Is cash king? No, but short maturity bonds just may be!

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1 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 For Financial Intermediary, Institutional and Consultant use only. Not for redistribution under any circumstances. Is cash king? No, but short maturity bonds just may be! August 2018 By Lisa Hornby, Portfolio Manager, Fixed Income For the first time in a decade, investors can now look at shorter maturity, high quality and liquid fixed income assets as an option which offers positive real returns. The return of value at the front end of the yield curve may have a negative impact on the demand for high octane fixed income products across sectors as investors now have the ability to achieve much of their fixed income return targets with a lower risk profile. As fixed income total return investors, we have largely ignored cash (defined as the 0-3 month Treasury Bill index) as an asset class for the last several years. Policy rates cut to zero (and below) by global central banks, as well as the need for yield, have resulted in cash and cash equivalents adding no value and having little place in investors asset allocations. Many years of increasing central bank liquidity and steep yield curves meant that there was more opportunity to be found elsewhere. Fast forward to today, with seven interest rate hikes now behind us, and with credit valuations on the more expensive side of historical averages, one may be wondering whether an allocation to cash now has some merit. While cash currently provides a yield of 1.95% (as of July 31), its real return, or the return after adjusting for the rate of inflation, is still negative. One related area that does offer value, however, is short-maturity investment-grade fixed income. Short duration assets offer similar advantages to cash in terms of liquidity and provide the additional flexibility to add risk when valuations appear more attractive. However, unlike cash, real returns on short-duration fixed income are positive and increasingly attractive. As of July 31, the ICE BAML 1-3 Year US Corporate Index yielded 3.29%, a nine-year high. This comes with a sub-two year duration, meaning fairly limited room for principal loss in the event of rising rates. These metrics compare quite favorably to those of the broad ICE BAML US Corporate index, which as of July 31 had a yield of 4.03% and duration of over 7 years! When looking at alternatives on a yield basis, the equity market looks expensive relative to Treasuries, and considerably less attractive than it has in a few years. In addition, with high yield bonds hovering around their historical lows in yield, risk assets overall have become increasingly rich while short Treasuries and short corporates have moved in the opposite direction. Figure 1: Equity yields have fallen while bond yields are on the rise 3.00% 2.50% 2.00% 1.50% 1.00% US Treasury S&P 500 Dividend Yield (RHS) Source: Bloomberg and Bank of America Merrill Lynch (BAML), July Yields fluctuate over time. Graph shown for illustrative purposes only. Other fixed income instruments (including high-yield bonds) may offer higher current yields than those shown above. Unlike fixed income coupons, equity dividends do not carry the same level of certainty and are subject to fluctuate over time. Is cash king? No, but short maturity bonds just may be! 1

2 With regards to concern for interest rate duration and the potential impact of interest rate increases, it is interesting to note that the ICE BAML 1-3 Year US Treasury index has never generated a negative absolute return in a calendar year since its inception in This is particularly remarkable given the magnitude of some of the rate hiking cycles that have existed over the last 40+ years. The same can also be said about the ICE BAML 1-3 Year US Corporate Index, with the exception of 2008 when the return was -2.7%. But those returns were recouped within a matter of months, with double digit returns in 2009 of 14.7% (Figure 2). This speaks to the benefit of adding more short-term bonds to the portfolio as we head into a period of higher rates. To put this into numbers, over the course of a year, the 1-3 year Treasury index can withstand a yield shock of approximately 200 bps above the 1-year forwards, without producing a negative return. Similarly, thanks to the additional yield on the 1-3 year corporate index, it could withstand a yield shock of 230 bps over the course of a year without drawing down on capital. Figure 2: Short Treasury and short corporate annual returns 25% 20% 15% 10% 5% 0% -5% Year Treasury 1-3 Year Corp Source: Bloomberg, BAML, through December Reflects index returns, actual results would vary. Past performance is no guarantee of future results. In addition, given how flat yield curves have become (Figure 3), the opportunity cost of shortening the portfolio has fallen to its lowest level in a decade. Figure 3: The spread between 2-year and 10-year Treasury yields is the narrowest since 2007 Bps Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jul-18 Source: Bloomberg, July Spreads fluctuate over time. A similar comparison can be made when looking at the all-in yield of the long corporate index (10+ years until maturity) versus the all-in yield of the short index (1-3-years until maturity). The spread between these two indices is the narrowest that it has been in a decade (see chart 4). Short-dated corporates came under pressure at the start of the year as competing asset supply as well as diminishing demand conspired against them. First, they lost some of their sponsorship following tax reform, as US multi-national corporations have repatriated overseas cash. These corporations, mainly within the pharmaceutical and technology sectors, have historically recycled their Is cash king? No, but short maturity bonds just may be! 2

3 trapped overseas cash to the short-dated investment grade corporate market. Now that this cash has become accessible again (following a one-time tax payment), corporations are free to use their cash balances for alternative purposes. The second pressure point on front-end credit has come from increased short-dated Treasury issuance. In an effort to fund increasing deficits, in addition to shoring up low cash balances, the Treasury issued $300bn in Treasury bills over a relatively short period. These bills at increasingly higher yields have acted as a competing asset to short-term credit. Going forward, however, we believe that bill supply is set to moderate as the Treasury s cash balances have improved and additional funding is likely to be done in longer-dated Treasuries. This should help to stabilize the front-end of the credit markets, making now an opportune time to invest. Figure 4: All-in yields suggest that investors are no longer paid to own duration 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jul-18 Spread 1-3 Year Corp 10+ Year Corp Source: Bloomberg, July These views are subject to change over time. As yields on shorter maturity investment grade corporate bonds have risen considerably over the last year, we believe that they now provide significant cushion against the risk of further rising yields. Although corporate spreads remain expensive in a historical context, carry and roll are the by far most important determinants of future returns at shorter maturities. Therefore today s higher yields make short corporates relatively attractive in our view. While longer-dated corporate bonds have underperformed Treasuries this year, they still remain historically expensive from a valuation standpoint. Admittedly, given the zig-zag pattern of spread moves and the increased volatility this year, the corporate market s underperformance has felt much more significant. It has been our view that credit assets have benefitted disproportionately in recent years from a regime of low inflation, low volatility and central banks reducing the free float of risk-free assets by several trillion dollars. This dynamic created a perfect storm of yield and risk-seeking behavior. The technical environment, which has been so beneficial for credit in recent years, has begun to change for the following reasons: The net supply of assets available to the market will increase as central banks buy a trillion dollar fewer assets this year than they did in 2017 (Figure 5). As a result, their balance sheets will actually begin contracting by the end of this year. The narrative of perpetually low inflation which enabled central bank intervention, risk taking and suppressed volatility is likely coming to an end. The demand for US dollar fixed income has become increasingly challenged as non-domestic investors, who have been the single biggest driver of incremental demand, step back thanks to the increased costs of hedging the currency exposure. As discussed above, this has been exacerbated by reduced demand from US multi-national institutions. Is cash king? No, but short maturity bonds just may be! 3

4 F 2018F Figure 5: Net supply set to increase meaningfully in Net issuance in developed markets ($tn) Govt. Financial Bonds Non-Financial Bonds Rest of World Shares Central Bank Interventions Net Source: Nomura, December F = forecasted issuance levels. With these tailwinds turning to headwinds, credit assets are also competing with a significant increase in Treasury supply as net issuance is expected to increase nearly 40% over the balance of the year. Cash and short-dated fixed income have become a more compelling asset for the first time in a decade as they are now trading at close to 10-year highs in yield. This dynamic will further challenge the investment thesis behind longer-dated corporate credit. The view is further enhanced when you layer on the challenges of operating in a market with potentially rising volatility and diminishing liquidity. With investment banks no longer able to warehouse risk on their balance sheets, spread moves become amplified as selling begets further selling. As the inevitable end of the credit cycle approaches, owning liquid, short-dated assets with low spread duration should enable us to be buyers of riskier assets at attractive valuations. Is cash king? No, but short maturity bonds just may be! 4

5 Risk disclosures All investments involve risk, including the risk of possible loss of principal. The market value of a bond portfolio may decline as a result of a number of factors, including interest rate risk, credit risk, inflation/deflation risk, mortgage and asset-backed securities risk, U.S. Government securities risk, foreign investment risk, high yield securities risk and derivatives risk. Asset allocation and diversification cannot ensure a profit or protect against loss of principal. Duration is a measure of volatility expressed in years. The higher the number, the greater potential for volatility as interest rates change. Bonds rated BBB/Baa or higher are considered investment grade, while bonds rated BB/Ba or lower are considered speculative as to the timely payment of principal and interest. Important information The views and opinions contained herein are those of Schroders US Multi-Sector Fixed Income team, and do not necessarily represent Schroder Investment Management North America Inc. s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument mentioned in this commentary. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable but Schroder Investment Management North America Inc. (SIMNA Inc.) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. The information and opinions contained in this document have been obtained from sources we consider reliable. No responsibility can be accepted for errors of fact obtained from third parties. The opinions stated in this document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. Sectors/Indices/countries mentioned for illustrative purposes only and should not be viewed as a recommendation to buy/sell. SIMNA Inc. is registered as an investment adviser with the U.S. Securities and Exchange Commission and as a Portfolio Manager with the securities regulatory authorities in Alberta, British Columbia, Manitoba, Nova Scotia, Ontario, Quebec and Saskatchewan. It provides asset management products and services to clients in the United States and Canada. Schroder Fund Advisors, LLC ( SFA ) is a wholly-owned subsidiary of Schroder Investment Management North America Inc. and is registered as a limited purpose broker-dealer with the Financial Industry Regulatory Authority and as an Exempt Market Dealer with the securities regulatory authorities of Alberta, British Columbia, Manitoba, New Brunswick, Nova Scotia, Ontario, Quebec, Saskatchewan, Newfoundland and Labrador. SFA markets certain investment vehicles for which SIMNA Inc. is an investment adviser. SIMNA Inc. and SFA are indirect, wholly-owned subsidiaries of Schroders plc, a UK public company with shares listed on the London Stock Exchange. This document does not purport to provide investment advice and the information contained in this newsletter is for informational purposes and not to engage in a trading activities. It does not purport to describe the business or affairs of any issuer and is not being provided for delivery to or review by any prospective purchaser so as to assist the prospective purchaser to make an investment decision in respect of securities being sold in a distribution. Past performance is no guarantee of future results. Further information about Schroders can be found at or by calling (212) Schroder Investment Management North America Inc. Is cash king? No, but short maturity bonds just may be! 5