Tapping Yield at the Front End of the Curve

Tapping Yield at the Front End of the Curve

After a decade of anemic short-term yields, recent volatility is auguring a shift in the status quo. We’re now seeing opportunities for active investors to tap yield and spread at the front end of the curve – sending investors a clear signal that it may be time to actively reevaluate their liquidity management. These trends may even accelerate as the Federal Reserve continues its hiking path and with late-cycle fiscal stimulus in the U.S. this year.

An opportunity, not a warning

What exactly are we seeing to support this view? A case in point is the spread between overnight index swaps (OIS), considered the “risk-free” rate tied to the federal funds rate, and forward rate agreements (FRA), which are tied to Libor. Over the past three months, the FRA/OIS spread has more than tripled, from just over 10 basis points (bps) to over 35 bps (see chart). Such a move would typically signal some sort of stress in the credit markets – particularly banks having difficulty getting short-term funding.

That is not the case this time. We believe the primary drivers are more innocuous: namely, increased Treasury bill issuance to meet pent-up need following the debt ceiling impasse and to fund larger deficits, paired with a decline in investor demand related to tax reform (primarily repatriation of assets, which lowers corporate treasurers’ need for front-end assets).

In this context, we view the widening of Libor versus OIS benchmarks as an opportunity rather than as a harbinger of a structural breakdown – and we think it should be a call to action to investors to rethink their short-term liquidity options.

Investment takeaways

Historically, investors have relied on money market funds, time deposits or certificates of deposit (CDs) to manage liquidity within a portfolio construct. The problem is that these vehicles cannot fully take advantage of opportunities like we’re seeing today, precipitated by the changing landscape of supply and altered demand from participants in the front end. These traditional strategies may not be able to buy the types of assets that have repriced to more attractive spreads/yields, are limited to investments that are slow to react to higher yields (in the case of time deposits), and liquidity is often trapped, as with CDs, which penalize early withdrawals and inhibit redeployment of cash to higher-yielding securities.

We think investors could potentially benefit from expanding their liquidity toolkits to active strategies with a more diversified set of investments that can seek to exploit the opportunities in the market. These include ultra-short strategies, which seek to offer higher yields and better risk/return profiles through dynamic liquidity management, albeit with the potential for modest volatility relative to traditional cash investments.

More broadly, when thinking about asset allocation in light of flatter yield curves resulting from higher rates in the front end, we believe that increasing allocations to shorter-duration securities to capture those higher yields is attractive – and is consistent with the approach we are taking as active managers across our strategies, as appropriate.

U.S. readers: For more of our views on liquidity management, please visit our hub for long-term thinking about short-term strategies.

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Jerome Schneider is PIMCO’s head of short-term portfolio management and is a regular contributor to the PIMCO Blog. Andrew Wittkop is a PIMCO portfolio manager focusing on Treasury bonds, agencies and interest rate derivatives and is a contributor to the PIMCO Blog.

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Disclosures

The "risk-free" rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return. All investments contain risk and may lose value.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. All investments contain risk and may lose value. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.