State Street Global Investors recently posted an "Insight" piece entitled, "Navigating Short-Term Fixed Income Amid Inflation, Tightening, and the Pandemic." Written by Senior Portfolio Manager James Palmieri, the piece discusses ultra-short and short-term investing strategies and explains, "Given where we are in the economic cycle, coupled with rich valuations and the inception of global monetary tightening, we are carrying modest risk. We are a little overweight in duration toward the front end of the curve where the roll down and carry is significant. Compared to a year ago, we've paired back a lot of credit risk. We are positioned with dry powder in case the Fed runs into trouble with its monetary tightening in 2022." (Note: SSGA's Palmieri will be speaking at our upcoming Bond Fund Symposium conference in Newport Beach, Calif., March 28-29. Click here for the agenda and click here to register.)
SSGA's posting tells us, "Amid continued US economic growth, tighter Fed policy, and rich valuations, we have been forced to pare back risk targets substantially, not only on corporate credit but also commercial mortgage-backed securities (CMBS). This is enabling us to look for opportunities to invest in credit in 2022 given the tightening cycle."
Asked about the best value in the front end, Palmieri says, "Two areas are intriguing. One is risk-free rates, such as the 2-year Treasury Note, given the enormous carry and roll-down, which is on the order of 100+ basis points. This is certainly favorable to the longer part of the yield curve and to short-duration corporate credit spreads, which are cyclically quite tight. The second opportunity is in the AAA CMBS floater market, in very stable properties such as industrial warehouses involved in e-commerce and cold storage facilities for supermarkets. These offer significant yield pickup compared to AA or A corporate credit floaters. In fact, AAA CMBS floaters offer as much yield as BBB corporate credit with far less fundamental credit risk."
He states, "I believe investors should be more concerned about risk than return in 2022. We are in more of a principal protection environment as the Fed embarks on a tightening cycle in the context of tight credit spread valuations. Our funds' risk exposure is about as mild as it has been in a long time."
The SSGA PM also says, "We believe that inefficiencies exist on multiple time horizons due to the complexity of supply and demand in the fixed income markets. We initially construct our investment portfolios from a top-down perspective by establishing modest amounts of strategic risk -- consistent with the client's risk/reward appetite -- to take advantage of long-term inefficiencies in the fixed income market. Examples of such risk would be modest amounts of positive duration and incremental credit spread duration relative to a pre-defined performance benchmark."
He comments, "The second time horizon has to do with the shorter-term or cyclical movement of the markets. In this case we seek to take advantage of opportunities when market pricing deviates from our estimates of fundamental fair value. We hold a monthly asset allocation meeting where we conduct a full review of the economy and market pricing to detect deviations from long-term fair value. Ultimately the goal of the meeting is to set risk targets."
Palmieri adds, "Finally, for portfolio construction we use a collaborative approach with a bottom-up fundamental fair value perspective. For each segment of the fixed income market, the security selection process includes contributions from portfolio management, research, and trading. Whether it's corporate credit or fixed income securitized markets, the respective teams get together and examine the fair value of the opportunities and select securities that ultimately make up the portfolio."
Asked why short-term and ultra-short strategies are important today, he responds, "The front end of the curve is becoming an interesting place, considering the Fed's [inflation] framework, the pulling forward of ... potential rate hikes, and what appears to be a lower terminal Fed funds rate. We think that the front end is offering a lot of value compared to the back end."
In other news, the Federal Reserve released its latest "Monetary Policy Report" last week, which contained several mentions of money market funds. It states, "Funding markets remain relatively stable. Domestic banks continue to maintain significant levels of high quality liquid assets. Assets under management at prime and tax-exempt money market funds (MMFs), which experienced significant outflows during the March 2020 turmoil, continued to decline, on net, since mid-2021, while those at government MMFs remained near historical highs. In December 2021, the Securities and Exchange Commission (SEC) proposed reforms to MMFs intended to mitigate the financial stability risks they pose, including the adoption of swing pricing for certain fund types, increased liquidity requirements, and other measures meant to make them more resilient to redemptions."
The report continues, "In July of last year, the Federal Reserve established a domestic standing repurchase agreement (repo) facility and a standing repo facility for foreign and international monetary authorities. These facilities are intended to serve as backstops in money markets to support the effective implementation of monetary policy and smooth market functioning. The rates for these facilities have been maintained at levels somewhat higher than rates in overnight funding markets, consistent with their intended roles as backstops."
It adds, "Money markets continued to function smoothly amid these developments, with ample liquidity putting broad downward pressure on short-term interest rates. In addition, the limited supply of Treasury bills during the debt limit episode pushed bill yields lower. In this environment of ample liquidity, limited Treasury bill supply, and low repurchase agreement rates, the ON RRP facility continued to serve its intended purpose of helping to provide a floor under short-term interest rates and support effective implementation of monetary policy. Usage of the facility has nearly doubled, on average, since early July, primarily driven by greater participation from government money market funds. The ON RRP take-up reached a record high of $1.9 trillion on year-end before retracing to around $1.6 trillion in early January."
