Hitting the Sweet Spot: Macro Uncertainty and the Ultra-Short Solution

In the current uncertain macro environment, it is tempting for treasurers to hunker down in their short-term investment comfort zone, namely money market funds (MMFs). Nevertheless, if they are prepared to step out into an ultra-short-duration strategy, investors can potentially garner returns over and above those offered by MMFs, while remaining in a low-risk solution.

Eleanor Hill, Editor, TMI (EH): How is today’s macroeconomic uncertainty impacting short-term cash investors?

Neil Hutchison, Lead Portfolio Manager for Managed Reserves, Europe, J.P. Morgan Asset Management (NH): Besides the ongoing macro shocks we are all familiar with, such as the US-China trade war and the UK-EU Brexit situation, one of the biggest uncertainties facing short-term investors is interest rates. When the Federal Reserve (Fed) made its first rate cut since 2008 in July this year, it was described as an ‘insurance cut’ of 25 basis points.

But investors were left wondering whether that cut was enough to prolong this stage of the cycle and continue expansion? Or whether it was insufficient, and recession was on the cards? The Fed made a second rate cut of 25 basis points in mid-September, throwing investors into greater uncertainty. And given that members of the Federal Open Market Committee are divided on what action the Fed should take moving forward, treasurers are understandably on edge.

In Europe, investors are also questioning where the lower bound for interest rates actually lies. Prior to European Central Bank (ECB) President Mario Draghi’s Sintra speech, it seemed that -0.4% would be the bottom. But that has now shifted down to -0.5% and could go lower. Switzerland, for example, is already at -0.75% and although the Swiss National Bank recently voted to hold rates at this level, a drop to -1% is possible. The ECB could well follow suit.

The extremely low interest rate environment and the question marks hanging over future interest rate cuts are posing a growing challenge for treasurers sitting on relatively large cash piles. Investors are looking for different ways to invest their short-term cash, as deposits aren’t able to offer the kind of return they would like. Even ‘platinum’ clients are now finding that their relationship banks cannot offer them 0% on deposits, so the gloves are off in terms of exploring alternatives.

EH: Against the backdrop of these macro-factors, what is the credit cycle situation?

NH: In our opinion, investment grade (IG) credit has been a concern for a while now. Ten to twelve years ago, around 20% of the European IG market was sitting in the BBB universe and everything else was rated higher; not all AAA - but laddered upwards. Fast forward to current markets and more than 50% of the European IG market is sitting in the BBB spectrum.

This makes sense as it’s been very cheap to finance and there’s been good merger and acquisition (M&A) activity, but the concern is what happens when we enter a recessionary environment. Analysis of an average recession shows that around 10% of those BBB securities will migrate out of investment grade into non-investment grade – and we believe none of this risk is currently priced in.

Currently in Europe, investors need a 100% BBB portfolio invested out to five years on the curve to earn 0%. The question then becomes whether this is the right level of risk for a treasurer. It’s important not to be blinded by the yield. Once you move out of the cash world, total returns and risk controls are the important factors, as well as having the right approach to managing credit.

EH: In light of this, how can treasurers approach their short-term investments in a smarter manner?

NH: There has probably never been a better time to have the conversation around cash segmentation. If you are looking for an incremental return on your cash, you have to think creatively – doing nothing or doing exactly the same as you have always done could end up being very expensive.

Treasurers need to look closely at their cash balances and decide precisely what needs to be kept in same-day instruments and then look for alternatives for the remainder. That means being prepared to look beyond traditional banking products and MMFs – and having an investment policy in place that is flexible enough to accommodate different instruments.

EH: What kind of instruments are we talking about?

NH: Ultra-short duration strategies for example, offer treasurers access to different characteristics from MMFs. For example, under the new regulations, MMFs can have only a weighted average maturity of 60 days, but the ultra-short duration strategy can go out to one year. Likewise, there is more flexibility from a credit perspective – the strategy is not hamstrung by a minimum single A rating (like most AAA cash funds), it can invest in BBBs.

Although I have highlighted concerns around BBB credit, at J.P. Morgan Asset Management, we are very selective when we buy BBBs and we position them appropriately within the overall portfolio. BBBs could make up 20-30% of the ultra-short strategy, if they are solid names. And in today’s short-term investment climate, based on investors’ objectives and risk appetite, this kind of exposure could be beneficial for treasurers because in order to achieve any yield, they might consider taking on a little more risk – in a strategic manner.

EH: Where exactly does the ultra-short strategy sit on the investment spectrum and what kind of returns can it offer?

NH: Simply put, they are generally positioned between cash and fixed income – rather like a hybrid structure. An ultra-short strategy isn’t the same as an operational cash vehicle, but equally, it isn’t like fixed income either. Rather than making this a grey area, sitting between cash and fixed income actually offers the best of both worlds.

Cash funds are not currently providing treasurers with sufficient yield, while arguably treasurers do not need to invest their strategic or reserve cash segments in those types of products. We believe investors could have opportunities to generate excess return over MMFs by stepping out into a ultra-short strategy, based on their investment objectives and risk appetite.

Fixed-income strategies, meanwhile, usually can’t take their duration lower than one year. In an ultra-short strategy, the duration can go as low as 0.2 or 0.3 of a year, depending on the situation. Having natural liquidity with shorter assets, as well as overweight exposure to money market instruments relative to bonds, provides enhanced market liquidity when compared to traditional fixed income alternatives.

In other words, ultra-short strategies are not just optimal for certain times in the cycle, but provide the flexibility with an objective to deliver in different market conditions.

EH: How do you manage J.P. Morgan Asset Management’s ultra-short duration strategy during different market conditions?

NH: Our Sterling Managed Reserves strategy, which is part of our ultra-short fixed income offering, seeks to achieve additional returns over MMFs with a focus on capital preservation through an actively managed, sterling-denominated ultra-short portfolio. We seek to hit the ultra-short sweet spot by using a conservative credit approach that is active, liquid and diversified.

To ensure a robust investment process, we leverage our Global Liquidity approved-for-purchase list and risk framework. We focus on credit quality and liquidity, with an average of approximately 60/40 ratio of money market securities to short-term bonds, including corporate bonds and mortgage-backed securities.

These sectors tend to behave differently depending on the level of stress in the market, which enables treasurers to access various types of returns – and our Sterling Managed Reserves strategy has a strong track record throughout the interest rate cycle. We therefore see it as providing a potentially attractive solution for cash investors looking to maximise returns from their strategic allocations, while keeping a firm handle on risk.

This is a fast-growing area, so treasurers not yet invested in the ultra-short space would do well to keep it on their radar. Nearly 15% of our firm’s ultra-short duration fixed income assets under management (USD 12bn AUM out of a total of USD 82bn as at September 2019) has come during this year. The global ultra-short duration universe stands at around USD 662bn and USD 59bn of those assets were attracted over the past 12 months.

EH: What is your parting wisdom for treasurers struggling to know where to park their short-term cash?

NH: In the current climate, it can be very helpful for treasurers to take a fresh look at their cash segmentation and investment policies. In order to get more yield, or any yield, treasurers might need to consider taking on a little more risk – and this will mean looking at different types of instruments, such as an ultra-short duration strategy. When taking on more risk, the choice of an investment partner also becomes even more important as you need an asset manager who can help you to take advantage of opportunities, while seeking to protect from as much of the downside as possible.

My final point would be to reappraise your attitude to yield. With clients that are coming out of the liquidity fund space, the first question they always ask about short-term strategies is, “What do they yield?” But that’s not really the right question to ask because yield doesn’t tell you everything. Instead, investors should ask what the strategies are expected to return and what the risk is. These are the important points to raise. A fixation on yield in a negative interest rate environment could be dangerous, and there are arguably smarter ways for treasurers to be looking after their short-term cash. 

To find out more, please visit www.jpmgloballiquidity.com