Since the disruptions that roiled financial markets in March 2020, investors have turned more to cash and other short-term instruments typically associated with risk aversion and preservation of capital and liquidity. Yet such investments can come with their own sets of risks. Recent bouts of volatility in U.S. prime (credit) money market funds have heightened the focus on unexpected liquidity issues in seemingly “safe” investments, as well as on the pitfalls of taking credit risk for minimal additional compensation. When considering cash allocations today, investors should be mindful of how near-zero short-term interest rates coupled with traditional liquidity-management strategies may hinder attempts to preserve the purchasing power of capital while posing potential hidden opportunity costs.
Cash yields likely to stay near zero
Efforts to combat the economic effects of the pandemic have contributed to historically low short-term yields for money market instruments, elevated levels of savings and bank deposits, as well as increased demand for cash-like investments. The U.S. Federal Reserve last year cut its policy rate near 0% and could keep it there well into 2023, we believe, anchoring front-end rates and suppressing yields on Treasury bills and money market funds. A temporary relaxation of bank capital regulations ended in March (see “SLR Expiration: Treasury Markets Likely to Shoulder the Costs”), which could make large lenders resist taking on new deposits and push more investors into money market funds. Continued growth in such funds – where balances are already near record highs, at about $4.5 trillion – as well as in excess reserves could keep cash investment yields close to 0% for a prolonged period.
Much of the money investors have shifted into cash since last March has remained there, often due to worries about rising long-term bond yields or elevated valuations in equity markets. Yet having too much defensive cash in today’s environment can impose a cost if it’s concentrated largely in traditional money market funds offering near-zero returns. The recent Treasury yield-curve steepening has increased the penalty associated with holding cash, as the broader opportunity set outside regulated money markets offers higher starting yields for a modest increase in risk.
Optimizing allocations to preserve both liquidity and returns
Government or Treasury U.S. money market funds offer principal preservation and easy access to near-term or daily liquidity. But many investors have more cash stashed in money market funds than they would actually require for their near-term liquidity needs. Furthermore, the performance of several prime money funds in 2020 has led to increased discussions among regulators and shareholders (see our April blog post “Revisiting Money Market Reform”) about whether the current structure is appropriate for those focused on same-day liquidity management.
Structuring a cash allocation based on forecasted liquidity needs creates opportunities for investors to potentially benefit from an investment time horizon or holding period. This tiering approach can use the cash not immediately needed for spending to invest in strategies that still emphasize liquidity and capital preservation with shorter-maturity investments, but have more return potential for only modest increases in risk. Tiering can be attractive for investors looking to reduce volatility or rate exposure – whether they have already moved to cash or want to reduce more traditional risks stemming from rising rates or broader market uncertainty.
The large amount of cash now in the financial system could augur a period of lower volatility for front-end assets, but with lower returns too. Strategies that offer some modest “step out” from money market funds can capitalize on a wider array of opportunities, while offering a diversified means to potentially have higher risk-adjusted returns than traditional cash investments. These opportunities can range from selection within sectors such as agency debentures, investment grade corporate bonds, and high quality securitized assets, to structural trades that capture inefficiencies at the front end of the yield curve. Such a diversified approach in this interest rate environment can enable not just higher return potential but also the possibility for resiliency and consistency of those returns.
Jerome M. Schneider is a managing director and PIMCO’s head of short-term portfolio management.
Kenneth Chambers is a senior vice president and strategist on the multi-sector fixed income team in the Newport Beach office, with responsibility across income and short duration strategies.