The Case for Short-Duration Strategies

Transcription

1 The Case for Short-Duration Strategies Will Goldthwait: Good morning. And welcome to State Street Global Advisors webinar on short-duration strategies. Thank you for joining us today. My name is Will Goldthwait and I m a short-term fixed income strategist. I m here with Tom Connelley and Nick Pidgeon, both portfolio managers focused on short-term fixed income strategies. Tom is located in Boston and Nick is located in London. We will start today s webinar by outlining some of the challenges that are affecting fixed income and the money markets. We will then talk about strategies to deal with these changes and challenges, specifically short-duration strategies, and what type of investors they may be appropriate for. Lastly, we will discuss how SSGA manages those portfolios and the techniques we use to balance the trade-offs inherent in short-duration strategies. For the past six years, the market has experienced major regulatory changes. Both banks and money market funds face a slew of new rules and regulations to abide by. Couple that with central bank policy rates of zero, negative or close to zero, it s made short-term investing very challenging, specifically, the increased demand for those short-term assets, what we will refer to as liquidity or the liquidity premium. Money market funds are now required to own a certain amount of short-term investments to satisfy the new rules on fund liquidity. Also as a result of new regulation, banking institutions lack an appetite to issue short-term funding, preferring to issue their debt further out on the yield curve. And even as these banks have increased their capital and liquidity buffers and are stronger and more stable on the whole, we see their credit ratings lowered as the credit rating agencies reconfigure their rating models. So we re seeing the cost of liquidity increasing. With so many investors reaching for so few investments, we re seeing yields drop to historic lows. So now, in the new regulatory environment, owning liquidity becomes expensive or a very low yielding investment. For this reason, clients should ask -- how much liquidity do I need, and do I need all of it? Tom, how would you answer that question? Tom Connelley: Well, obviously, this question is a tough one and a different answer for every client. Having said that, for clients that understand their cash flows and see stable balances for a certain amount of their cash and for a certain amount of time, those clients should consider short-duration strategies that don t require a maximum liquidity. Short-duration funds can add incremental yield to their overall cash position without adding significant credit risk or interest rate risk to the portfolio. We think investors are well compensated for the additional risk that they do take on in this space.

2 Will Goldthwait: It sounds like you re talking about something that s more aggressive than a money market fund. Why do clients want to look at this in front of a potential US Fed rate hike? Tom Connelley: Well, that s a great question and it s one we do hear a lot. In this environment, we would recommend a strategy where portfolio duration or interest rate risk is limited to something that s not much longer than what a money market fund s duration would be. Will Goldthwait: But, Nick, you have a slightly different issue in Euroland. Nick Pidgeon: Yeah, we do not have the same dynamic in Europe in terms of European Central Bank rhetoric on interest rates with the ECB not expected to hike rates until late 2017 at present. They re still working through various stimulus programs including QE, which has resulted in a negative yield environment across the curve, but especially in the short end of the curve. Many investors are focused on how to minimize the negative yield impact on their portfolios which is where short-duration strategies are certainly beneficial. Will Goldthwait: So switching back to the US, Tom, how would you set up the fund? Tom Connelley: Well, I mentioned that we managed duration to a very low figure. And how we do that is by investing primarily in floating-rate securities. And these are securities whose coupons reset every one to three months. So this allows us to keep portfolio durations right around 90 days or a quarter of a year. Again, this is only slightly longer than a money market fund s duration. While this type of strategy works well across a variety of interest rate environments, it should do particularly well during a rising rate environment that we may be on the cusp of. Will Goldthwait: And, Nick, how about you? Nick Pidgeon: Yeah, sure, going just focusing on the euro currency, we find that the positive fixed-in paid over the one and three-month resets on the floating rate notes allows us to maintain a higher portfolio yield with a lower WAM against fixed rate securities of similar maturities which offer very little return in the current markets. Will Goldthwait: Interesting. So how is this beneficial versus a money fund? Don t they also own floating rate instruments? Tom Connelley: Yes, they can and certainly most of them do. However, they are currently limited to a maximum maturity of 13 months. As you know, investors are compensated more as they extend their maturities out the curve.

3 This term premium exits for floating rate notes as well. Generally speaking, our shortduration funds will invest in securities beyond the 13th month limit. By investing in bonds with maturities in the 18-month to 3-year range with the occasional AAA foray into four and even five years, we pick up extra yield to through the bond s higher credit spreads. Will Goldthwait: Okay. So could you give me an example? Tom Connelley: Sure. So as I mentioned before, money market fund is restricted to the 13th month maturity space maximum. Currently, you can buy a AA rated bank floater in 13 months at three months LIBOR plus five basis points. Our short-duration funds can buy the same bank in a two-year maturity at three months LIBOR plus 25 basis points, or a three-year maturity at three months LIBOR plus 43 basis points. Also, as our two or three-year bonds age or roll down the curve, there is generally a compression of this credit spread. So think about it this way, our two-year floater at three months LIBOR plus 25 will be a one-year bond in 12 months time. So all else equal, that bond will then trade closer to the LIBOR plus 5 level where I just mentioned the 13- month bonds trade. So our bond will benefit from the spread narrowing and trade up in price to reflect it. So not only do we benefit from the extra yield, we also benefit from a slight price increase as well. Will Goldthwait: Okay. Nick? Nick Pidgeon: Yeah, I certainly agree with Tom. The same can be said for European markets with the roll-down effects of bonds falling into the money market fund world. I would say this is even more pronounced in Europe with bonds tightening further due to the negative yield on money market securities, pulling the yields lower on these securities that have just moved into the 13-month duration. Will Goldthwait: Well, that sounds pretty easy, but I assume that there s no free lunch. Tom Connelley: Yes, Will, that s true. One important risk to consider in this space is certainly spread duration or weighted average life. So while floating rate securities generally protect you against rising rates, there is still credit risk to consider. A two-year corporate bond or asset-backed security will have a spread duration figure of around two years regardless of whether its coupon is fixed or floating. If credit spreads widen due to a credit-specific event or just general credit widening due to the economic situation, whatever the case may be, a longer maturity will suffer more than a shorter one.

4 So loading up the portfolio on five-year floaters for the yield advantage with limited interest rate risk is really not a riskless strategy. A 20 basis point move wider in credit spreads will bring down that five-year floating rate note s price by $1. This same move wider will bring down a one-year floater s price by approximately $0.20. So this is one reason why the SEC introduced a weighted average life limit for money market funds back in We think consideration of weighted average life or spread duration risk is very important and very necessary. In order to limit potential negative price volatility for moves lighter in credit spreads, we strive to keep our portfolio spread durations or weighted average life in a one to five to two-year range. So while we may give up some potential yield by adhering to this rule, we feel it s appropriate to limit the downside price risk in our portfolios. Will Goldthwait: And Nick, how about in Europe? Nick Pidgeon: Yes. We re no different really in Europe. Our short-duration strategies are covered by rules where we are limited to a weighted average maturity of 12 months and a weighted average loss of two years at portfolio level. Will Goldthwait: Okay. So what type of credit risks are these funds taking? Tom Connelley: So we like to think of these funds as longer cash versus shorter fixed income funds. And what I mean by that is we still strive for capital preservation as the number one goal in this portfolio. Consistent with that, we have a minimum credit requirement of A3/A- for corporate bonds and AAA* for our asset-backed holdings. In fact, many of our portfolio maintained an average rating in the AA area due to the mix of this A or better corporate AAA asset backs and then some treasuries and agencies as well. Will Goldthwait: And Nick? Nick Pidgeon: Yes, you are -- and sterling short-duration strategies are very similar with A2/A- long-term requirements, and A1 or P1 or F1 for short-term securities. Our funds that also highly rated by S&P with the AA-f/S1 rating. The S1 rating may not be too familiar to all. It s a volatility rating that measures sensitivity to changing market conditions. With that S1 rating, only one much lower than the highest S1+ rating with S6 the lowest. It shows we have high quality and low sensitivity in the funds. Will Goldthwait: That s interesting. So this doesn t sound like substantially more risk than a prime money market fund.

5 Tom Connelley: That s correct. Especially at the portfolio level. At the individual bond level, I d like to think about it this way. Money market rules limit most purchases to paper rated A1, P1, F1, some combination thereof. So these short-term ratings are generally equivalent to long-term ratings of A2/A or higher, mid single A. Therefore by going down to the A3/A- rating, we are effectively going only one notch lower than what is generally allowed by the SEC for money market funds. Will Goldthwait: And Nick? Nick Pidgeon: Yes. I always like to think that for the short-duration strategies that we just wanted to drive it with the money market funds around. In the money market funds, we look at principal preservation, liquidity, and yield. And in that short-duration strategies, we look at principal preservation yield and then liquidity. Will Goldthwait: Okay. So with that said, I d like to pause and open it up for a polling question. Given the choice, would you prefer to take interest rate risk or credit risk in your portfolio? Okay. So let s turn it back to Tom. You mentioned ABS. This can be a touchy subject for some investors. How do you think about that? Tom Connelley: Well, the ABS, they ve got most of the negative headlines and deservedly so during the crisis with subprime home equity related. In these portfolios, we stick to the most liquid, most well-known and best structured securities. We focus on AAA-rated primarily credit card, auto, and equipment-related collateral. These types of securities have been around for many, many years and are well-known to short-duration investors. We feel that this exposure helps diversify our portfolios without sacrificing either quality or liquidity. Will Goldthwait: And Nick, what about in Europe? Nick Pidgeon: Yes. We have a slight difference between the US holdings and the European ABS holdings with the biggest sector in Europe being autos and our MBS transactions. But like Tom, we only focus on senior tranches and from non-peripheral issues. Tom Connelley: I would also mention that all of our holdings in these short-duration funds are fully vetted by our credit research team. So we work strictly from an approval list much like our money market funds for both corporate credits and ABS issuers. All of our holdings are continuously monitored to determine if they remain appropriate for our funds. We strive to own stable, to improving credits whose ratings won t migrate down or bringing unwanted negative price volatility. When there is a negative credit rating event,

6 we work closely with our analysts in order to determine the best course of action obviously, that is in compliance with client guidelines. Will Goldthwait: Okay. So if a client is comfortable with these slight increases in risk, what kind of yield pickup could they expect from the strategy you ve described? Tom Connelley: In this environment, our funds** that follow the strategy currently yield approximately 30 basis points over a prime money market fund. So they have duration figures of a quarter of the year as I mentioned, and spread durations or weighted average lives of right around 1.5 years. And the average portfolio quality is in the low AA area. Will Goldthwait: And Nick, how about in Europe? Nick Pidgeon: Yes. Again, we seem to be hitting from the same bat, it s not too different. We target around 20 basis points with very similar WAMs and WALs across the portfolios. Will Goldthwait: Well, AA rating is pretty high. What about the credit composition of the portfolio? Tom Connelley: I think another important point really is that our funds are generally more widely diversified than most prime money market funds. We generally will have a greater exposure to industrials and ABS while money market funds have more exposure to financials. It s quite common for industrial issuers to issue two to three-year floaters, sometimes either/or or sometimes both when they come to market with their typical 5-, 10-, and the 30-year issuance. So this really provides a great opportunity to diversify our portfolios across different credit sectors. Will Goldthwait: Okay. That s great. That s interesting. So let s pause here and ask our second polling question before we wrap up this call. If ratings are required, would you consider investing in a A-rated or a AA-rated fund? Or does it have to be a AAA-rated fund? You can check all that apply. Well, thanks, Nick, and thanks, Tom. That s been a lot of great info. And I m sure our listeners have gained valuable insight in the short-duration strategies. I want to wrap things up by summarizing a few key points. First, market conditions and regulatory changes are causing the liquidity premium to increase. And we are seeing that in the market today. Money market funds are no longer one-stop shopping and there will be a larger differences in the yield and liquidity based on the type of short-term product you choose.

7 Second, if upon examining your cash flows, you feel you have excess liquidity, you should consider a short-term investment strategy. But you must be aware of the risks and know that this is not ready cash. Third and lastly, choosing the right type of short-term strategy can involve many different types of assets and term and duration structures. SSGA has extensive experience in managing these pools or separately managed accounts. Thank you for joining us on today s call. And if you have any follow-up questions or comments, please be sure to reach out to us at the contact information provided. Thank you and good bye. This material is solely for the private use of SSGA clients and is not intended for public dissemination. Investing involves risk including the risk of loss of principal. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent. This webinar is provided for informational purposes only and should not be considered investment advice or an offer for a particular security or securities. The views and opinions expressed by the speaker are those of his or her own as of the date of the recording, and do not necessarily represent the views of State Street or its affiliates. Any such views are subject to change at any time based upon market or other conditions and State Street disclaims any responsibility to update such views. These views should not be relied on as investment advice, and because investment decisions are based on numerous factors, may not be relied on as an indication of trading intent on behalf of State Street. Neither State Street nor the speaker can be held responsible for any direct or incidental loss incurred by applying any of the information offered. Please consult your tax or financial advisor for additional information concerning your specific situation. This video cannot be used for commercial purposes, and should only be used in the United States as restrictions exist with some products and services marketed globally Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable. U.S. Treasury Bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate. These investments may have difficulty in liquidating an investment position without taking a significant discount from current market value, which can be a significant problem with certain lightly traded securities. Diversification does not ensure a profit or guarantee against loss. Investments in asset backed and mortgage backed securities are subject to prepayment risk which can limit the potential for gain during a declining interest rate environment and increases the potential for loss in a rising interest rate environment. The values of debt securities may decrease as a result of many factors, including, by way of example, general market fluctuations; increases in interest rates; actual or perceived inability or unwillingness of issuers, guarantors or liquidity providers to make scheduled principal or interest payments; illiquidity in debt securities markets; and prepayments of principal, which often must be reinvested in obligations paying interest at lower rates. The above targets are estimates based on certain assumptions and analysis made by SSGA. There is no guarantee that the estimates will be achieved. The information contained above is for illustrative purposes only. Past performance is not a guarantee of future results.

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