Today’s podcast features a discussion about what fixed-income investors with lots of cash on hand can do to increase their return potential. In today’s low-yield world, we’ll be talking about how extending maturity and taking more credit risk can be used. To discuss, we’re talking with Michael Rodgers, Senior Portfolio Specialist at Wells Fargo Asset Management (WFAM).
Laurie King: I’m Laurie King and you are listening to On the Trading Desk®. Today I’ll be talking with Mike Rodgers, Senior Portfolio Specialist at Wells Fargo Asset Management Global Fixed Income, about ways to potentially increase returns on cash portfolios. He’ll explain ways to consider, and one way is to adjust duration or the maturity of short-term bonds, and the second way is to invest in lower-rated credit, usually corporate bonds. Welcome to the program, Mike.
Mike Rodgers: Thank you, Laurie. Happy to be here.
Laurie: Let’s begin by talking about why investing cash portfolios is an important and timely topic right now.
Mike: Sure, I’d be happy to. It’s unfortunate we find ourselves in the all-too-familiar situation of an extraordinary ultra-low rate environment—orchestrated by the Fed, of course—to help buffer the economy and the market fallout associated with the COVID-19 pandemic.
The last time we found ourselves in an extraordinary ultra-low rate environment, it was for a different reason, which lasted seven long years.
Corporations have issued record levels of debt in the corporate bond market. For example, investment-grade new issue volume has reached an all-time high of more than $1.9 trillion as of the end of October, which is an increase of about 50% over the entire year of 2019. They also drew down their credit facilities at banks, and together, these two sources of cash allowed corporations to build their war chest of cash to help them through the uncertain environment of the pandemic.
Meanwhile, investors once again find themselves asking the same question the last time we were here.
Laurie: So the question for cash investors—or what they’ve been asking—is what can they do to earn more than 1 basis point, which is what, say, a government money market fund is offering? Is that right?
Mike: Yes, that’s the key question investors are asking. Money market mutual funds are one of the primary vehicles cash investors use to manage their short-term cash. Following the implementation of money market fund reform in October 2016, government money market funds became the preferred choice for institutional cash investors, as they are not subject to liquidity fees and redemption gates and maintain a constant NAV versus a floating rate NAV for prime funds.
In early March of this year, institutional government money market fund balances exploded as investors fled to cash as the pandemic spread globally and our economy began to shut down. In fact, government money market funds breached the $3 trillion level by the end of April.
Following the Fed’s aggressive response in cutting the Fed Funds target rate to a range of 0 to 25 basis points, investors in Treasury and government money market funds, in many cases, find themselves once again earning a paltry 1 basis point.
It’s our view that as investors think about increasing returns on their cash investments, it’s important to understand the two components of total return in fixed income, which are price return and income return.
Income return is and always has been the largest driver of total return in high-quality short-duration fixed-income. To increase return on cash, investors should be considering high-quality sources of income while achieving the primary objectives of capital preservation and liquidity.
There are two primary levers investors can pull to increase returns. One is extending maturities further out the yield curve or taking more credit risk within investment grade. Or they can do both depending on their appetite for risk and liquidity. Pulling one or both of these levers serves to increase income in portfolios, increasing the overall total return for investors.
Laurie: So these two levers that you just mentioned, one was to extend duration or move out the yield curve. So what exactly does that mean? Can you give us an example?
Mike: Sure, Laurie. Great question. One of the tools we use to determine relative value along the yield curve is to measure the amount of yield pick-up the curve offers depending on how steep the slope is.
With the Fed on hold for the foreseeable future, short-term rates on maturities two years and less are expected to remain anchored. Beyond two years, the curve begins to steepen. This allows investors to pick up additional yield, while at the same time, benefiting from rolling down the yield curve and capturing price appreciation, which adds to total return.
For example, right now the yield pick up from 3-months to 2-years is only 8 basis points, but the yield pick-up between two and five years is about 23 basis points. That’s not to say we advocate putting all your money out five years, but it does suggest opportunities beyond two years, which may make sense for a portion of your cash you may not need right away. This is one way to increase return.
Laurie: And what do you mean by the second lever, going down in credit?
Mike: As experienced short-duration fixed-income investors, our approach to managing portfolios emphasizes the importance of income generation by investing in sectors beyond U.S. Treasuries. We advocate prudently casting a broader net to capture well-diversified sources of high-quality income.
Some of the primary ways we achieve this are allocations to investment grade corporate bonds and high-quality AAA-rated asset-backed securities and agency mortgage-backed securities.
To increase diversification, we also include other high-quality sectors like U.S. agency debentures and other U.S. dollar-denominated foreign government-related debt. These sectors of the market are what we refer to as yield-advantaged sectors, as they provide income opportunities above and beyond U.S. Treasuries while still achieving the primary objectives of capital preservation and liquidity.
The goal is to capture well-underwritten diversified sources of high-quality income to drive long-term risk-adjusted returns over time. This focus on income is also important because it can mitigate the downside risk by providing an effective cushion to price volatility, which can lead to a more stable, resilient return stream.
I’d also like to point out that while income is important, bottom-up security selection is paramount to achieving the goals of capital preservation and liquidity, particularly in an environment such as this.
To mitigate credit risk, we leverage the expertise of our Global Credit Research team, which proactively helps ensure that we are buying stable to improving credits and avoiding those we expect to deteriorate. We build portfolios from the bottom up through a combination of robust fundamental research at the issuer level and an assessment of relative value, which is focused on ensuring that we are adequately being compensated for risk. Well-researched diversified sources of income are the key to providing consistent income and risk-adjusted returns over time.
Laurie: Well, many of our institutional cash investors are invested in money market funds, as you explained earlier. So now that you’ve described ways to add income and, thereby help boost and have more resilient total return, is there a more holistic or structural approach to take to optimize a cash portfolio?
Mike: That’s a great question, Laurie. As cash investors seek to increase returns, we typically see them navigate this challenge by tiering their cash portfolios into liquidity buckets, depending on their cash flow needs.
For example, operating funds needed to run their business on a daily basis are typically either invested in money market funds or held on deposit at their operating bank. Working capital and strategic cash, which are often defined as those funds not needed within the next six months to 12 months, can be invested beyond the money market fund spectrum.
By investing further out on the yield curve, these cash investors may be able to capture additional return opportunities that complement their operating cash investments. The investment vehicles appropriate for working capital and strategic cash buckets may include ultra-short-term bond funds, short-term bond funds, or a customized separately managed account. Ultra short and short-term bond funds can be a great way for investors who lack the scale to fully diversify an institutional portfolio to pull the two levers we discussed earlier.
Those investors with sizable cash balances may want to consider a separately managed account that can be specifically customized to their risk tolerance and liquidity needs and has lower fees generally than a money market fund or a bond fund, which can also be additive to total return.
Laurie: So Mike, do you have any last thoughts for our listeners to tie together all these ideas we’ve discussed today?
Mike: Yeah, fixed-income investors face three persistent challenges: managing liquidity, finding diversified sources of income, and protecting purchasing power.
Now in November 2020, we again find ourselves in another environment of ultra-low interest rates and the questions about where to find diversified sources of income and how to preserve liquidity while, at the same time, achieving the first objective—capital preservation. This is especially true for cash investors.
We believe there are two important levers to pull depending on risk tolerance and return objectives, which are to extend along the yield curve or seek high quality income within a variety of investment grade sectors.
Cash investors may also want to navigate this challenge at a more holistic level by considering their entire cash portfolio and tiering it into liquidity buckets with each bucket— operating cash, working capital, and strategic cash—being invested with specific goals in mind. This can be a daunting task, so what I’d like our listeners to know is that we are here to help navigate these challenges in this extraordinary low-yield environment.
Laurie: Well, thanks so much for your insights today and for joining us, Mike.
Mike: My pleasure, Laurie. I’ve enjoyed speaking with you today.
Laurie: For our listeners, if you’d like to read more market insights and investment perspectives from the fixed-income teams at WFAM, you can find them at our AdvantageVoice blog as well as on our website at wellsfargoassetmanagement.com. Institutional investors can also find all of the Income Generator series at wellsfargoassetmanagement.com.
Finally, to stay connected to our On the Trading Desk podcast and listen to past and future episodes, you can subscribe to the podcast on iTunes, Stitcher, or Overcast. Until next time, I’m Laurie King; take care.
100 basis points equals 1.00%.
Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.
The ratings indicated are from Standard & Poor’s, Moody’s Investors Service, and/or Fitch Ratings Ltd. Credit-quality ratings: Credit-quality ratings apply to underlying holdings of the fund and not the fund itself. Standard & Poor’s rates the creditworthiness of bonds from AAA (highest) to D (lowest). Ratings from A to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the rating categories. Moody’s rates the creditworthiness of bonds from Aaa (highest) to C (lowest). Ratings Aa to B may be modified by the addition of a number 1 (highest) to 3 (lowest) to show relative standing within the ratings categories. Fitch rates the creditworthiness of bonds from AAA (highest) to D (lowest).
For floating NAV money market funds: You could lose money by investing in the fund. Because the share price of the fund will fluctuate, when you sell your shares they may be worth more or less than what you originally paid for them. The fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time.
For retail money market funds: You could lose money by investing in the fund. Although the fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time.
For government money market funds: You could lose money by investing in the fund. Although the fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time. For the municipal money market funds, a portion of the fund’s income may be subject to federal, state, and/or local income taxes or the alternative minimum tax. Any capital gains distributions may be taxable. For the government money market funds, the U.S. government guarantee applies to certain underlying securities and not to shares of the fund.
Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. For a current prospectus and, if available, a summary prospectus, containing this and other information, visit wfam.com. Read it carefully before investing.