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Market View

An ultra-short bond strategy has the potential to provide higher income than money-market funds, while offering lower volatility than either short- or intermediate-term bonds.

The U.S. money-market fund sector is undergoing a sea change. Reforms that fundamentally change the way money-market funds operate were issued by the U.S. Securities and Exchange Commission (SEC) in July 2014, and took effect October 14, 2016. The major structural changes adopted by the SEC affect prime and tax-exempt money-market funds. (Prime money-market funds invest in non-U.S. government debt, while tax-exempt money-market funds generally invest in short-term municipal bonds.) Variable net asset value (NAV) pricing now will apply to institutional prime and tax-exempt funds. These funds will no longer operate with a NAV pricing of $1.00 per share.

In addition, liquidity fees and redemption gates will apply to all nongovernment funds. These measures do not, however, affect U.S. Treasury and government money-market funds. (In July 2016, Zane Brown, Lord Abbett Partner and Fixed-Income Strategist, provided a detailed analysis of changes in the U.S. money-market funds.)

Despite their low yields, investors traditionally turned to money-market funds for two reasons. First, their NAV was fixed at $1. Second, money funds have provided daily liquidity, so that investors could get their money whenever they wanted. However, with the new reforms, the $1 NAV and the daily liquidity are available only from government-only money-market funds. Prime money-market funds, which invest in corporate-related securities such as commercial paper and short-term corporate debt, now may be forced to either have a floating NAV or may have to impose redemption gates or fees in some circumstances. 

So, for many investors, there really is no reason to hold a prime money-market fund anymore. People who have relied on prime money-market funds for their stability and liquidity are faced with some important decisions.

What Has the Impact Been?
Already, investors have shifted more than $1 trillion from prime money-market funds to government-only money-market funds (see Chart 1), owing to fund manager conversions and investor outflows. Assets of government-only funds, which never exceeded 40% of all money-market assets before December 2015, now account for 77% of the total, according to Investment Company Institute data cited in a recent Bloomberg article. Meanwhile, since demand for short-term, nongovernment debt instruments has declined by $1 trillion, yields on securities tied to the London interbank offered rate (LIBOR) and other short-term instruments have moved higher.

 

Chart 1. U.S. Money-Market Assets Have Shifted to Government-Only Funds
Total assets in indicated categories, October 14, 2015–October 12, 2016

Source: Bloomberg and ICI Money Market Fund data. Past performance is not a reliable indicator or a guarantee of future results.

 

What Can Investors Do?
Investors now face a choice: If they want the benefits of a true money-market fund (specifically, the daily liquidity), they are left with funds that invest only in government securities, which yield close to zero (the Lipper average government money-market fund yield was 0.03%, as of September 30, 2016). Those prime money-market funds, which offer a little additional yield, no longer have the desired characteristics of a $1 NAV and daily liquidity.

Ultimately, money-market fund investors may tire of earning zero, and may wish to extend out to longer maturities in order to pick up additional yield. Indeed, that desire already has become evident, with solid demand for short- and intermediate-term bond funds in recent years. But in this new environment, another option—funds that invest in ultra-short duration bonds—may be an attractive option. “Ultra-short” bond funds are defined by Morningstar as funds investing in fixed-income securities with duration of less than one year, while “short-term” funds fall in the duration range of one to three and a half years. 

What are the potential benefits of ultra-short bonds? They historically have provided higher yield and total return potential than cash or money-market funds, but with lower volatility than either short- or intermediate-term bonds (see Chart 2).

 

Chart 2. Ultra-Short Bonds Have Displayed Lower Volatility Than Other Fixed-Income Investments
Trailing five-year standard deviation of indicated asset classes, as of September 30, 2016

Source: Morningstar.  Data as of September 30, 2016.
Data represents standard deviation statistics for the Bloomberg Barclays U.S. Aggregate Bond Index (Barclays Aggregate) and Morningstar Fund Category averages (intermediate-term refers to funds investing in fixed-income securities with duration of 3.5 to 6.0 years; short-term, funds investing in fixed-income securities with duration of 1.0 to 3.5 years; ultra-short, funds investing in fixed-income securities with duration of less than one year).
Past performance is not a reliable indicator or a guarantee of future results.  The historical data shown in the chart are for illustrative purposes only and do 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. Due to market volatility, the market may not perform in a similar manner in the future.

 

Given their low interest-rate sensitivity, ultra-short bond portfolios historically have fared well during periods of rising Treasury yields and intervals in which the U.S. Federal Reserve (Fed) was hiking short-term interest rates (see Table 1).

 

Table 1. Ultra-Short Bonds Have Outperformed During Past Periods of Rising U.S. Treasury Yields…
Total return by index or Morningstar fund category during indicated periods of increases of 100 basis points or more in the yield on 10-year U.S. Treasury notes

… and U.S. Federal Reserve Interest-Rate Hikes
Total return by index or Morningstar fund category during indicated periods of U.S. Federal Reserve rate hikes

Source: Federal Reserve Bank of New York, Bloomberg Barclays, Citigroup, and Morningstar. 10-Year Treasury represented by Citigroup 10-Year Treasury Bond Index. Morningstar Ultrashort Bond Category represents funds investing in fixed-income securities with duration of less than one year.
Past performance is not a reliable indicator or a guarantee of future results.  The historical data shown in the chart are for illustrative purposes only and do 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. Due to market volatility, the market may not perform in a similar manner in the future.

 

One caveat, though, is that looking only at duration does not give a full picture of a portfolio’s risk. For example, a fund could, theoretically, hold a portfolio of 10-year, credit-sensitive bonds, and use interest-rate derivatives to bring the portfolio’s duration back to zero. However, during periods of credit-spread widening, the longer-term bonds can have significant price declines, even though the interest-rate risk was hedged away. For this reason, it is important to look at not only short-duration bonds but also short-maturity bonds in order to keep volatility to a desirably low level.

A Tiered Approach
With the changes in money-market funds, investors may want to consider a new approach to their excess cash reserves. As Brown noted in his July 2016 analysis, one approach to striking the right balance between liquidity and return in this new money-market world may be to think in terms of liquidity tiers. That portion of short-term assets in which immediate and reliable liquidity is vital, despite relatively low yield, can be allocated to a government money-market fund (a first-liquidity tier). The remaining short-term assets may find additional yield, yet adequate liquidity, through a second tier, an ultra-short duration portfolio (i.e., closer to a duration of 1.0), and a third tier, a short-duration portfolio (i.e., a duration of 2.0).

Allocation among the portfolio’s liquidity tiers can be adjusted during periods of political, market, or economic uncertainty. The combination of a government money-market fund with a short-duration or ultra-short duration portfolio not only allows important investment flexibility but also it may yield substantially more than the prime money-market fund it replaces.

A Final Note
In a previous Market View, we noted the recent moves in LIBOR and how they may affect the floating-rate loan market. We also noted that bank loans offer a number of potential advantages, including high income, portfolio diversification, and rising yields during periods of interest-rate increases, since their coupons adjust higher with LIBOR. While this asset class offers tremendous opportunity, a floating-rate fund is a below-investment-grade asset class, which comes with some element of credit risk. 

However, there are other securities, such as investment-grade corporate bonds with floating interest rates, that feature high credit quality and coupons that adjust with LIBOR. Due to the market dynamics discussed earlier, these are investment-grade instruments (such as corporate floating-rate notes and commercial paper) that also have seen their yields tick higher. For active managers with advanced research capabilities, those conditions can present compelling opportunities within an ultra-short bond portfolio.  

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

THE ULTRA-SHORT STORY
The Lord Abbett Ultra Short Bond Fund seeks to deliver current income consistent with the preservation of capital by investing in a broad range of investment grade ultra-short fixed income and money market securities with a weighted average duration of less than one year. Learn more.

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