The US Federal Reserve’s (Fed’s) recent adjustments to its monetary policy framework are impactful for short-term investor returns, affirming our expectation that short-end interest rates will likely remain at or near zero for at least the foreseeable future. This brings short investors back to the dilemma many knew all too well post-2008: With most deposits and money market funds earning next to nothing in yield, how should I invest my liquid and reserve assets?
For clients’ second-tier cash bucket (reserves or excess liquidity), here are three suggestions to modestly increase income without adding significant risk.
1. Increase duration flexibility for excess reserves
Money market funds are governed by strict rules that limit the investable universe. There has also been a surge of inflows into money markets (Figure 1), further suppressing potential income from assets meeting the money market criteria. Thus, we believe expanding one’s opportunity set beyond the traditional money market rules — while still remaining on the short end — may make sense in today’s environment. Investors can potentially pick up incremental yield by: a) incorporating longer-tenure bonds, allowing for a more flexible duration that can float higher when the yield curve is upward sloping; and b) adding non-money market eligible instruments, like some asset-backed securities (ABS) and non-USD assets (see points 2 and 3 below).
This combination may enable investors to maintain a low-risk approach, while easing the constraints of money markets to earn higher yields on their cash reserve balances.
2. Prudently add short credit and ABS exposure
A pure US Treasury portfolio is the highest-quality and most liquid expression of reserve investing, but offers investors very little yield. Adding some investment-grade corporate credit exposure may deliver diversification versus Treasuries, along with potential yield enhancement. We also believe an allocation to ABS may be appropriate for income diversification to corporate credit. And, since many ABS deals amortize, they may generate a high level of cash through early return of principal — a potentially valuable benefit for clients with uncertainty around the timing of cash needs.
To be clear, we suggest that cash investors have short credit exposure alongside Treasuries. Pure credit may not provide the liquidity needed in periods of stress, as we experienced in March 2020. It’s also wise to consider staggering short credit maturities to give clients optionality to either draw on cash as maturities come due or reinvest.
3. Consider non-USD assets hedged back to USD
For clients with capacity to allocate a portion of reserve assets to developed non-USD currencies, doing so and hedging returns back to US dollars — for example, a non-US government allocation hedged to USD — may allow for a potential pickup in yield without incurring undue credit risk. This strategy can also be a way to further diversify liquidity and income streams.
Although most global risk-free rates have recently converged at zero, “cross-currency” investing may still enable US-based investors to reap a premium for holding overseas debt denominated in local currencies. This yield advantage derives from the inefficiencies of cross-border investing, including through highly rated developed sovereigns (such as Canada and Japan). The benefit may be magnified at times when other developed economies exhibit steeper credit spreads than the US.