Pimco: Where to stash your cash

Due to new money market regulations and other structural changes in the cash markets, institutional and retail investors are focusing more intently on their short-term liquidity needs and investment options. Jerome Schneider, deputy head of PIMCO’s money market and funding desk, and Paul Reisz, money market and enhanced cash product manager, provide an overview of the recent developments in these markets – including changes in 2a-7 money market regulations – and the impact on yields and cash investment strategies.

Q: First, let’s get your outlook for the primary drivers of the cash markets: the economy and how the Federal Reserve will navigate.
Schneider: Policy responses to the financial crisis and economic downturn helped to stabilize the global economy in 2009 and recovery is underway.

The recovery is likely to be bifurcated between emerging economies – where we believe growth will be relatively robust, though slower than when the crisis began – and developed economies, where we expect growth to be more tepid and public balance sheets to be more levered. Growth is likely to be choppy as well. In this environment, for the developed economies we don’t expect increases in wages or consumption will be strong enough to be significant drivers for growth. In the U.S. specifically, the Fed will likely remain on hold for a while, anticipating a long road to meaningful declines in unemployment and a time when the seeds of credit creation are fully sown.

Look for increased government regulation in many aspects of finance in the near term. This is already evident in the new amendments to the SEC 2a-7 money market regulations.

Q: How will the changes to 2a-7 money market regulations affect cash and short duration strategies?
Reisz: The Rule 2a-7 reforms, which must be implemented by the end of May, should increase liquidity, but that will likely result in lower yields. In addition to increasing liquidity, the amendments are supposed to increase credit quality, shorten maturity limits and trim back risk in money market strategies, with the overall objective of preventing potential future losses and runs on the money markets such as those experienced after the collapse of the $62 billion Reserve Primary Fund in September 2008.

There are four key changes in the regulations: 1) improved liquidity – money market strategies will be required to have a minimum of 10% overnight and 30% seven-day liquidity to ensure cash or securities are readily available, 2) shorter maturity limits – the weighted average portfolio maturity limit will be reduced from 90 days to 60 days, 3) higher credit quality – money market strategies will have stricter limits on investments in securities with lower credit quality, and 4) a new maximum weighted average life (WAL) measure will likely result in fewer purchases of floating rate notes. This new WAL measure uses the longer final maturity of the security in the calculation rather than the shorter interest rate reset date.

The upshot is that yields on money market investments – already hovering just above zero – may remain constrained even when the Fed does eventually raise rates, and this is a key reason why many cash investors are looking for higher-yielding alternatives. At the same time, we think most investors will remain very conservative and want to ensure ample liquidity after their experience in the cash markets over the past two years. Of course reducing risk and remaining conservative makes a lot of sense, but investors are definitely evaluating their risk tolerances as they consider opportunities to shift a portion of their liquidity allocation away from money market strategies to short duration strategies to pick up those higher potential yields when they do not need immediate liquidity.

Q: So do you believe this will alter the way investors should think about liquidity going forward?
Schneider: Absolutely. As Paul suggested, the new 2a-7 regulations will create a structural impediment that will inherently limit the yields traditional money market funds can offer by confining them to very short or overnight maturities to meet the stringent liquidity requirements. Structurally, the yield curve should price the assets available to these funds at a great premium, which in turn investors will pay for via lower yields. There’s little doubt that the 60-day weighted average maturity (WAM) requirements and 397-day maximum maturity threshold for regulated money market funds will stand, so investors must decide whether they want to reach beyond this structural hurdle to invest outside of the 2a-7 space and whether doing so will produce a better risk vs. liquidity proposition. We think it will.

Meanwhile, we see greater demand for term cash coming from both financial and non-financial institutions. After the events of 2008, CFOs are tending to be more concerned with longer-term funding plans and are becoming less reliant on short-term funding to meet recurring obligations. This demand for term funding is coming at a time when the system, structurally speaking, is not ready to provide it.

Again, all of this means investors need to start thinking about liquidity not as a factor of contingency planning, but as a primary input into their portfolio construction. Understanding your true need for liquidity is paramount.

Q: How is PIMCO managing cash today?
Schneider: Because of the policy uncertainty and rich valuation for many fixed income assets, we are still cautious about overall risk exposure in our clients’ portfolios. We carefully evaluate liquidity to help ensure we are not overpaying for it. And because our investors do not want surprises, we are focusing on preserving capital without stretching for returns. We want to maintain a focus on liquidity to avoid penalizing our investors down the road when they might choose to deploy funds in longer duration strategies.

We are also finding tactical investment opportunities for our short-term and low duration strategies, as many money market strategies sell securities in order to comply with the new regulations. For example, we have been focusing on opportunities to purchase term commercial paper in the six- to nine-month maturity range at attractive prices. We have also found opportunities to purchase corporate floating rate notes that will no longer be eligible in money market strategies under the new 2a-7 regulations. So even though we have to manage portfolios conservatively, we are seeing new opportunities brought about by the new money market regulations.

Q: How might rising interest rates affect cash strategies?
Schneider: While we do not expect the Fed to raise interest rates until more robust job growth and final demand begin to emerge – perhaps not until 2011 – eventually interest rates will move higher. At the same time, we also believe that longer-term U.S. interest rates should remain somewhat range-bound. We think the Fed will begin to unwind the so-called quantitative easing through reverse repurchase agreements and by employing term deposit facilities to drain excess reserves. This should be a precursor to any changes in target rate. Once the Federal Open Market Committee (FOMC) decides a rate change is required, we believe the magnitude of the rate increases will be gradual in nature and not dramatic. This should cushion the impact of rising rates on short duration portfolios. As a result, from a duration perspective we are positioned at the lower end of our historical norms, as we know the only direction for interest rates is up.

Reisz: In addition, we have been working on scenario analyses to see how short duration portfolios might perform in rising rate environments. We find that shorter duration strategies are likely to be prudently positioned against rising rates. As you would expect, money market strategies are designed to preserve principal, but we have also found that other short duration strategies – when managed conservatively – can also seek to preserve principal as well.

Short-term and low duration strategies have higher yield potential than money market strategies, providing a yield cushion against rising rates. Our analyses indicate that if the Fed raises rates gradually, then the impact on short duration portfolios will likely be minimized.

Investors will likely come to recognize that the new regulatory changes will have a dampening effect on money market yields and that the demand for true liquidity has become too costly in terms of yield performance. Holding cash in money markets funds has become an incredibly painful proposition. This has influenced many investors to look for higher-yielding alternatives that offer high degrees of liquidity at more attractive yields, albeit with a higher risk spectrum. As a result, short-term and low duration strategies may fill this niche quite effectively, not only now with rates near zero, but even as rates begin to increase in the future.