Western Asset hosted a, "Liquidity Strategy Update: Mid-Year Review and Economic Outlook" earlier this week, which featured Head of Liquidity Portfolio Management Kevin Kennedy, and also announced the completion of its merger with Franklin Templeton. The webinar discussed, "the impact of the COVID-19 crisis on liquidity markets, including the Federal Reserve's policy response, [the] market outlook for liquidity investors ... and ... conditions ahead." We excerpt from Western's update below. (See also our Feb. 20 News, "Franklin, Legg Mason Deal Signals More Consolidation; More Liquidations.")
Kennedy says, "I'll try to give the portfolio manager perspective, which is acknowledging the harsh realities of the rate remaining close to zero for quite a long period of time. On U.S. short term rates ... obviously, it's generally a trend toward significant rate declines toward zero.... The Fed was viewed as moving aggressively, quickly, proactively, and, it was viewed by markets in general that they made the right move at the right time.... There was a strong demand to remain liquid, to move towards the most liquid of securities, to build up cash, to make sure you had access to it should you need it quickly. And what that resulted in was a huge shift out of Prime funds, out of less liquid instruments, into Treasury securities, and out of equities to a certain extent. During that point it became impossible for banks, for industrials, CP issuers to raise funds. Really, in order to raise funds during that time it was probably necessary to pay as much as two percent, you know, when you had a Fed funds rate that was close to zero."
He continues, "The Fed stepped in very quickly with a number of programs; probably the most important of which when it came down to reopening the short-term markets and rebuilding liquidity was the Money Market Liquidity Facility. [The MMLF] on a nonrecourse basis provides financing for dealers to finance commercial paper and CDs with the Fed. That ... had a quick, direct impact on money markets. That’s when we started to see a steady decline in LIBOR, in fact, a fairly rapid decline. And that was in conjunction with a number of the other Fed programs."
The Western veteran explains, "One of the most incredible increases in supply ... that I think we've ever seen, was the dramatic increase in Treasury bill supply, which began at the end of March. We may remember, those who keep an eye on the short-term markets and the bill market, that there was a period of time towards the end of the first quarter, really prior to the time when Treasury bill issuance jumped higher, right before then bills did go briefly negative for a period of time.... Towards the end of March both were trading as low as negative 10 to 20 basis points."
He tells us, "[To] overseas investors, certainly with ... a largely negative rate environment in many areas of the globe, the U.S. still represented value, if only because there was a positive yield, … excellent liquidity characteristics, and money market funds themselves.... There was certainly a building demand ... from investors of money markets, certainly on the Treasury and government side.... Their fears were relieved somewhat as the Fed acted strongly, [but] they still maintain very high levels of balances in Treasury and government funds.... You did start to see a bit of a decline as investors started to venture into other short-term alternatives, or back into equity markets, or corporates, or other risk sectors. But still, to date Treasury and Government funds are still are much larger than they were prior to the onset of the crisis."
Kennedy also comments, "As time has gone on, we've noticed a significant flattening in yield curves in general. Certainly, the U.S. Treasury yield curve has flattened significantly. And that [has] helped the bill market maintain its attractiveness.... Those who were generally Treasury investors in that one-to-three-year area ... looked to take less duration risk since they really weren't getting paid.... They could get close to the same return in the Treasury bill market. Industrial grade issuers ... those spreads have come in sharply since the height of the crisis. And, we really don't see that changing very much going forward, especially since the Fed has announced extensions of their liquidity programs and extension of their swap lines through the end of 2020."
He states, "One of the positives when it comes down to being comfortable that yields won't drift too close ... to zero, is that there will continue to be an increase in Treasury issuance going forward.... It will keep a floor under funding rates going forward. So I think we will see overnight rates perhaps remain fairly steady, provide a bit of a floor for what Treasury bills yield and therefore a bit of a floor for where money market instruments are trading."
Kennedy adds, "As a portfolio manager of a Prime fund, I'm certainly looking to take advantage of whatever yield curve steepness there is. We might be a bit more selective from a credit perspective on banks and industrial issues further out curve, some that might be a little bit more impacted by some disappointments on the economic side or with concerns that there might be some sort of a delay in an eventual answer to Covid.... But until we see a flatter curve, we’ll take advantage of what is available on the yield curve by investing in some solid global money center banks – out in the six to twelve-month range."
He tells the webinar, "With Treasury and Government funds, it's a tougher story. Yields on Treasury bills from one-month to 12-months are anywhere from 9 to 11 basis points -- so not much to work with from a yield curve perspective. And the same can be said as far as Government agencies, which trade pretty much on top of Treasuries. So, they're a little bit more challenging, a little bit more dependent on money market technicals and where overnight rates are trading. Thankfully, we will have some steady increase in supply over the second half the year, which, might provide a very modest uplift in Treasury bill yields."
When asked about ultra-shorts during a Q&A, Kennedy says, "What we're doing in our portfolios now outside money funds is taking advantage of short duration investment grade credit one to five-year part of the curve, trying to take advantage of any issuance that does take place. Certainly, the opportunity in the front end of the curve is not what it had been. There has been strong demand for high quality investment grade credit in the front end by those types of investors who are generally in short duration or in money funds, and certainly are conscious of the fact that credit quality still remains quite solid in general in the U.S."
He explains, "So, spreads have come in quite a bit here.... You're looking at an all-in yield of under 50 basis points for a solid liquid credit. But that is where you begin to think about relative value and perhaps look at money markets from time to time. But in general, that's the expensive side of what's out there. If you're looking at financial sector … I think you have to do your homework. That's where we rely quite a bit on our credit team. But, yeah, we are certainly looking for opportunities in that one to five-year space, whether it be fixed or floating. And, certainly there would be no home runs from where we are now."
Finally, Western wrote recently to clients, saying, "We are pleased to inform you that on Friday, July 31st, Franklin Templeton successfully completed its acquisition of Legg Mason and officially welcomed Western Asset to the Franklin Templeton family. It is important to reinforce that while our parent company has changed, your relationship team, your investment team, the Western Asset leadership team and our investment philosophy and process remain unchanged. Western Asset’s organizational and investment autonomy will be preserved by Franklin Templeton. We are also thrilled to be gaining access to a new and expansive distribution platform and greater product development resources to benefit our clients."
