considerably, driving
down yields even as demand for money-market instruments grows. This can and has
led to less desirable risk/return options as many money-market portfolios are
forced to diversify into short-dated credits they would likely have avoided if
other alternatives were available. We are often seeing these funds forced into
a corner of the world that is growing more and unattractive due to dwindling
supply mechanics. Evidence of this is the high percentage of CP/CD assets that
still make up a large percentage of assets under management for these regulated
funds: more than 40% as of September 30.
Cash investors
often over-allocate to money market and bank investment vehicles, while the
most attractive risk-adjusted opportunities might fall just outside of this
space. In the past, we have suggested that when an investor has an abundance of
excess cash that they should look at short-duration and enhanced-cash
strategies. Investors can move excess liquidity out of traditional money
markets often for incremental adjustments in risk, and with active portfolio
management that is not constrained by traditional money market fund regulatory
guidelines, dynamically adjust their positioning to liquidity changing conditions
while seeking to produce more attractive risk-adjusted returns. To be able to
do so, however, their managers must be able to continuously and consistently
analyze credit and manage their portfolios accordingly.
When investors
develop a logical framework and determine that some of their cash can instead
be invested in strategies that exist beyond money markets, they may discover a
new world of liquidity and higher return potential that they hadn’t seen
before. Market volatility that causes portfolio losses may be uncomfortable for
some cash investors, but daily volatility does not always equate to longer-term
losses. While it might create losses for the money-market portfolio looking to
sell CP below par, for strategic short-term portfolios it can create
opportunities to capture liquidity premiums by acquiring positions at
discounted levels or purchasing assets that offer compelling yields and may
have a high probability of being called or maturing in full. The poorly
positioned investors who are being forced to sell to generate liquidity are
helping to create these opportunities.
Where We See Value
Investors should look deep into the mines of investment opportunities to find glittering value. To cite just one example, we currently see compelling opportunities in short-dated, non-financial BBB-rated corporate bonds. The ratings alone might discourage some investors from pursuing such an opportunity, but our macroeconomic insights and credit analysis allow us to identify companies with stable cash flows and profitability. So we can pursue opportunities for our clients that differ from those seen in strategies constrained by traditional money market fund regulatory frameworks alone.
Other examples of
where PIMCO sees value in cash equivalents include buying bonds and bills
issued by sovereigns with solid balance sheets (think Australia, Mexico, and
Japan, for example) and hedging them back to the U.S. dollar.
Putting it all
together, PIMCO believes that pursuing better-than-zero returns in an actively
managed, short-term cash strategy – and doing so with an eye toward proper risk
management – requires actively reassessing both your immediate versus
intermediate liquidity needs, while allocating quality credit risk to your
portfolio at proper risk-reward metrics. Failure to do both may cause you to
end up holding fool’s gold.
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Cash Equivalents
are defined as any security with a duration less than one year.
Past performance is not a guarantee
or a reliable indicator of future results.
Investing in the bond market is subject to certain risks
including market, interest-rate, issuer, credit, and inflation risk. Investing
in foreign denominated and/or domiciled securities may involve heightened risk
due to currency fluctuations, and economic and political risks, which may be
enhanced in emerging markets. Sovereign securities are generally backed by the
issuing government, obligations of U.S. Government agencies and authorities are
supported by varying degrees but are generally not backed by the full faith of
the U.S. Government; portfolios that invest in such securities are not
guaranteed and will fluctuate in value. There is no guarantee that these
investment strategies will work under all market conditions or are suitable for
all investors and each investor should evaluate their ability to invest
long-term, especially during periods of downturn in the market.
This
material contains the opinions of the author but not necessarily those of PIMCO
and such opinions are subject to change without notice. This material has been
distributed for informational purposes only and should not be considered as
investment advice or a recommendation of any particular security, strategy or
investment product. Information contained herein has been obtained from sources
believed to be reliable, but not guaranteed. No part of this material may be
reproduced in any form, or referred to in any other publication, without
express written permission.
Pacific Investment
Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2011,
PIMCO.
Article from PIMCO
Australia