Our December Bond Fund Intelligence profiles Sue Hill, who is not only one of the leading authorities in the money market fund space as Senior Portfolio Manager for many of Federated's Government MMFs, she's also manager of Federated's Government Ultrashort Duration Fund. The $800 million fund is the only conservative ultra-short bond fund that invests exclusively in government securities. With the Federal Reserve voting to raise interest rates at its December 15-16 FOMC meeting, Hill shared her thoughts on the Fed and how the pending increase could ultimately help the ultra-short sector. She also talks about how this fund is built to weather market volatility. Here is a reprint of our Q&A with Hill from the latest BFI. (Note: Contact us if you'd like to see the latest Bond Fund Intelligence, Crane Data's newest product that tracks the bond mutual fund marketplace.)
BFI: How long has Federated been running short term bonds? Hill: The Federated Government Ultrashort Duration Fund launched in 1997. Obviously, Federated has a lot of expertise in the money fund space, and we leverage that expertise and commitment of resources as we take a step out the cash yield curve into the ultra-short space. We manage our government ultra-short portfolio with a team approach -- a combination of that money market expertise joined with our expertise on the fixed income side in the government mortgage-backed space.
We have products that span all the way out the yield curve in the fixed income arena, but this fund is kind of a niche product, believed to be the only one of its kind in the government ultrashort space. It is designed to be an incremental step out the yield curve for clients to gain additional incremental yield with relatively minimal principal volatility. We do have to emphasize that the NAV does fluctuate, although we can attempt to minimize volatility through conservative management and portfolio positioning. Generally speaking, it has not fluctuated very much over a variety of market environments.
BFI: What is the biggest challenge for this fund? Hill: The main challenge for ultra-short products recently has been the low rate environment. In a transition period between rates being so low for so long to -- knock on wood -- a rising rate environment, it may take a little bit of time for the income component of the fund to catch up to the price effect of rising rates. But as soon as rates rise -- and our expectation ... is that the Fed will do so in a very gradual, controlled fashion -- the lower volatility of that type of market environment may allow an ultra-short fund, on a total return basis, to do reasonably well.
BFI: What are you buying? Hill: The fund holds traditional government money market types of instruments to provide liquidity and to enhance principal stability. But the incremental yield comes from an allocation to government mortgage-backed securities that typically fall into two categories: adjustable rate mortgages and floating rate CMOs. Both are responsive to rising rates, but the reset feature of a floating rate CMO is a little more frequent than that of some of the adjustable rate mortgages. More recently we've shifted somewhat out of adjustable rate mortgages -- not entirely -- in favor of more floating rate CMOs in the anticipation of a rising rate environment. They tend to have a little less price volatility and a little more interest rate responsiveness; they adjust more often and more quickly to rates rising at the very front end.
BFI: Tell us more about portfolio construction. Hill: The allocation between the money market sector and the agency mortgage-backed sector of the portfolio tends to be split roughly in half. The purpose of the money market sector in many cases is not only to enhance the principal stability of the overall portfolio, but also to serve as the liquidity base for the ultra-short product. The fund is a home for investors that have a longer time horizon for their cash than would typically be the case in a money market product. But we still need to hold a liquidity position within the portfolio in order to meet the day-to-day redemption needs of investors. So, the repo positions that we know and love in our money market funds are also present in this ultra short product. We typically have somewhere between 20%-25% of the fund in repo -- usually overnight or short term repo to meet the liquidity needs.
The SEC has a very strong focus on the liquidity of bond funds these days, and this particular portfolio is naturally highly liquid by virtue of its money market exposure. We manage that core, money market position as we do our other money market funds: the same strategy, the same types of securities. The agencies that you'll see in the mortgage backed sector are the traditional ones -- Fannie and Freddie, and Ginnie Mae as well. Ginnie Mae is not a traditional money market issuer, but is the insurer in the agency mortgage-backed space. We have typically averaged about half a year in weighted average duration in this fund since the inception of the fund, although we have drifted shorter more recently.
BFI: Do you offer similar products? Hill: We do have two other ultra-short products -- Federated Municipal Ultra-Short Fund and Federated UltraShort Bond Fund -- both with long track records and good performance. We have also had substantial discussions with clients regarding how they may be adjusting their cash management strategies over the next year, and we do offer various separate account strategies that may be attractive to a client in the changing money market world to come.
BFI: What about investors and reforms? Hill: The portfolio has a fairly diverse investor base. We have a variety of types of institutional investors -- corporations or governmental entities, as examples -- and we expect it to continue to be attractive to that type of base going forward. None of us really knows how things will unfold as we move forward into October of next year, but we could see a shift of a portion of cash positions from larger institutions that traditionally have been in the money market space moving out to capture the additional yield that could be available in products just outside the money market world.
BFI: What are your expectations for rates? Hill: As we sit here today, we're looking for liftoff from the Fed later this week. [Note: This interview took place prior to the Fed's rate hike.] We've seen the front end of the curve re-price rather significantly, particular over the past couple of weeks. The money market sector now reflects a Fed that will be moving soon, but gradually. It's not priced to a 'one-and-done' scenario. There are a couple of rate hikes throughout 2016 built into the pricing of the curve depending on where you're looking. So, we are starting to see the reflection of that in the portfolio yields.
BFI: What are the risks? Hill: The biggest risk we face is how the net asset value of the fund will perform in a rising rate environment. Historically, we've done reasonably well with the strategy that we have -- the nature of the securities that the fund invests in are naturally defensive. It's really the pace of tightening that is important, and we believe that the pace of tightening will be relatively moderate. In addition, the Fed owns a significant amount of Treasuries and Agency mortgage backed securities on its balance sheet. How the Fed ultimately unwinds those holdings is a concern for the broader MBS market. That said, the nature of the securities in the agency mortgage-backed market that our fund holds are not those being held on the Fed's balance sheet. The adjustable rate and floating rate CMO market is something the Fed has not been purchasing, so I think we can weather that unwind when it eventually happens relatively well.
Finally, the future of Fannie and Freddie is always on the table. Given that Fannie and Freddie are primary investments in this particular portfolio, it's something that that we're watching. I do think that the political appetite to reform Fannie and Freddie and to move them out of conservatorship has cooled since the 2008-2009 period. There is some movement in Congress to define what the entities will look like once they emerge from conservatorship, but I think the eligibility of those securities for portfolios like Federated's should remain intact.
BFI: Are gradually rising rates an ideal scenario? Hill: Nirvana for portfolios like ours, but not necessarily in the money market world, is that the Fed raises rates in a gradual fashion. As rates rise, the income component of the portfolio eventually will rise to offset at least some of any price volatility. To the extent that we're wrong about that forecast and the Fed tightens aggressively -- obviously I'll be happy in the other part of my life here (from the money fund perspective). With a relatively low volatility rising rate environment, I would expect these funds to ultimately become more attractive -- not only from a total return perspective, but also among clients evaluating their investment strategies and feeling more comfortable taking steps out into a space like this where they have not gone before.
