As we approach a rising rate environment and money market reform is looming (new SEC rules take effect in October 2016), it’s time to take another look at how you are managing your liquidity. The amount of cash people are holding today remains at or near all-time highs and yields at or near all-time lows. Deciding how much near-term cash to hold is by definition a balancing act, but at the end of the day one should be able to forecast cash flow with some degree of certainty. Greater certainty enables the owner to take on more risk and potentially add significant value to his/her pool of liquidity. Think about tiering your liquidity, separating operational and strategic cash, using a mix of money market funds, short-term bond funds and separate accounts.
Don’t fear money market reform. It has made the sector stronger and more transparent and the new rules will present the opportunity to add value. You will be afforded all the necessary vehicles to take advantage of it (new products and strategies are now on the drawing board). Take the time to cash flow forecast, tier your cash and don’t fear rising rates. As one of the portfolio managers I work with likes to say “it’s not timing the market, it’s time in the market”. The yield advantage and roll down of slightly extending duration is significant (the ML 1-3 year UST Index yield was 0.34% on 11/04/10 and 0.37% on 03/31/12. The return of 0.74% is well in excess of this stated yield due in large part to the roll down effect). Put plainly, higher rates can be a GOOD thing. The natural turnover of shorter strategies reinvesting at higher rate levels will enhance longer-term returns over time. Adding credit and other spread sectors can also enhance the yield and return potential further without a material pick up in volatility. The entry point today for credit is significantly better than it was 18 months ago.
So take another look at your liquidity management: even with today’s super-low yields, the picture is prettier than you might expect.
Investors often think of high yield as simply the risky asset class within the broad Fixed Income family – the brash cousin who is more tolerable in small doses due to his greater propensity to pass out at the dinner table. However, we should not allow the occasional lapse to overshadow a plethora of positive attributes that distinguish the asset class from its more staid bond market relations.
High yield’s medium and long term correlation (5 year, 10 year, and 25 year, as measured by the JPMorgan Domestic HY Index) to Treasuries has been negative or very low, while for the same time periods, the correlation to equities is above 0.70 (Table 1). These correlations show that high yield returns behave less like bonds and more like equities, which combined with the cushion high yield bonds provide in the case of interest rate hikes (see High Yield Bond Market in a Rising Rate Environment), increases the diversification effect in fixed income portfolios. The positive correlation to equities should not be surprising given that high yield returns are linked strongly to company fundamentals and earnings.
More interestingly, the annual returns in Table 2, show that both U.S. and European high yield bonds performed similarly to equities (data for 25 years are not available as high yield returns don’t exist). The asset class has managed to generate these returns consistently with almost half the equity volatility, which indicates that investors can reduce risk, as measured by volatility, and maintain the level of returns by simply adding high yield bonds in a portfolio. In the worst case scenario for both bond and equity holders, bankruptcy, an investor is better off holding high yield as bond investors are senior in the capital structure vs. equities.
As well as moving investors up in the capital structure, high yield bonds can also enhance the diversification of a portfolio’s corporate risk by expanding the investible corporate universe to well-known but privately owned companies without listed shares. For example, the number of companies that are in both the STOXX 600 and the European High Yield index is just 38. These 38 companies make up 7% of the STOXX 600 on a market cap weighted basis*. Equivalently, 62 companies appear in both the S&P 500 and the U.S. High Yield Index (HUC0). In other words, there are hundreds of companies whose cash flows are only accessible to investors via the high yield bond market.
With credit quality in the high yield market improving, default rates well below the historical average both in the U.S. and Europe, limited correlation to interest rate increases and favourable risk-return characteristics of high yield bonds as discussed above, investors are likely to benefit from an allocation to high yield debt.
*data as of December 2014
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