Volatility — and how to find shelter from it — is top of mind for investors. Cash has moved from apathetic afterthought to a recognized component of portfolio composition. Many investors have scaled back allocations to riskier investments — including emerging markets, high-yield bonds and equities — as implied and actual volatility has edged higher during periods of market stress, especially this year.
This defensive response has left investors with plenty of residual cash. Yet, just as investors have more cash to invest, the landscape in this area of the market is undergoing significant changes. We have identified three critical changes for investors to watch:
Independent credit and interest rate expertise has become essential. Over the past seven years, quantitative easing, zero interest rate policies and a generally positive credit cycle meant that investors did not have to think much about cash. But the Federal Reserve is beginning to normalize U.S. rates, and credit risk is increasing as the business cycle advances. Credit expertise will thus be essential to preserving capital when investing. It is also important for investors to recognize that there will be volatility in cashlike securities as the market adjusts to expectations of future Fed hikes. Such volatility increases the probability of investor miscalculation and can potentially lead to negative absolute returns — just when investors may need access to their cash.
Relatively attractive interest rate policy in the U.S. is creating more demand in U.S. markets. Investors in Japan and the euro zone will likely search more aggressively for return and income following the recent actions by the Bank of Japan, which introduced negative deposit rates in late January, and the European Central Bank, which lowered deposit rates further into negative territory in early March. For these investors, capital preservation is becoming a daunting prospect. Already, many money market funds in Japan have closed because they cannot adapt to the emerging negative rate structure.
These investors have begun to search for investments abroad where they can still find positive interest rates, such as in the U.S. We see opportunities for capital appreciation in short-term securities as a result of this growing structural demand. U.S. investors could potentially benefit from positioning here, especially within the front end of the credit sector.
Regulatory reforms are changing the risks in money market funds. The long-expected implementation of reforms in the U.S. for regulated Rule 2a-7 money market funds in the third quarter of 2016 will be noteworthy — though for different reasons than many investors might think. Investors need to be aware of the changes themselves, as well as some of their knock-on effects.
One change is the possible imposition of redemption gates and fees. Prime (credit) money market funds not only will no longer be valued at $1 par net asset value, but many will also be subject to potential gates and fees during times of stress. For many investors, the guarantee of liquidity without a punitive cost is no longer ensured.
Another thing to watch for with regard to the regulation is structurally low yields. Unlike previous economic cycles when higher interest rates were reflected in similar increases in the net yields of money market funds, going forward net yields will likely lag rises in official rates. There are a few reasons for this: a limited supply of investable money market assets, administrative fund fees no longer being waived and recent regulations that have increased demand for money market instruments to meet liquidity and central clearing requirements. Although net yields on money market funds should eventually increase with future rate hikes, they may underperform other front-end assets and strategies that do not face the same rigid parameters.
Investors should also keep an eye on any erosion of purchasing power. For much of the past 40 years, money market fund investors benefited from handsome nominal returns. As measured by a widely used index, during most of those four decades, returns were higher than the rate of inflation. Achieving attractive positive returns, in nominal or real terms, will be extremely challenging after the reforms are implemented later this year, however.
Now is the time for cash investors to wake up before money market reforms officially take effect and before the Fed raises rates again. Awareness of cash allocations is critical to successful investing because of the structural transitions under way.
We are seeing some investors begin to evaluate alternatives to traditional cash vehicles and adjust their strategic allocations to include short-term strategies that have more flexibility to manage credit, interest rate and liquidity risks.
As many investors revisit their cash investments in the face of market volatility, to successfully navigate the changing cash landscape, this is an opportunity to consider capital preservation strategies that are multifaceted in approach and global in scope.
Jerome Schneider is a managing director in Pacific Investment Management Co.’s Newport Beach, California, office and head of the short-term and funding desk.
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