Last month's Money Fund Symposium was of course mostly about money funds. But it also included a session entitled, "Enhanced Cash and Ultra-Short Bond Funds," which featured JP Morgan Securities' Alex Roever, Fidelity Investments' Michael Morin and Goldman Sachs Asset Management's John Olivo. They discussed why they think ultra-short bond funds are poised for significant growth in the post money fund reform environment. The following article is reprinted from the July issue of Bond Fund Intelligence. (Note: We'll also be featuring a session on "Beyond MMFs: Enhanced Cash Strategies" with Jason Granet of Goldman Sachs A.M., Neil Hutchison of J.P. Morgan Asset Mgmt., and Peter Yi of Northern Trust Asset Mgmt. at our upcoming European Money Fund Symposium, which is Sept. 20-21 in London.)
At our U.S. Symposium in late June, Roever commented, "One of the issues in working in this space just beyond money markets is trying to get your head around all the different nomenclature that gets thrown around. We all know what a money fund is, it's defined in rule 2a-7, but some of these other strategies are a lot less defined.... The Ultra-Short category is relative small, about $73 billion."
Roever asked the panel: How do you address the different categories when talking to institutional clients? Fidelity's Morin said, "You want to have a full lineup ... and you want to have different risk return products and profiles." He added, "We think about the time horizon. Where we're heading is segmentation of cash. Do you need intraday cash? What cash do you need next day? What do you need within 11 days? And almost every bucket in between." Morin added, "As we segment our cash, there's a pecking order of that liquidity ... you have the bank, you have government funds, you have prime funds, then you can go into the Ultra-Short."
Morin continued, "Pete [Crane] has this new conservative Ultra-Short bond index he created. This is kind of the new breed of funds that have been out there now for 5 years in some cases. This is where the fund sponsors' said, 'Let's try to minimize the NAV volatility, let's figure out how we can control risk and have some very strict guidelines and lower the NAV volatility in these funds.' And even within Pete's universe of Conservative Ultra-Short, there's still a lot of variety of strategies." The key, he said, is educating clients about the need to include ultra-shorts in the investment policy. "If you look at investment policies today, they have a broad set of fixed income parameters around duration, credit quality, and derivative use.... But we're trying to get them across the hurdle to add Ultra-Short bond funds specifically to their investment policies."
Roever asked: How has the space evolved over the past 5 years? Morin explained, "The asset class hasn't grown, certainly for the funds we can track. The universe is flat. I think we had a decrease in the old cash plus, enhanced cash space after the financial crisis so that went lower. But if you add the Ultra-Short bond fund assets, we're back to where we were. The opportunity for Ultra-Shorts is for those maybe smaller clients where the time horizon isn't sufficient to set up an SMA and the yield compression in money market funds over the last 7 years have gotten them thinking about the next risk return profile beyond MMFs."
Morin continued, "So these conversations have been going on and the momentum is building, but everybody always asks me, 'How come we haven't doubled in size?' That's because a $1 Prime money market fund is still available. In October, they will lose that option, so I think we're very bullish on this asset class. When we're here talking next year, I think we're going to have some noticeable increases in the Ultra-Short space."
Olivo added, "I think we have seen growth in an area that is difficult to chart -- the SMAs that money managers are doing directly with clients. That's where you've seen the growth in the short duration industry rather than in the fund space. There is a big pile of cash trapped offshore that doesn't want to pay for liquidity and doesn't want the volatility associated with longer duration strategies, so short duration tends to be a sweet spot for them. That's where many money managers have seen the growth of their short duration business."
What is the bigger driver of increased activity in Ultra-Shorts, low yields or money market fund reform? Olivo responded, "I would say the low interest rate has been more of a driver of increased opportunity over the last several years." However, he added, "What money fund regulation is going to do, and it has started to already, is cause investors to get more granular on their liquidity management.... 'Do I need different buckets to manage that? Do I want some in a Govie fund? Do I want some in a prime fund or an Ultra-Short duration mutual fund ... or an SMA.' It is opening their eyes that they can earn higher returns and that there are different opportunities out there."
Roever also asked about benchmarks in the Ultra-Short space. "It's a little bit like snowflakes, each one is a little bit different. How do you counsel clients to look at returns? What's the right return? Is it the return you're getting over a MMF or is it a return you're getting over some short-term bond index?" Morin commented, "I think it's the additional pickup over prime money market funds. They are willing to take a little bit of risk to earn slightly higher returns. Through the education process, you can identify where you want to take your risk -- Do you want to do credit, duration, both? It's really what they're comfortable with."
There was also a question about opportunities for Ultra-Shorts related to money fund reform. Said Olivo, "Spreads in that 6 to 12-month space are definitely starting to widen. That's certainly an opportunity for a number of our ultra-short duration strategies. We think it will only continue as we get closer to October as money fund managers are certain [to] building liquidity."
On the Fed, Roever asked, "We know the storm (MMF reform) is coming hell or high water. What we don't know is whether or not the Fed is going to raise Interest rates. How do you deal with that uncertainty of if or when they'll hike?" Olivo answered, "In the Short Duration space a big component of the total return is the roll down you achieve by owning longer dated bonds and the excess carry that you get relative to your benchmark. It's challenging to do that when you're constantly short from a duration perspective. From a duration perspective, we have been meaningfully short relative to our benchmarks despite the fact that we do think the Fed will ultimately raise rates in the second half of this year."
Olivo continued, "Many first time investors in the short duration space are scared to death of interest rate volatility -- they're concerned about the fed raising rates. When we speak to them, the goal is to convey the message that higher rates are better for this strategy. The Fed is not going to be raising the interest rates 300 basis points in a short period, so a slow, gradually tightening policy is good for these strategies because those higher yields bleed back into the portfolio in relatively short order. We're hopeful that the Fed does continue to raise rates and ultimately we think that's in the best interest of our short duration clients."
In conclusion, Roever asked, "Let's project forward a year. What does the liquidity landscape look like a year from now? What's the breakout between Govie and Prime and how are we seeing this Ultra-Short space evolve?" Commented Morin, "I think we're all anticipating that the peak assets in government money market funds are going to be around October of this year. We think that credit spreads are going to widen, they're going to widen to an extent that over time investors will get more comfortable with the floating NAV."
He added that once a client realizes they can handle the floating NAV they will get more comfortable with Prime funds as well as Ultra-Short bond funds. "I think we are starting to see some traction and momentum with clients adding Ultra-Short bond funds to their investment policy. I think the balance in Ultra-Short bond funds will be significantly higher than it is today and I think it continues to grow."
Olivo stated, "I think that for clients that have SMAs you will see assets move from prime funds into SMAs." But he added, that he doesn't think there will be many clients moving into SMAs for the first time -- "I'll take the under on that." Finally, he commented, "Once the dust settles on reform, you'll see a great diversification of the liquidity solutions that investors have in their portfolio. Hopefully, they continue to use the Short Duration strategies as a complement to money funds."
