Cash Management: How Short Credit Passed Its “Stress Test”
VOICEOVER: Welcome back to The Investment Conversation. I’m Tony Fisher.
VO: Everybody loves a good sequel, so for this market update, let’s revisit a popular topic from two years ago that’s still quite relevant today. I’ll let my colleague Will Andrews take it from here.
Will Andrews: Welcome to the podcast. I’m Will Andrews. I'm joined today by Joe Graham, managing director and investment strategist for Lord Abbett. A little over two years ago, Joe wrote a paper on the potential role that short credit can play in cash management strategies. We got a lot of positive response on the paper and on a related podcast. Of course, a lot has happened since then and listeners might be wondering how such a strategy might have stood up in the market volatility of 2020--and how it might be positioned for today's market. So let's get started.
Maybe the first thing to talk about in in terms of considering short credit as a possible tool in cash management strategies is the concept of tiering, which you outlined last time around. So Joe, talk us through this concept and why it’s important for investors to understand.
Joseph Graham: Sure, thanks Will. You know the first kind of point there's is that cash allocation shouldn't be necessarily binary. It shouldn't be what's allocated to cash and then everything else that’s invested in, say, equities or something else that has a loss of a principal potential.
We consider cash allocations a spectrum, and I think you need to see it that way, especially with how much cash is on the sidelines today--you need to put it to work. Now of course, there's an upper limit to what you can do with your cash and still call it cash
And we kind of define that limit as a safety of principal. You know, once you get into where your principal is at modest or serious risk, then that stops being cash management. So what we've recommended to clients is segmenting cash into three buckets, essentially. The first bucket is what we call operating cash, and that's zero to three months. And that's cash you really can’t have much volatility with, you know, you can't stomach any kind of price swings. That stuff that you know, should be at your bank or in a money market strategy… unfortunately there's very little yield in that today, but that's kind of just the cost of doing business today, for that zero to three-month bucket.
Now the second bucket is what we call core cash--that's three to 12 months in terms of when you need that cash. And there, you know, some volatility can be allowed, but not a lot. If it's three to 12 months you don't have a lot of time to see it through, so typically assets in that pool are one- to two-year assets, things that mature in one to two years, and there's a name for it--it's the ultra short space that has kind of come into to fill that bucket.
And then, finally, the third bucket is what we call strategic cash--that is, 12 months or longer. You can stomach a little more NAV volatility. We still think principal loss potential should be very limited in a strategy like that, but we're willing to live with more NAV volatility, and there you can get some real returns like on the order of about a percent and a half today, and that's kind of the short duration space where you're dealing more with maturities and then the one-to-four year window, typically.
One last comment I’ll make on this, you mentioned credit--so that's another layer to this is whether you can use credit for cash management, because these principles of laying out where you invest relative to your liabilities--that's very simple, that's like LDI or liability duration matching. But then bringing credit into the picture--we think you can do that in cash management, because in very short term, very high-quality credit, the preponderance of credit spread that you're getting paid to take that risk is really more about liquidity risk than it is about principal risk or a risk of loss. As you're dealing with short-term high quality credit, but the losses on those [securities]--whether it be corporates or securitized [products], or a bunch of different asset classes--are really pretty limited, especially if you're doing you know, good quality credit [research] work on these things. So those are the buckets and that's what we mean by cash tiering.
Andrews: That approach has worked rather well, I would say, at least in the last few decades, but then we come to a rather difficult and remarkable year—2020--and I think a lot of markets around the globe were stress tested by the events of last March and April. So how would such an approach have held up during that time, Joe--how would it have worked?
Graham: Yes, that that was definitely a stress test, as you say, that was a pretty severe liquidity crisis and it was a justified liquidity crisis. It wasn’t just one based off of irrational fear… I mean market participants were trying to cover their operating expenses for months to come, because things were shutting down. And so what you see in situations like that--what you often see is an inversion of credit curves where things that are very short maturity yield a lot more than things that are longer maturity. And that's because market participants are out there just trying to raise money at the highest dollar price that they can--and so that's definitely what occurred.
But then what else occurred was the Fed [U.S. Federal Reserve] and fiscal policy were massive in their response to this. You know, the Fed came in with a whole “alphabet soup” of programs to buy corporate bonds which they’d never done before, and actually offered to buy corporate bonds and the primary market as well. No one ever really took them up on that. But then also fiscal policy became very expansionary … deficit spending to the tune of $6 trillion, when you kind of add it all up. So that very clear and immediate action helped the credit markets see very clearly that there wasn't going to be a default crisis anytime soon. And then, as those markets recovered, it kind of became clear that we probably would have a pretty tepid default cycle altogether.
And so, this kind of cash tiering strategy really did hold up very well almost exactly in line with kind of how we talked about it. Ultra short strategies, that second bucket that I mentioned--and obviously it varies by strategy-- but that took about three months for it to fully heal from top to bottom. And so, as we say, three to 12 months it's kind of an appropriate sort of holding period.
The short duration type strategies--those more two-year type of maturities and longer--that took about four months to recover, just broadly speaking, so again [that] fit right in line with kind of how we talked about it. And, by the way, both of those strategies, both at Lord Abbett and really around the market, ended up having really good years. So it was a great stress test, and one that I think people can look to for the future and say yeah, this is a good way to structure cash management programs.
Andrews: I’d like to let our listeners know that our guest Joe Graham has written a related whitepaper that really ties this all together—we’ll give you details where to find it at the end of the podcast. One of the things that really stood out to me, Joe, was the pace of recovery from the worst point of the 2020 crisis for those short term securities, where it was only four months, and you contrast that with some of the worst market action of the 2008-2009 financial crisis, where it took over eight months--two thirds of a year.
Graham: Yeah and I think that speaks to just how expansive this action was on the part of the Fed, and on the part of just governments in general. The U.S., especially, though…I mean our programs in the U.S. dwarfed on a percentage of GDP basis [other comparable] programs around the world, and so it helped a lot and help those markets recover. Yeah, so it really was different. If you look at the whole of 2008-2009, it was on the order of about $2 trillion in fiscal deficit spending, but more importantly, as you point out, it took years to roll all that stuff out. [In 2020] we compressed it into weeks for the major programs and then over the following months in some more programs, but it was much more compressed time frame.
Andrews: So take us up to today, Joe. The markets have recovered and spreads have compressed. How should investors be thinking about these approaches to cash management in light of the current market?
Graham: Yeah, today's market is one that comes with its own set of challenges, you know spreads are back to pre-pandemic tights in most cases. And that worries, a lot of people--they look at the market and they say, “yeah I understand cash tiering, I understand what you're trying to do, but today, everything is so tight that there's no there's nothing we can do.” And we take some issue with that. First of all, the precedent that we just talked about, Will, with Fed action and fiscal action, that's an unforgettable thing--you know it worked really well in order to calm markets down and reignite the “animal spirits,” as it were. So [if] you have another crisis, you have another liquidity crisis, you have another seizure of markets you're very likely to see [the Fed and government policymakers] go back to that playbook. In many cases, what they did in 2020 was dust off the 2008 playbook, but do it in bigger scale and faster. So it's pretty likely we see that kind of action again. So that's one way, I think you can sort of justify these tight credit spreads is that it's a “Fed put” and a “fiscal put” in essence that's there.
The other thing that's happened is there's been a lot of refinancing activity and a lot of that money hasn't just been spent--it's been hoarded, in essence, on corporate balance sheets. So [cash on] corporate balance sheets is 30% larger than it was a year ago, so that that's two reasons why we think today's tight spread levels are pretty justified.
The other thing is these markets haven't recovered evenly; there are still opportunities. For example, we still find some steepness in the credit curve, as you go down in quality, a bit to the triple B [rated] area you do still see some pickup [in yield] to relative to pre-pandemic levels. So that's an area of opportunity, the other is in securitized markets--you know, some of those markets, like CMBS, like CLOs, for example, haven't recovered fully to pre-pandemic levels. They actually offered decent amounts of liquidity over the last year, so we see those as some areas of opportunity today.
Andrews: Joe, time to wrap things up. This has been a great discussion, and I’ve learned a lot. Do you have any final thoughts for our listeners?
Graham: Well, I haven't mentioned Lord Abbett’s capabilities. We've been we've been running short duration credit in its current form for about 13 years and we have a tremendous track record of consistency, so we've seen markets like this before. We managed through 2008, we managed through 2020. And it's something that right now I think it's especially topical for investors, not only from a strategic cash management perspective that we've been talking about today, but also when you look at the rest of the fixed income marketplace like core fixed income, for example. You know spreads are narrow but also rates are really low so a lot of investors have migrated some of the core allocations over into short duration. So we're seeing a lot of opportunity there as well. We think short duration has a nice setup in today's market, but especially for these strategic cash management purposes.
Andrews: Great, thanks so much for being with us, Joe. I just want to remind everyone that Joe Graham has written a whitepaper entitled “Credit and Strategic Cash Management: A Review of Performance and Applicability in the Pandemic Era,” and you can find that on the lordabbett.com website or obtain a PDF copy by contacting your Lord Abbett representative.
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CLOs refers to collateralized loan obligations.
CMBS refers to commercial mortgage-backed securities.
A credit spread is the difference in yield between two bonds of similar maturity but different credit quality.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.
Fed refers to the U.S. Federal Reserve.
GDP refers to gross domestic product.
Liability-driven investing is primarily slated toward gaining enough assets to cover all present and future liabilities, an important consideration for institutions such as endowment funds and pension plans.Net asset value (NAV) represents a fund's per share market value.
Securitized products are pools of financial assets that are brought together to create a new security, which is then divided and sold to investors.
The yield curve is a graphical representation of the interest rates on debt for a range of maturities. It shows the yield an investor is expecting to earn for lending money for a given period of time. An inverted yield curve represents a situation in which long-term debt instruments have lower yields than short-term debt instruments of the same credit quality. An inverted yield curve is sometimes referred to as a negative yield curve.
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The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.
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