Low interest rates penalize savers. And in PIMCO’s secular New Neutral framework – where the neutral fed funds rate is lower than in the past – savers are rethinking their cash strategies as inflation steadily erodes the real value of their capital. Nowhere is this truer than in money market funds, where the forthcoming reform has prodded a mass migration of $550 billion from prime to government-only funds.
As the 14 October reform deadline nears, we believe it is not only prudent, but essential for cash investors to evaluate their strategies in this low interest rate world. The prevalent use of money market funds for managing savings or excess liquidity may prove costly, and investors could potentially benefit by looking toward other strategies, such as ultra-short bond funds.
Traditionally, investors have looked to money market funds as an alternative to bank deposits for managing their liquidity needs. Investors expected to earn a slightly higher yield versus bank deposits for an incremental increase in risk. Money market funds offered capital preservation via a stable $1/share net asset value (NAV): Put a dollar in, get a dollar out. There was no fuss with changing NAVs, and no one ever expected a money market fund to “break the buck.”
For much of the past 40+ years, money market investors received the added benefit of interest rates that exceeded the prevailing rate of inflation. Indeed, in the two decades prior to the Great Recession, there was only one period in which money market funds’ average returns did not outpace the headline U.S. Consumer Price Index (CPI) (see chart). These positive real returns helped preserve savers’ purchasing power.
Money market fund returns no longer outpace inflation
But things have changed. Money market funds have failed to yield above CPI in any year since the recession ended in 2009, and investors have seen their purchasing power decrease by roughly 1.50% per year. On a cumulative basis, an investment in money market funds since the beginning of 2009 would have decreased purchasing power by more than 14% – a trend that has only worsened in 2016.
If PIMCO’s New Neutral framework holds as we expect, then protecting “par” may no longer be an adequate objective for managing short-term capital over the foreseeable future. Preserving purchasing power has become critical to cash investors managing toward future liability payments – even retirement!
Outside the box: ultra-short bond funds
So where should investors turn to mitigate the corrosive effects of inflation in their cash portfolios?
We believe ultra-short bond funds are an attractive option. Many of these funds will have similar characteristics to prime funds once money market reform takes effect. Ultra-short bond funds historically have offered higher yields with only slightly higher volatility largely because they can invest in a more diverse set of instruments. Most importantly, the total return on ultra-short bond funds historically has tended to outpace the yield on prime funds over time.
As 14 October approaches, investors can adapt to the structural changes in cash and short-term markets by avoiding the inevitable consequences of keeping excess cash and liquidity in money market funds and seeking strategies that have the potential to preserve purchasing power. For investors facing the New Neutral reality of near-zero interest rates and positive inflation, every cent matters.
In a related Q&A Jerome Schneider answers five key questions on Libor and money market reform.