Wells Fargo Asset Management's latest monthly "`Portfolio Manager Commentary" features a section entitled, "The Year in Review," which highlights some of the major market events of 2020. They write, "It's hard to believe, but the beginning of 2020 was relatively benign. In January, the Federal Reserve (Fed) was expected to keep engaging in Temporary and Permanent Open Market Operations through April in order to minimize volatility and maintain a stable rate environment, with yields generally bumping along at the bottom of its target range of 1.50% to 1.75%. The prime markets experienced a collapse in credit spreads, which began trading below benchmark London Interbank Offered Rate (LIBOR) rates, as well as a flattening of the yield curve, pricing in the possibility of Fed rate cuts late in the year.... In February, we examined the state of the credit environment in the money markets, both as it pertained to relevant asset classes as well as regional differences. We noted that, in general, corporate and financial balance sheets were in good shape and economies were stable and prosperous. While in retrospect it does not seem adequate, we devoted a paragraph to the novel coronavirus and the 'great deal of uncertainty about both the spread of the disease, its management, and the ultimate economic impact.'"
Wells continues, "In March, much of that uncertainty became manifest: with more than $204 billion flowing out of risk assets such as equity and bond funds and $160 billion redeemed from prime money market funds, the money market industry experienced the largest inflows ever seen in records dating back 28 years, with over $625 billion of new money flowing into those funds as individuals and businesses alike built liquidity to deal with the nascent pandemic. In response, the Fed not only slashed rates to the zero lower bound, they also unleased a veritable alphabet soup of programs designed to help dampen volatility and support smooth market functioning."
The commentary explains, "Money market inflows continued to be the story in April, with prime funds regaining more than half the assets that had left the previous month. Asset inflows started to moderate slightly in May, as money market funds hit an industry record of $5.12 trillion under management. In June's quarterly recap, we noted that the resulting supply and demand imbalance had resulted in yields and credit spreads in both the government and prime markets grinding tighter."
Wells also says, "In late summer and early fall, investors gained clarity on the Fed's intentions going forward. At August's Jackson Hole summit, the Fed introduced the concept of Average Inflation Targets and made it official policy at its September meeting. The dot plots from the meeting also revealed committee members were anticipating rates would stay lower for longer, through the end of 2023. For the industry, outflows that began as a trickle in July were confirmed as a trend during the same period. Although in the absence of any stimulus or increased supply, yields ground ever tighter."
They add, "Finally, rolling into November, the combination of funds defensively elevating liquidity targets in the face of uncertain election results, declining asset levels, and ongoing supply constraints drove yields ever lower." (For more year-in-review stories, see our Crane Data News: "Rolling w/Reform Changes III: Recap of '20 Prime Exits, News & Moves" (1/7/21) and "Top 10 Stories of 2020: Assets Skyrocket; Yields Plunge; Regs Coming?" (12/17/20)).
Wells Fargo Asset Management also released a publication entitled, "Making sense of a market transformed," which contains a section called, "Managing cash balances in a sea of liquidity." They also write, "Since the onset of the COVID-19 pandemic, we have seen the cash balances of many of our institutional clients surge. Both companies and individuals have built significant rainy day funds to buffer against the risks of potentially damaging economic fallout. But how should investors go about managing this swelling 'sea of liquidity' to meet their unique return and risk requirements most efficiently? We'd like to share a real-life example of how we helped one of our large corporate clients go about answering this question."
It explains, "The client was sitting on the proceeds of a large bond issue, raised specifically to increase balance sheet liquidity as a type of insurance policy against uncertainties created by changing demand dynamics in the pandemic's wake. Potential answers may seem simple and straightforward at first blush, but a proper solution invariably requires an intimate understanding of client needs and the development of a sophisticated approach to help balance the competing challenges of maximizing investment returns while ensuring adequate safety and liquidity. Let's begin by considering the available levers for diversification of income."
The section continues, "There is typically a term premium that investors can pursue by holding longer-maturity instruments. Specifically, in the current market environment, the yield curve begins to steepen meaningfully after the two-year mark, allowing investors to pick up additional yield in bonds near these maturities. They also can benefit from 'rolling down the yield curve,' which refers to the natural decline in yields as maturity approaches, providing price appreciation that adds to total return."
It tells us, "Other sources of income include diversifying a cash portfolio into lower-rated credits or investing in a broader set of fixed-income sectors. For example, allocations to high-quality investment-grade corporate bonds, asset-backed securities, or agency mortgage-backed securities can add yield with relatively modest increases in risk. Investments in other high-quality sectors, like U.S. agency debentures, sovereigns, supranationals, or foreign agency bonds, may also be used to increase diversification of a portfolio and its sources of income."
Wells comments, "If the goal is to capture diversified sources of income to drive reliable long-term risk adjusted returns over time, it may often make sense to do both of the above. That is, to extend duration and invest in additional credit-quality categories and sectors. The key objective is to determine the most client-appropriate mix of duration and diversification to increase income, which is the primary driver of total return over time."
The piece states, "We also emphasized that, while income is important, prudent bottom-up security selection would be paramount to achieving the goal of capital preservation and liquidity, particularly in the current market environment. To mitigate credit risk in any portfolio we manage, we leverage the expertise of our Global Credit Research team to help ensure we select stable-to-improving credits and avoid those we expect to deteriorate."
Lastly, it adds, "Generalizing from the above, there are a number of ways to incorporate a high-quality one- to three-year duration strategy as part of an overall cash solution. It can be designed to pull both levers for diversifying income. That is, it can simultaneously extend to a steeper part of the yield curve and invest in high-quality yield-advantaged sectors, as client circumstances allow. The inherent flexibility of our approach may help bring appropriate, and potentially optimal, cash management solutions to many investors."
