The Time Could Be Right to Extend Maturities

With money market rates close to zero and the Federal Reserve Board signaling at least another two years of low short-term interest rates, institutional investors are eyeing their short-term investment goals and asking: What is the best combination of risk and return?

In an environment where money market funds yield about one or two basis points rather than one to two percentage points, it's natural to seek better returns for core cash portfolios. While one size doesn't fit all, many investors find they can obtain better returns without sacrificing liquidity or protection of principal by moving a bit further out along the yield curve from traditional money market funds.

Obviously, institutional investors have to follow established investment guidelines, especially for a strategy that must provide liquidity and a high level of safety. But a carefully managed approach, in which an enhanced cash strategy is stretched or extended into the ultra-short fixed-income space, could gain a substantially better return with only modestly higher risks.

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Pumping Up Yield

"What we call 'standard enhanced cash' – an actively managed strategy with a slightly higher risk/return profile than money markets – is not likely to add as much value as an ultra-short strategy," said Carol Sullivan, head of Northern Trust's enhanced cash group and co-portfolio manager for the Ultra-Short Fixed Income Fund. Because of today's low short-term yields, cash – even enhanced cash – just doesn't have a long enough duration to offer sufficient return.

"Enhanced cash usually refers to a roughly six-month weighted average maturity with a range of overnight to two-year securities," Sullivan explained. "With an ultra-short strategy, we're looking at durations of one year or longer and maturities as far out as three years. This approach also invests across the entire credit spectrum of the investment-grade universe."

Liquidity needn't be sacrificed in an ultra-short fixed-income strategy. For example, a barbell approach emphasizes securities with maturities of 90 days or less, as well as maturities in the two- to three-year range, where additional yield can be captured. "With the Ultra-Short Fund, we've purchased corporate floating-rate notes that reset every three months, as well as callable agency bonds," said Scott Warner, co-portfolio manager of the Ultra-Short Fixed Income Fund. "This offers us some yield pickup with the flatness of the Treasury curve in the front-end, as well as some back-end protection with the floating-rate securities in a volatile interest rate environment."

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Managing Moderate Risks

However, increased durations can bring additional risk factors – as well as strategies for mitigating those factors – that investors should consider.

Interest-rate risk – Venturing further out from a six-month weighted average maturity to a year or more does expose investors to the possibility of rising rates. A diversified portfolio that includes securities that respond favorably to rising rates – such as corporate floating-rate notes and securities with 90-day or shorter maturities – could help protect against interest-rate risk.

Liquidity risk – Using a barbell approach and assessing individual liquidity needs can be instrumental in managing liquidity risk. Once an investor's immediate liquidity needs are addressed, an investor can pick up incremental yield where possible. For example, during the very volatile market of 2009, yield spreads widened substantially, presenting a great opportunity to outperform as riskier assets rallied. Having enough liquidity to respond quickly was the key to outperforming the short-term benchmark.

Credit risk – Careful adherence to prudent risk management based on thorough credit research can help mitigate credit risk. Maintaining a diversified portfolio also helps protect against credit risk, and gives investors the opportunity to include allocations to fixed-income sectors where the yield spread is attractive. It also can offer the option to cross over between taxable securities and tax-free municipal bonds based on what makes sense on a "best net after-tax" basis. With the environment of the past couple of years, being able to manage a "swing" strategy across taxable and tax-exempt securities has been an important source of alpha for investors.

"What has always drawn investors to this strategy has been the desire to outperform a money market fund strategy for core cash positions," Sullivan said. "The idea that we can potentially improve upon a money market strategy net of fees by taking modest interest-rate, credit and liquidity risk – and carefully managing those risks – has always been the operating concept behind the strategy."

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A Flexible Approach

Although the focus in the current environment is on earning additional yield on core cash holdings, an ultra-short fixed-income strategy also can appeal to those seeking to move down the yield curve in a rising rate environment. Investors moving to shorter durations instead of cash to guard against interest-rate risk could still earn relatively attractive yields compared with the core cash/money market segment.

"This strategy is ideal for a falling rate environment, but it's nimble enough to be a good way to respond to rising rates," Sullivan said. Also important is being able to customize the strategy to serve the specific needs of particular investors.

Another key ingredient is the willingness of investors to separate their "core" managers from their "plus" managers, says Frank Szymanek, senior product manager at Northern Trust. "Core" managers, he said, take careful, conservative approaches where "safe" and "secure" investments are as important as "superior" returns. "Plus" managers tend to invest in more volatile segments such as high yield, emerging markets or currencies.

By shifting their approach to their short-term cash portfolios, whether through extending the average maturity or exploring new investment vehicles, investors can potentially achieve higher yields in the current low-rate environment.

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