Fixed income is an investment approach focused on preservation of capital and income. Have recent events started to reshape thinking in this space for investors and providers? TMI consults an expert.
In the fixed income space right now, there’s good demand for investment grade (IG) credit mandates, says Paul Mueller, Head of Global Liquidity EMEA Portfolios, Invesco. “We see it as a solid product that shouldn’t give treasurers too many sleepless nights,” he says.
However, Mueller, who manages strategies for Invesco’s euro and sterling MMFs, as well as its ultra-short (or ‘cash-plus’) funds, has seen the fixed-income space change in the last few years, most notably with the general downward migration of ratings, with far more in the BBB+ space now than a decade ago.
That said, while the underlying make-up of the IG universe is perhaps less focused on the top drawer, Mueller comments that “it still looks to be in a very healthy position”. Indeed, it has emerged from the depths of the pandemic (notwithstanding any new effects of the latest Omicron variant) with “some good rebound” in developed markets.
“Corporates have had no issues in raising cash, there’s been good demand for IG credits, they have good cash balances, they seem to be fundamentally well positioned, and financial conditions are still very easy,” comments Mueller. With investors feeling “relatively optimistic”, he believes that the short-term space “is just starting to see a bit more of a focus, by both providers and investors, on where we go from here”.
The return of the return?
Questions are naturally being asked about whether or not returns have peaked, and how risk assets will be performing from now on. Across the markets there has recently been intense debate on inflation, many asking if the increases in some economies are transitory or not, and how respective central banks will respond.
In the case of the US Federal Reserve, Muller notes, they instigated a new consideration into their rate decisions known as flexible average inflation target (FAIT). This was in an attempt to communicate to the market that it would not necessarily increase rates if inflation was over-target, if this was deemed as transitory, and previous inflation prints had been under-target. However, the recent run of stronger-than-expected inflation prints, alongside an improving labour market, has led some Fed officials to suggest that inflation may be more persistent and they may need to take action sooner than first indicated.
While in the case of the Bank of England (BoE), what has happened was that there were comments from several Monetary Policy Committee (MPC) members that led “the market to get itself in a position where it was expecting an increase in interest rates in November,” he notes. “It didn’t happen as the MPC vote was seven-to-two against. This surprised the market because the commentary from a number of members prior to meeting seemed to suggest they were ready to take action.”
Nonetheless, the market is still anticipating a BoE rise, and is pricing in a possible 10-15 basis points (bps) increase, even if, as Mueller says, “it’s not ideal raising rates just before year-end when market liquidity is not as good as it is the rest of the year”. And even if it does happen (there is precedent), he suggests “it shouldn’t move the needle too much”.
The UK has been an interesting case, having dropped in terms of growth more than any other developed market economy. The fall may have been magnified by the difference in the way growth is calculated compared with other countries (the UK takes into account aspects such as education, so when the schools close, gross domestic product (GDP) drops, and equally now they are open, the upside may be overstated).
“Net-net, the UK is coming out of the pandemic quite well at this stage,” comments Mueller. “Inflation is clearly printing above where BoE was forecasting it would be. There had been concerns about the labour market and the unwinding of the furlough scheme, but recent data, particularly the timelier PAYE data, suggest that the labour market is looking extremely healthy.”
Security, liquidity, then yield
For corporate investors, the priority remains security, followed by liquidity and then yield, says Mueller. “In the past 12 months, we’ve seen a little more emphasis on yield, with decent growth in the euro cash-plus space, but security and liquidity are still the most important for treasurers.”
The euro market may have seen some outflow in recent weeks due to spread-widening, but investors are still trying to find a positive yield in their euro cash but are not taking too much duration or credit risk. If interest rates do rise, then improved yields ought to follow. But treasurers will keep playing a waiting game, most treading carefully with their operational, and even strategic, cash, says Mueller.
The ultra-short space always represents a mixed bag, with some providers notably more aggressive in terms of the risk they take than others. Invesco’s own cash-plus product is viewed in-house as “pretty conservative” being relatively short duration and predominantly IG. Even so, Mueller acknowledges that some investors continue to demand even greater security and will be staying in regular MMFs, for now.
Of course, the idea of cash segmentation – bracketing operational, reserve, and strategic surplus and then choosing the optimal investment solution for each – has “certainly been the subject of a lot of talk” says Mueller. Talk, he notes, has not translated into action, suggesting that any treasurer not currently doing so “may be patiently waiting for an interest rate rise”. If that is the aim, they may have a long wait to see anything substantial.
“What’s interesting now is yield curves,” comments Mueller. “In the US, 10-year yields, despite inflation and improved growth, are flattening, struggling even to reach 1.75%. The market is starting to think this may be the new terminal rate.”
It’s a similar curve movement in the UK. “It makes sense why the market is pricing there; the pandemic has created extremely elevated levels of government debt to GDP, and servicing that debt will be more manageable if rates stay lower, so even if rates do rise over the next 12 to 18 months, they may not rise by much.”
One aspect of investment that is garnering plentiful interest is the incorporation of ESG factors into funds. Investors are still trying to understand what it means, says Mueller. While he says ESG has not been a major theme for money funds, he notes away from these “there has been a definite shift across the industry” as client requests increase. There is an additional regulatory push.
Invesco has transitioned “a sizeable portion” of its funds to an Article 8 strategy, Mueller reports. Article 8 funds (along with Articles 6 and 9) fall under the draft regulatory technical standard, issued in February 2021, by the European Supervisory Authorities (ESAs) as part of the EU’s Sustainable Finance Disclosure Regulation (SFDR). If approved, these will come into force for asset managers on 1 January 2022. In essence, Article 6 is a classification of fund strategy that carries no sustainability element. An Article 8 strategy promotes (but is not obliged to act on) environmental and social factors. Article 9 explicitly targets sustainable investments.
Regulatory intervention in ESG product categorisation will certainly help investors who seek to understand the difference. However, while the prevailing view of the market is that if an issuer has poor ESG credentials, it is probably going to perform poorly as an investment, Mueller observes that ESG mostly focuses on bond funds rather than MMFs because currently there is insufficient supply to meet the needs of a diversified a money fund.
“Our MMFs, versus a typical IG bond fund, are invested in very short-dated CP [commercial paper] or CD [certificate of deposit]. Because ESG is more about supporting the longer-term view, it’s more important for companies to issue 10, 20 or 30-year bonds than three-month CP or CD, which is mostly financing operational cash,” he explains. “Although we’re seeing some green CD programmes emerge in our space, they are still very rare.”
MMFs have so far not been impacted by the pandemic in that clients could get their money when they needed it, and there have been no recorded breaches of regulatory limits. Nonetheless, regulatory investigation into the response of the short-term market is ongoing and a number of potential changes are being discussed with industry players and representative bodies.
“It’s hard to believe that there won’t be further changes to MMFs , but we hope they will be thoughtful and considered,” comments Mueller. “One idea we’ve talked about is the de-linking of fees and gates,” he says. “It’s good to have a liquidity buffer, but in an unusual market circumstance a fund should be able to use that buffer. If a fund feels it can’t, fearing a self-fulfilling outflow because investors are uncomfortable with slightly lower liquidity than another fund, it seems counter-productive.” The short-term space is also looking to makes its own changes, and Mueller sees the adoption of modern technology gathering pace. “Driven in part by clients being quite aggressive on fees in the low-yield environment, the industry now sees scale as the best approach,” he notes. “It’s why all asset managers are looking to be as efficient as they can be.”