With negative interest rates deeply entrenched in the eurozone, there has been much discussion about how to achieve a zero yield. We talk with three members of the Invesco Global Liquidity team about not only getting to zero, but how to potentially go beyond zero in the short-term European fixed income market.
Natalie Cross: Money market fund assets experienced a sharp drop after the crisis, although, in the US, this dynamic was mainly a flow out of prime funds and into government funds, so not a drop in US money market funds overall. In Europe, banks found it very costly to maintain client deposits at zero or slightly negative interest rates. As depositors looked elsewhere to invest cash, many money market funds were the beneficiaries. As such, money market flows have recovered strongly since the March/April decline, especially in Europe.1
Paul Mueller: The European money market is composed of “standard” and “short-term” money market funds. Standard funds can take on more risk, which makes them potentially attractive in Europe, given the prevailing negative interest rate environment. Standard money market funds are not regulated, while short-term money market funds are. Ratings agencies also place further limits on short-term funds beyond government regulations for their high-quality ratings.
Average standard money market funds tend to use the ability afforded to them under current regulations to take greater spread and duration risk than short-term funds. Standard money market funds also typically buy lower-rated issuers than short-term money market funds and may invest in longer-term securities.
But here, we point out how we think about the difference in risk between the two types of funds: We base our investment decisions on the potential for the “return of principal,” not the “return on principal.” We think this concept is paramount when thinking about the risk differentials between the different types of money market funds and cash management alternatives. In other words, while standard money market funds also have the aim of capital preservation and liquidity, they might generate more volatility if market conditions worsen, compared to a short-term money market fund.
Europe’s other cash management alternatives comprise “ultrashort” or “cash-plus” funds that are less regulated than money market funds and often take on more risk than money market funds. Given these additional risks and our focus on “return of principal,” we believe it is important to do one’s homework when it comes to these funds’ investment strategies and not to mistake them for money market funds.
Paul Mueller: Money market yield curves are very flat in Europe, making it difficult for money market funds to generate yield. Recently, there has been an uptick in market expectations for US policy rates, given the recent outcome of the US election (a Democrat-controlled government), improving macro data, and the ramping up of the COVID-19 vaccine rollout. So, it is not surprising that futures markets are starting to price in Fed rate hikes in the second half of 2023. Things are very different in Europe, where no one expects rate increases for a long time, inflation is stubborn, the vaccine is rolling out slowly, and the macro outlook is subdued. Globally, we expect to stay in this low yield environment for at least 18-24 months, with perhaps hope on the horizon that we will get higher yields in the US in the middle of 2023.
Paul Mueller: This is a simplification, but to achieve a positive yield at the moment in the European money market fund universe, we would need to consider a five-year maturity and the lower-rated end of investment-grade securities. Alternatively, we could tap the high yield market and avoid having to take on as much duration.
Luke Greenwood: Yes, achieving a yield above zero in euros is still possible. However, choosing longer maturities and taking considerably higher duration risk might not be appealing to some investors – so we step back and look at the broader market. We believe opportunities exist outside of the money market fund universe – particularly if you can go down the capital structure. By doing this, we find we are able to potentially pick up attractive yield versus Euribor in the European investment grade market.
In the European investment grade market, we would expect certain sectors to offer more spread versus others due to the differential impacts of COVID-19 on different sectors (think of the severe impact of COVID-19 on retail and travel versus its more limited impact on manufacturing). Surprisingly this is not the case. Aggressive monetary policy and optimism over the vaccine have effectively dampened sector spread dispersion.
Our strategy to deal with this dynamic is to look a little deeper and consider things like subordinated corporate debt. We also consider subordinated financials, for example, Tier 2 financials versus senior financials. The spread dispersion here is still quite substantial. And moving further out to additional Tier 1 bonds offers further pick-up in the spread versus senior financials.
So, there are opportunities in investment grade, but we must look away from simple sector dispersions and instead consider dispersion within sub-sectors. While money market funds cannot invest in these securities, ultrashort and cash-plus funds can, so they may be an interesting option for some investors. There are trade-offs, of course, in terms of credit quality and liquidity, but we believe Invesco Fixed Income’s deep and broad research capability allows us to understand these nuances. These strategies may also add diversification while allowing investors to reach beyond zero.
Luke Greenwood: When jumping from money market funds to shorter-duration strategies, we believe a key consideration must be liquidity. Shorter-duration funds will tend to face greater volatility in returns and lower liquidity versus money market funds. But they still invest in high-quality securities and focus on risk-adjusted returns with a similar risk profile to money market funds.
Paul Mueller: The type of investor and the uses of cash also help determine whether a money market fund or ultrashort strategy is appropriate. For example, can the investor take mark-to-market risk? If the cash is needed for operational purposes, for example, to pay dividends or salaries, it may not be suitable for strategies outside of money market funds.
1 Source: IMMFA’s iMoneyNet data, data from Jan. 1, 2020, to Nov. 30, 2020.
Aggressive macro and fiscal policies and a vaccine rollout that potentially paves the way for normalized economic activity have renewed the market’s focus on inflation.
At Invesco Fixed Income, we see several megatrends that are likely to support a shift in consumer behavior toward such ESG considerations over the longer term.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
All data is as at 31 January 2021 unless otherwise stated.
This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.
