Step-out strategies: Hitting the sweet spot between liquidity and short duration

Sponsored article: Jemma Clee describes how a short duration strategy can help local authorities enhance returns.

Despite the expectation of a low, and possibly negative, UK interest rate environment for several years to come, many local authorities aren’t able to use all their assets to hunt for higher yields, due to investment policy objectives for security and capital preservation.

As a result, investors are increasingly focused on segmenting their short-term investments to try to enhance return. Step-out strategies offer a practical solution, by minimising the drag of carrying pure cash in money market funds by incrementally adding risk to generate slightly higher returns.

Step-up and step-out

Step-out strategies provide compelling opportunities for cash investors looking to segment their cash balances. However, when it comes to producing consistent cash-plus returns across the credit and interest rate cycle, it is crucial for investors to seek out strategies that are backed by proven in-house credit research capabilities, particularly with credit risk dispersion elevated in today’s markets. At the height of the Covid-19 crisis, some step-out strategies with less rigorous credit allocations came under pressure and struggled to provide liquidity when investors needed it most.

The step-out strategies managed by J.P. Morgan Asset Management’s Global Liquidity team remained liquid throughout the market turmoil. Thanks to our conservative approach to credit risk and our focus on high-quality security selection, our step-out strategies were able to satisfy all redemptions in cash, not in-kind, while maintaining an attractive cash-plus yield.

Target a higher return profile

At J.P. Morgan Asset Management, ultra-short duration is the first strategy for investors to consider as they step out from liquidity or traditional money market funds. Our ultra-short duration strategy blends money market securities, such as commercial paper and certificates of deposit, with short-dated bonds. Typically, the strategy holds securities with final maturities out to either three years or five years. The blend of instruments can include government, agency, covered and corporate bonds with some securitised credit, such as AAA-rated prime residential mortgage-backed securities (RMBS). Derivatives are only used to hedge currency risk back to sterling.

The J.P. Morgan ultra-short duration strategy typically allows a duration out to a maximum of one year, compared to a weighted average maturity cap of 60 days for short-term money market funds. This additional duration risk is one lever to help generate additional returns. Credit risk is the other lever. Whereas money market funds have a minimum credit rating floor of single A, our ultra-short duration strategy often includes BBB rated securities.

Diversified exposure

The widening of the bond universe not only allows our ultra-short duration strategy to generate additional returns, but also offers greater diversification of underlying issuers, which is important with approximately 50% of all corporate bond indices today rated BBB. Diversification is even more beneficial within the sterling market because supply is more constrained, relative to the US dollar and euro markets. Furthermore, whereas traditional money market funds offer exposure mainly to issuers from the financials sector, the one- to three-year and one- to five-year corporate bond markets also include issuers from the industrials and utilities sectors.

Like money markets funds, our ultra-short duration strategy also seeks capital preservation in addition to a higher return target relative to cash. A typical range of outperformance could be 20 to 60 basis points. However, ultra-short duration offers less “instant access” to liquidity compared to money market funds, making it most appropriate for a secondary tier of strategic cash, where investors have an investment horizon of approximately six to nine months. While there is a step up in risk, the frequency of ever experiencing a negative quarter remains near zero, if risk is managed appropriately.

While cash investors are moving up the risk curve to add returns, some fixed income investors are moving assets down into short and ultra-short duration to reduce risk. In an environment of continued low, and possibly negative, UK interest rates, and with credit spreads back to pre-March 2020 levels, many fixed income investors are not being compensated for the additional risk they are taking. Step-out strategies, such as our ultra-short duration strategy, are seeing increased demand from investors seeking to hold a lower-risk fixed income allocation; this flow is amplified further as the debate about global reflation creeps in for the second half of the year.

Active is key to success

In today’s low interest rate, more disparate credit risk world, the ability to generate returns over cash is more aligned than ever with the capabilities of an active manager. Seeking out managers with proven security section backed by a strong fundamental credit investment process, and investing in strategies that have the ability to diversify opportunistically, will be the key to success.

Step-out strategies, such as our ultra-short duration strategy, can help local authorities enhance returns compared to traditional money market funds, while also helping to reduce the bumps from volatility that may lie ahead in these challenging markets.

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

Jemma Clee is lead investment specialist, global liquidity EMEA, J.P. Morgan Asset Management.

 

 

 

 

Photo by Markus Winkler on Unsplash

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