How Active Short‑Term Strategies Can Fill the Void Left by the Diminished Money Market Landscape
Investors seeking short-term, liquid, capital-preserving investment options with historically attractive returns may need to look just outside the money market universe to actively managed short-term strategies. The commercial paper (CP) market – one of the primary traditional sources of yield for money market funds – is broadly unattractive, after declining issuance in nonfinancial sectors tightened spreads and pushed absolute yields to near-zero levels. Amid this low-rate environment, active strategies that can adapt to ever-changing market conditions by utilizing a broader opportunity set may offer liquidity-focused investors materially higher levels of income for only modestly higher credit and maturity risk.
Liquidity déjà vu shrinks supply (and appeal) of commercial paper
Regulatory reforms, designed to make the system safer following the 2008 global financial crisis, fell short and the commercial paper market froze in March amid a wave of panic selling as virus fears intensified. The Federal Reserve stepped in and since the end of May has become proactively focused on ensuring ample structural liquidity in the financial system to prevent conditions from tightening again prematurely. As a result, U.S. front-end liquidity markets have largely functioned well, but structural changes have occurred, which have pushed the money market opportunity set to the lower bound, thus impacting investors seeking yield from capital preservation options. Consider that:
Corporate borrowers have changed their debt maturity profile. When money markets froze in March, many investment grade nonfinancial commercial paper issuers turned to lines of credit that were in place specifically to help reduce rollover risk. Since then, new Fed programs that increased investor demand for longer-dated investment grade corporate bonds have enabled corporate treasurers to replace some short-term funding with longer-term debt – shrinking commercial paper issuance to the lowest level since 2015 (see Figure 1).
- Prime money market funds have lost ground to government money market funds, just as they did in 2008. Investors and prime money market providers alike appear to have a renewed appreciation for the liquidity risk inherent in commercial paper and believe that spreads over T-bills – which are lower than before the March freeze – don’t justify the risk. Prime funds now own just 21% of all the commercial paper outstanding, down sharply from over 35% prior to the 2016 implementation of money market reforms. We think this trend will continue the longer benchmark rates remain near 0%.
Short-term credit markets: Where does PIMCO find yield?
We believe that defensive cash investors who remain return-oriented have options to selectively move beyond money funds into allocations focused, not just on yield, but importantly on total return (i.e., income + capital appreciation = total return). Our actively managed short-term strategies have key advantages over money market funds in seeking strong returns while maintaining a strict eye on liquidity and capital preservation (see Figure 2). These include:
- Potential yield advantage. Our strategies offer investors a potential yield advantage over traditional savings vehicles. With the passage of time, yield advantages can be earned, returned, and compounded upon as investors are able to grow their cash balance and potentially avoid the lower bound (see Figure 3).
- Diversification across asset classes. PIMCO’s short-term strategies manage a broader portfolio of sectors beyond the typical exposure to banks and corporate credit found in many front-end funds. We’re able to diversify by adding secured credit such as asset-backed securities (which are collateralized by a pool of assets, such as loans, credit card debt and receivables) and mortgage notes to a portfolio. Highly rated (usually AAA) asset-backed securities may offer better yield potential with the same or lower risk than lower-rated investment grade corporate debt, all without sacrificing liquidity.
- Appreciation potential. Our liquidity strategies – designed for intermediate needs, (i.e., over the next few months or quarters) – are positioned to benefit as opportunities present themselves. Selling appreciated assets before maturity – a tactic generally overlooked in short-term buy-and-hold liquidity portfolios – we believe is key to producing above-coupon returns in today’s near-zero-percent rate environment. Similar to previous zero interest rate periods, we are starting to see interest from investors tiering their allocations beyond immediate liquidity money markets to take advantage of the structural inefficiencies at the front end of the yield curve.
For the most recent quarter-end performance data, please see below.
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Key takeaway: alpha is more meaningful now than ever
With yields once again languishing near zero, delivering excess returns (alpha) by looking for relative value in multiple asset classes can be more meaningful because that alpha will be a much larger portion of an investor’s overall return. To generate alpha, PIMCO’s actively managed funds reallocate between asset classes as relative returns and risks evolve, proactively seeking to capture returns on appreciated assets, and even adapt as yields rise over the secular horizon. Thus, these actively managed short-term strategies aim to avoid the constraints of their passive benchmarks and are designed to be able to produce risk-adjusted returns that may better preserve investors’ purchasing power in this ultra-low interest rate environment, where every basis point counts.
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