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Market View

What are some attractive alternatives for those who may be reassessing their cash holdings following the recent inversion of the yield curve?

 

In Brief

  • We have previously noted that the recent inversion of the yield curve does not by itself signal an imminent U.S. recession.
  • Nonetheless, recent headlines about the inversion, and related economic uncertainty, may have led investors to reassess their portfolio cash holdings.
  • For those investors, we believe that a managed portfolio incorporating floating-rate notes, commercial paper, and asset-backed securities may present an attractive alternative to cash. 

 

In last week’s Market View, Lord Abbett investment strategist Tim Paulson talked about the potential implications for the U.S. economy from an inverted yield curve. To recap, on March 22, 2019, the yield on three-month U.S. Treasury bills exceeded that of the 10-year U.S. Treasury note, the first time the curve had inverted since the 2008–09 financial crisis. (It should be noted that the three-month/10-year spread subsequently moved back into positive territory—de-inverting, if you will.)

Given the fact that a yield curve inversion has preceded each of the last seven U.S. recessions, some investors have become concerned that the decade-long U.S. economic expansion is close to ending. We would argue that a number of other data signals used to assess the likelihood of a downturn do not signal an imminent recession. (Last week’s Market View, along with an upcoming Fixed-Income Insights, explore the topic in more detail.)

Recession Risk Is Low. Still Want to Allocate to Cash?
Nonetheless, for those considering changing the composition of their portfolio’s cash position given a whiff of economic uncertainty, a multi-sector portfolio comprised of ultra-short, high quality bonds may offer a compelling alternative. In fact, a diversified allocation to investment-grade floating rate notes (FRNs; not to be confused with below investment grade bank loans commonly found in floating rate funds), high quality asset-backed securities (ABS), and commercial paper can combine to form an overall high quality, low duration, low volatility portfolio that offers incremental yield above cash and money market funds.

Three the Ultra-Short Way

Asset-backed securities (ABS) are collateralized by a pool of assets such as loans, leases, credit card debt, royalties or receivables. An ABS is similar to a mortgage-backed security, except that the underlying securities are not mortgage-based.

Commercial paper refers to short-term promissory notes either unsecured or backed by assets such as loans or mortgages issued by a corporation. The maturity of commercial paper is typically less than 270 days; the most common maturity range is 30 to 50 days or less.

Floating-rate notes (FRNs) are investment-grade corporate bonds that have floating-rate coupons, typically based on a spread over a short-term benchmark interest rate, such as the three-month London interbank offered rate (Libor).

These asset classes have each outperformed comparably dated U.S. Treasury bills over time, and offer other potential advantages, as Chart 1 shows.

 

Chart 1. These Asset Classes Historically Have Offered Higher Yields than Treasury Bills
Data for the period March 31, 2013–February 28, 2019

Source: Bloomberg Barclays Indices and ICE Data Indices, LLC. Data from 03/31/2013- 02/28/2019.
1Bloomberg Barclays U.S. Floating Rate Note Index (maturities less than 18 months).
2Bloomberg Barclays 3-Month U.S. Treasury Bill Index.
3ICE BofAML ABS Fixed Rate 0-3 Year Index.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Here are some other characteristics of the above-mentioned asset classes that might lend further appeal to a strategy employing all three:

Floating-rate notes: Research from Standard & Poor’s1 shows that from 1981–2017, one-year default rates for ‘AA’, ‘A’, and ‘BBB’ investment grade corporate bonds were 0.03%, 0.07%, and 0.21%, respectively. Additionally, the representative FRN Index (the less than 18-month component of the Bloomberg Barclays U.S. Floating Rate Note Index) had a maturity of roughly 1.2 years, a duration of 0.14, and a five-year standard deviation of 0.31% as of April 5, 2019.

Commercial paper: According to a Moody’s study,2 from 1972–2013 (through June 30), non-financial commercial paper rated ‘P-1’, ‘P-2’, and ‘P-3’had a 0.00%, 0.01%, and 0.05% default rate over a 90-day horizon, respectively.

Asset-backed securities: Another Standard & Poor’s study3 shows that from 1983–2017, one-year default rates for ‘AAA-’, ‘AA-’, and ‘A-’rated ABS were 0.00%, 0.01%, and 0.09%, respectively.

Summing Up: An Attractive Alternative to Cash
Overall, a portfolio that consists of FRNs with coupons that float with Libor, weekly maturing commercial paper, and primarily ‘AAA’ rated ABS could potentially mitigate interest rate risk, liquidity risk, and credit risk while producing a greater yield than cash. Investors who believe it may be prudent to allocate to a portfolio of highly liquid, historically stable securities may wish to take a closer look.

 

1Diane Vazza and Nik Kraemer, “2017 Annual Global Corporate Default Study and Rating Transitions,” S&P Global Ratings, April 5, 2018.

2”Default and Recovery Rates of Corporate Commercial Paper Issuers, 1972-H12013” Moody’s, October 9, 2013.

3Andrew South and Zev Gurwitz, “2017 Annual Global Structured Finance Default Study and Rating Transitions,” S&P Global Ratings, May 25, 2018.

 

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. Credit risk is the risk that debt issuers will become unable to make timely interest payments, and at worst will fail to repay the principal amount. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a guarantee or a reliable indicator of future results.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

A bond yield is the amount of return an investor will realize on a bond. Though several types of bond yields can be calculated, nominal yield is the most common. This is calculated by dividing the amount of interest paid by the face value. Yield to maturity is the rate of return anticipated on a bond if held until it matures. Yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

Duration is the change in the value of a fixed-income security that will result from a 1% change in market interest rates. Generally, the larger a portfolio’s duration, the greater the interest-rate risk or reward for underlying bond prices.

The London interbank offered rate (Libor) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It serves as the first step to calculating interest rates on various loans throughout the world.

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. One such comparison involves the two-year and 10-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

The Bloomberg Barclays U.S. Floating Rate Note Index measures the performance of U.S. dollar-denominated, investment-grade floating-rate notes.

The Bloomberg Barclays 3-Month U.S. Treasury Bill Index is designed to measure the performance of public obligations of the U.S. Treasury that have a remaining maturity of three months.

The ICE BofAML ABS Fixed Rate 0-3 Year Index is a rate- and maturity-specific subset of the ICE BofAML US Fixed & Floating Rate Asset Backed Securities Index.

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofAML INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

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. Moody’s rates short-term obligations such as commercial paper on the following scale (the “Prime” scale): P-1, issuers (or supporting institutions) having a superior ability to repay short-term debt obligations; P-2, issuers (or supporting institutions) having a strong ability to repay short-term debt obligations; P-3, issuers (or supporting institutions) having an acceptable ability to repay short-term obligations; and NP,  Issuers (or supporting institutions) rated which do not fall within any of the rating categories.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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