HOW DO WE BALANCE THE NEED FOR LIQUIDITY WITH THE NEED FOR A YIELD THAT OUTPACES INFLATION IN TODAY’S MARKET?
Most investors have at least a portion of their total portfolios allocated in fixed income. Some do this to ensure diversification and reduce risk from fluctuating equities, while others do it to generate a relatively steady cash flow or fund future liabilities. As a result, fixed income investments are among the largest asset classes in the financial markets.
The spectrum of fixed income investments is broad, ranging from money markets to bond funds, publicly traded securities and even privately placed securities. Yields can vary greatly, as can duration—from just a few days to several decades. As most investors know, there a negative correlation, or trade off, between liquidity (related to duration) and yield.
Sorting Out Options
Now, with fixed income yields at historic lows, many investors are trying to find investments that give them the level of liquidity they seek—often requiring shorter durations—with a yield that is high enough to outplace inflation.
Analyzing the source of expected returns is key. This allows investors to better appreciate the types of risk they are taking.
Highly liquid fixed income securities have lower yields than most bonds. Therefore, investors seeking a higher yield may have to sacrifice some liquidity and duration exposure. Fixed income duration generally measures the sensitivity of the fixed income instrument to a change in interest rate.
Money market funds offer the most liquidity as they invest in high quality, short term debt securities that pay dividends. They have generated great interest from investors, as they have reached about $4 trillion in total market value. Generally, money market mutual funds seek to maintain a stable net asset value (NAV) of $1.00. Such funds are very popular with not only retail investors but also institutions including publicly traded companies and financial institutions.
It’s worth noting that during the 2008 financial crisis, one money market fund fell below $1 in value and several other funds required sponsor support to avoid falling below that. This taught us that money market funds are not fail-proof, and that their underlying assets and duration must be analyzed just like any other investment.
Money Market Yields Not Keeping Up with Inflation
For today’s investors, one of the chief issues related to money market funds is that most of those with a fixed NAV, investing in government securities and other high-quality short-term securities, generate a yield below the rate of inflation—thus reducing purchasing power and the ability to preserve capital. Many believe (and some rightly so) that achieving inflation-beating yields requires a longer duration and undesirable liquidity risk.
This is particularly problematic when the Federal Reserve is increasing rates. Such moves can also result in significant headwinds for bond funds. However, the fourth quarter of 2019 brought some optimism to fixed income investors since the Federal Reserve indicated that they would put rate increases on hold or “pause.”
In Challenge Comes Opportunity
Here at FourThought, we believe the Fed’s pause could be an opportunity to take a small duration exposure move for better returns. Under the current market conditions, a fixed income portfolio comprised of a blend of a money market fund and a short-term bond fund could be a pragmatic approach to maintaining a desired level of liquidity—and at the same time, potentially earning a higher return than money market mutual funds or ultra-short bond funds alone. In other worlds, investors could benefit by applying the corporate finance principles of bifurcating operating cash versus strategic cash.