In its latest weekly "Short-Term Fixed Income," J.P. Morgan Securities published a segment entitled, "Short-Term Bond Funds: When cash is king" that suggests that ultra-short bond funds are gaining assets at the expense of money market funds and longer-term bond funds so far in 2018. Authors Alex Roever, Teresa Ho, Ryan Lessing explain, "The ongoing rise in short-term interest rates and the related bear-flattening continue to focus attention on investments in the front end of the yield curve. Not only are short-term yields growing more attractive, the lower duration reduces exposure to rising rates, bolstering relative total returns. Consequently, mutual fund and MMF flows data suggest money continues to flow into the low duration space."
They tell us, "In the case of bond funds we believe the flows represent primarily retail money mixed with limited corporate/institutional interest. Although a significant fraction of large corporate cash portfolios are invested in similar low-duration styles as the ultrashort and short-term bond funds, most of this corporate cash is held in privately administered SMAs where flows and holdings are not publicly available. In the case of MMF, we note that balances are running higher than would normally be expected this time of year, and we expect this reflects higher demand from both institutional and retail customers."
The JPM piece says, "With the overall yield curve bear flattening, total returns have suffered, and along with weaker returns have come an overall drop in demand for IG credit. However, the very front end of the curve has been something of an exception. Although short-term yields are rising and credit spreads widening modestly, the front end is outperforming the rest of the curve, with total returns in some categories managing to stay positive. And, with HG corporate yields now at 3.1%, a 9-year high, the yields on low-duration bond funds remain high relative to MMF and even high yielding bank deposits."
It continues, "That said, the yield advantage relative to MMF has eroded over the past year as money market rates have risen. Even so, the relatively high yields continue to attract flows into the front end -- mainly into ultrashort funds -- even as interest has flagged further out the curve."
Roever and co-authors comment, "But even in the short duration space, interest rate risk matters.... [T]he relative total returns and Sharpe ratios for ultrashort and short-term mutual funds by style, [show] that ultrashorts have generally outperformed similar short-term funds over the past year on both an absolute and risk adjusted basis. As is often the case, bond mutual fund flows have followed performance with inflows into short term bond funds stalling even as the non-government ultrashort short funds have continued to grow."
They state, "The keys to the outperformance of the credit sensitive ultrashort funds are evident in their holdings data.... First, credit sensitive funds benefit versus government funds because of their exposure to corporate credit and securitized products, which contribute spread to the returns. Second, the average duration of the ultrashorts is about a year and a half shorter than the short-term funds, which reduces exposure to rising yields. And finally, the ultrashorts hold significantly more floating rate notes which increase in yield and better hold their value as interest rates rise."
The Short-Term Fixed Income piece also says, "Clearly, the rising rate environment has helped ultrashort funds relative to longer maturity alternatives, and we suspect this will remain the case over the medium term. Aside from higher rates the other major focus in the front end has been implications of tax reform on repatriated corporate cash holdings."
It continues, "In general, we don't think the major corporate cash holders involved in repatriation are major investors in ultrashort or short-term bond funds. However, we know that many of them invest via privately administered SMA using similar strategies and generating similar returns. We also know that many of the large corporates use both MMF and MMF-style liquidity SMAs to manage their more liquid cash. Fitch Ratings estimates these corporate SMAs account for over $400bn in AUM."
The paper says, "We believe that in the wake of tax reform most of the large corporates with large offshore balances have put a hold on new short-term bond purchases. Instead they have focused on building liquidity for potential share buybacks and dividends. While in this holding pattern we believe corporate cash (from bond maturities, cash from operations, and from offshore MMF) has found its way into either MMF or into money market instruments within SMAs."
It adds, "Consequently, we note that although US based MMF balances are lower YTD, there is a seasonality to MMF flows. Relative to the average over 2013-2017 period cumulative net outflows from USD MMF are running about $50bn less, suggesting more money is staying in MMF, either because yields are higher or because corporates are using the MMF as a half-way house between the fixed income market and future payments to shareholders."
Finally, JPM writes, "Looking ahead, it may be several more months before future corporate flows to shareholders ramp-up. Possibly this could disrupt the normal late-year seasonal inflow pattern, and result in net outflows in late-2018. This would subsequently reduce demand for a variety of MMF instruments. Given that we expect another surge in T-bill supply in 4Q18, a late year shift to outflows from MMFs could contribute to upward pressure on the short-term rate complex." (For more on ultra-short bond funds, see Crane Data's latest `Bond Fund Intelligence newsletter, BFI XLS spreadsheet, and Bond Fund Portfolio Holdings data set. Let us know if you'd like to see the latest issue or files.)
