Cash segmentation is a sensible strategy in any market environment, but it can be especially useful when there’s a steep front end of the credit curve, as we see today. Credit fundamentals remain solid, and we believe when looking at the front end of the yield curve (with maturities of less than two years) one should focus on the 15-month-and- in part of the curve. Here’s why:
Yield on the EDSF is close to its one-year high
Looking at the Euro Dollar Spot Forward (EDSF), a pricing benchmark for credit whose maturities are less than 13 months, we see the current level of the one-year EDSF at an attractive 0.48%. That is well above its one-year average of 0.34% and only a few basis points below its one-year high of 0.53%. The EDSF trades at such a relatively high yield despite the news from the March 18th Federal Open Market Committee (FOMC) meeting, which was an important one for the Federal Reserve. FOMC members significantly lowered their interest rate forecasts in all periods from 2015 to 2017. The median forecast for 2015 now anticipates two rate hikes, whereas prior forecasts called for three or four hikes. At current yields, the break -evens of securities with maturities of 15 months and less vs. traditional cash investments look attractive over the next year across most interest rate scenarios.
If the Fed moves more quickly than projected, then floating rate notes (FRNs) may be quite helpful. FRNs can also serve as a complement to shorter fixed rate purchases in a cash segmentation strategy.
Bank ratings downgrades cheapen credit in the one-year part of the curve
Ratings downgrades in the banking sector by some of the Nationally Recognized Statistical Ratings Organizations (NRSRO) are making credit in the one-year part of the curve attractively valued. The basic premise of these downgrades over the past year has been the removal of an implied government support from each bank’s ratings. Banks generally have stronger balance sheets and better liquidity profiles than they did during the financial crisis, but because of the change in ratings methodology they have lower credit ratings. Given that banks are the largest issuers of credit in the short end of the curve, the relatively high yields on bank debt have led to higher yields in other sectors as well.
Market technicals should contain front-end curve steepening
Regulation of banks and money market funds will continue to funnel cash into the front end of the market, and these technical factors should contain the steepness of the front end curves. One interesting option is to think about segmenting their cash among money market funds and in investment vehicles further out the curve, where options include separately managed accounts (SMAs) and ultra short bond funds. SMAs can be customized to meet an investor’s particular guidelines. Ultra short bond funds vary with respect to duration, spread duration and permissible investments. Monthly, quarterly and yearly volatility are among the data points that an investor should examine when thinking about investing further out the curve.