By Jeff Weaver and Yeng Butler
This special edition of On the Trading Desk® features a discussion about the liquidity component of an investor’s portfolio.
Following the disruptions to the short-term bond market in March and April, cash investors are now looking for a balanced path forward. To help explain, Yeng Butler, Head of the Liquidity Client Group at Wells Fargo Asset Management, and Jeff Weaver, Senior Portfolio Manager and Head of Municipal and Short Duration Fixed Income, WFAM Global Fixed Income, share their insights about opportunities for cash investors in a low-rate environment, the questions investors should be asking as they assess their cash portfolios, and the potential risks and rewards of the short-term municipal market.
Yeng Butler: My name is Yeng Butler, and welcome to a special edition of On the Trading Desk®. I lead the Liquidity Client Group here at Wells Fargo Asset Management, where the team and I work with both institutional and retail clients to manage and optimize their cash portfolios using a full suite of liquidity and short-term fixed-income solutions.
Today’s topic is a focused discussion on the liquidity component of client portfolios, a subject that, let’s say, is often overlooked until there are dislocations in the market like we’ve seen as of late. So it’s a timely conversation given today’s market environment.
I’m joined by Jeff Weaver, Senior Portfolio Manager and Head of the Municipal Fixed Income, Short Duration Fixed Income, and Money Market Fund teams at WFAM. Thanks for being here, Jeff.
Jeff Weaver: Happy to be here, Yeng, and looking forward to our discussion.
Yeng: So let’s start here. The liquidity space has been historically categorized as largely uneventful, and some may even characterize it as a boring asset class, but I think you and I can certainly agree that the last few months have been anything but uneventful nor boring.
Jeff, can you talk about some of what you’ve seen in the market and how clients have fared over the last few months?
Jeff: We entered this year with COVID lurking in the global background. I don’t think we fully appreciated the full extent of the effects that it would have on the global economy and the U.S. economy.
But entering into the year and entering into March, we had fed funds at 1.5% and a pretty flat yield curve. There was certainly a lot of discussion about a potential slowdown. Yield spreads were quite tight, and so we had very much an up-in-quality bias coming into March.
As March developed and as COVID concerns spread and we moved into a period of time where we were all working from home, there was really a tremendous flight to quality that occurred in financial markets. We saw the Fed react quite quickly. They actually moved rates lower in two moves. These were intermeeting moves. They moved rates lower, 50 basis points lower on March 3 and then another 100 basis points around March 15.
At that point, there was a tremendous amount of concern in the markets. There was a tremendous amount of lack of liquidity in the money market sector, and really no sector was spared in the fixed-income market.
We saw a tremendous amount of equity volatility, so equity markets sold off rather dramatically and, in general, risk assets underperformed.
So meanwhile, we saw a tremendous flow into treasuries. Treasuries rallied tremendously. We also saw a lot of tremendous inflows into government funds, but outside of those high-quality sectors, there was a tremendous amount of illiquidity.
So the Fed noticed these and was certainly very responsive. The Fed dusted off their playbook from the 2008 global credit crisis and really reacted quite aggressively with a number of facilities, a number of programs designed to address market illiquidity.
Really again, no sector was spared from a short duration standpoint. From a money markets standpoint, the Money Market Liquidity Facility was certainly something that was quite important to the money market universe and that we’d seen a tremendous amount of the outflows from institutional prime funds. And fund managers were not able to find the liquidity to meet those outflows. So the Money Market Liquidity Facility was certainly quite effective in starting to return liquidity to the money market sector.
Of course, going out the curve, there were a number of other facilities, as well. There was the Commercial Paper Funding Facility for commercial paper issuers. There was the Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility for corporate bonds. There was TALF for asset-backed securities. There was the Municipal Liquidity Facility for municipals. And so what we started to see was liquidity returning to the market.
So we saw this dramatic selloff, and then we saw the Fed react quite quickly and quite swiftly and aggressively in addressing that, and we started to see these asset classes come back.
In addition, you saw a tremendous amount of fiscal support from Congress, from the Senate in the form of the CARES Act, etc. So a lot of extremely accommodative and swift policy action was taken to restore order to financial markets.
Yeng: Thanks, Jeff. So now that we’ve returned to a steadier state in the short-term markets, some clients—not all—are beginning to ask us what to expect next.
Some are certainly continuing to raise liquidity. In fact, the corporate issuance figures I saw month-to-date are at record levels, I believe. And some are rebalancing their overall portfolios, while others are thinking ahead about where and how to find yield in their portfolios.
So where are you seeing opportunities for cash investors, given our lower-for-longer expectations in the rate environment?
Jeff: Yes, corporations have certainly been hoarding cash in this environment, over $1 trillion in new issue investment grade corporate issuances incurred just in the last couple months, so tremendous surge in corporate bond issuance. A lot of cash in the system.
But cash yields are quite low. Government money market fund yields are approaching zero. Prime money market fund yields continue to offer a yield advantage, but that spread between government money market funds and prime money market funds continues to narrow.
And so what we’re seeing now is opportunities to add yield by extending in short-duration mandates to take advantage of spreads that are still relatively wide. So we see out the curve. We see longer corporate bonds offering value versus shorter. So those corporate bonds that are one year and shorter are quite rich now compared to where we were.
But there’s still value out the curve when we specifically look at 1-to-3 year versus 3-to-5 year bonds. We like single-A and BBB corporate bonds that are in the 3-to-5 year maturity spectrum, as we feel that there’s still room for those spreads to continue to compress, to continue to go down and provide attractive returns for our customers.
We also continue to see value in some high-quality sectors, such as mortgages and plain vanilla asset-backed securities. So longer out the curve and a little lower in credit quality is where we see value.
Yeng: Jeff, let me hone in on our institutional clients for a moment. Soon after the global financial crisis, we worked with many institutional investors looking for guidance, especially in their liquidity investment policy statements. And one would expect that a similar need will surface. What initial questions should clients be asking as they assess their cash portfolios?
Jeff: We think clients should first focus on their liquidity needs. You don’t want to be a forced seller in an illiquid market because you might be in a position where you have to take unnecessary losses.
So when we ask our clients to focus on their liquidity, we think it’s important that they look at their operating needs, their core needs, and their strategic needs and designate their cash in certain buckets along that way.
And so for day-to-day operating needs, we think it’s important that you have a significant allocation to government funds where there’s a constant NAV and withdrawals and additions can happen on a daily basis, even intraday.
We also recommend that investors consider prime funds in this operational cash bucket to pick up additional yield. We still offer and recommend those funds and feel that they do provide additional value above and beyond the government funds, but we do recommend that one ensures that there’s enough liquidity in the government funds to start with.
In the operating bucket of liquidity, we suggest a healthy allocation to government funds, as those funds have a constant NAV and funds are easily added or withdrawn with no principal volatility. We also suggest a consideration and allocation to prime funds as those continue to offer a healthy yield advantage and can enhance that performance of that operating bucket.
As you consider your core and strategic allocations, I think it’s important that investors consider ultra short-term bond funds or customized separate accounts in order to achieve additional return, but also, particularly with the separate account, use those to really match liquidity needs on a go-forward basis.
Yeng: And for our retail clients listening, let me pivot to the municipal market for a moment and ask you, Jeff, where do you see challenges and opportunities in this space, particularly in a COVID/post-COVID environment?
Jeff: The municipal market was certainly not spared along with the rest of the fixed-income market, but like the taxable market, the tax-exempt municipal market has continued to come back.
Liquidity in the municipal sector has improved, inflows have returned, and yields have come down in a sign that normalcy is returning to the municipal market.
We see certain sectors that are still under some pressure, such as the leasing and special tax sector bonds, while hospitals, water/sewer, and general obligation debt continues to perform strongly.
While we are likely to see downgrades in the investment-grade municipal sector, we don’t anticipate any major defaults and are quite comfortable in taking credit risk out the curve.
When it comes to opportunities in municipals, we do see value in lower investment grade credits and we also see value further out the curve as the sector continues to return to a state of normalcy.
Municipalities are exploring new revenue streams: the prospects of additional federal aid, expenditure cuts, and additional debt as tools to achieve balance budgets. While the HEROES Act did not advance to become law, we do expect additional aid to ultimately advance in the next federal package.
Yeng: Thank you very much, Jeff. So let me now summarize for our listeners what Jeff has shared with us today.
First, we do see opportunities in the short-term markets, and these include longer corporate bonds versus shorter, as there is value out the curve.
In addition, we also see value in high quality sectors, including mortgages and plain vanilla asset-backed securities.
Specifically for institutional investors, we suggest first fine-tuning your liquidity need and bucketing your operating, your core, and your strategic cash, and then reviewing your investment policy statements with your respective providers.
And for our retail clients, tax-exempt municipals have come back and great opportunities remain, particularly in lower investment grade, other credits, as well as further out the curve.
Thank you very much, Jeff, for joining us today. We appreciate your insights.
Jeff: It was a pleasure. Thank you, Yeng.
Yeng: For our listeners, if you’d like to read more market insights and investment perspectives from the fixed-income teams at WFAM, you can find them at our AdvantageVoice® blog, as well as on our website at http://on.wf.com/6121GTbGX. I’m Yeng Butler, and thanks for listening.
100 basis points equals 1.00%.
Originally Posted on July 8, 2020 – A Balanced Approach to Cash Management
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