Volatility gives ultra-short duration strategies the chance to shine

by Guest
in Treasury
— 19 Sep, 2017

Sponsored Article: Neil Hutchison discusses the current low yield environment and offers a yield enhancing alternative for clients with longer investment horizons but a reluctance to accept undue volatility.

More than a year on from the referendum on Brexit, the triggering of Article 50 has failed to draw a line under lingering uncertainty for the UK, and the outcome of the snap general election only added fuel to those flames. As the political dynamic has shifted, the economic outlook has deteriorated, in line with forecasts, keeping the Monetary Policy Committee’s (MPC’s) hands tied on rates for now.

This volatile investment backdrop has created some challenges for local authority treasurers, when it comes to generating the returns they need from short-term cash. But while a lot has changed in the past year, the three main objectives of effective short-term cash management “principal preservation, liquidity and yield” are the same as ever.

A shifting market dynamic means a shifting mindset

Despite the negative yields in Europe—and the potential for negative yields in the sterling space too—even ultra-short-duration funds that focus on buying investment grade bonds with maturities typically up to three years have experienced good returns during recent years. This has driven a tangible shift in the way clients think about their investment strategy when they move away from constant net asset value (CNAV) funds—where the focus is on book yield—towards variable net asset value (VNAV) structures, where the focus is on total rate of return. And it’s a shift that is motivating many investors to target additional returns by investing cash balances with a longer investment horizon and a higher tolerance for volatility.

Last summer, we responded to these challenges by launching a new sterling-denominated fund as part of our innovative ultra-short-duration Managed Reserves strategy. Investing primarily in short-term investment-grade sterling debt securities, the fund is specially designed for investors with longer investment horizons who are looking for a higher level of return than money market funds can deliver, while still aiming to preserve principal over a longer time horizon. All the funds in the strategy come with a maximum portfolio duration of one year (with a three-year final maturity limit) vs. 60 days (with a 13-month final maturity limit) for our AAA rated funds. What’s more, the fund has the flexibility to invest down as far as BBB (as opposed to A) and is structured as a VNAV vehicle and therefore marked to market, rather than a CNAV.

Targeting low-volatility, incremental returns over AAA money market funds, the Managed Reserves strategy follows a similar principal preservation focus and approved buy-list approach to our broader liquidity business. Crucially, for investors, moving from an index approach typical in fixed income to the buy-list approach required by Global Liquidity—where credit screening unwanted names—can minimise volatility, reducing interest rate risk along the way.

A sweet spot for liquidity investors stepping out and for fixed income investors stepping back

So where do ultra-short-duration strategies like this fit into the current investment landscape? Despite the recent more hawkish rhetoric from the MPC, rate rises are likely to be some way off for the UK, held back for now by weaker economic data and the evolving inflation vs. growth debate. In this kind of environment, ultra-short-duration strategies can look even more attractive when looking at the potential step-out incremental return vs. cash-to-cash alternatives, which are essentially locked to base rates.

Of course, it stands to reason that these strategies should successfully deliver an incremental return in a low-yield environment. But even in a rising-rate environment where duration represents a risk, strategies that sit a year shorter than short duration could well represent an attractive entry point for liquidity investors stepping out—and for fixed income investors stepping back.

Low-volatility, incremental returns can make all the difference

As clients strive to generate higher returns for those pockets of cash where they have no need for daily liquidity, they are increasingly segmenting their cash—and we expect this trend to continue, along with a corresponding move away from CNAV to VNAV structures.

A low-rate environment doesn’t mean you can’t make money. In a world where the neutral rate is far lower than historical levels, a VNAV structure can give investors greater potential to benefit from enhanced returns. In addition, strategies that aim to beat the return of liquidity funds by 20-40bps may appear to be setting their sights low in a “normal” environment. The current low-yield environment is far from normal, but if it’s here to stay—for now, at least—these low-volatility, incremental returns undoubtedly have the potential to make a big difference to local authority treasurers.