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The Markets September 22, 2016
Divining Trends in Global Fixed-Income Markets
Sean Rhoderick, taxable fixed-income investing leader at PNC
Capital Advisors, outlines unique opportunities driven by conflicted central
bank policies and a persistently abnormal rate environment.
Reported by John Manganaro
Despite years of record-low interest rates and cautiously optimistic signals from the U.S. Federal Reserve, Sean Rhoderick, chief investment officer of taxable fixed-income products for PNC Capital Advisors, says there’s little reason to suspect interest rates will normalize soon.
Acknowledging the hazard in making strong forward-looking predictions, Rhoderick is confident enough to say there’s “more reason than not to suspect we’ll be hovering around these interest rate levels for a decent amount of time still.” At least for the intermediate term, he says, investors will very likely have to accept low returns on fixed-income assets by historical standards.
“We have seen that the U.S. Federal Reserve is being hesitant to push rates higher too quickly out of the overhanging fear of stalling growth,” he tells PLANADVISER, “and very few other central policymakers in other important markets are likely to be any more aggressive than the Fed.” And so, with institutional and retail investors alike left waiting for a change in direction, “it makes sense to think about new types of approaches and exposures.”
At PNC Capital Advisors, Rhoderick says a lot of thought is “going into credit assets, generally speaking.” He suggests the perceived safety of government bond securities, on top of the low rate environment, has dramatically reduced the opportunity to generate returns on cash or cash-like assets that does not also come along with some real risk.
“We are cautious about corporate debt, of course, but we still feel it’s an increasingly important asset class for investors to consider,” Rhoderick explains. “We advocate for a defensive approach that closely considers moving up in credit quality and shorter in duration. There may be emerging opportunities in asset-backed securities as well. Shorter maturity securities have given us an opportunity to take prudent credit risk at very attractive spreads and yields compared to what is possible in U.S. government bond markets. It’s something we can do carefully and over the short term.”
NEXT: Making decisions in a shifting marketplace
Rhoderick observed that, just in the last couple of weeks alone, there has been yet another big shift in terms of how central bank policymakers are signaling their intentions for the remainder of 2016 and beyond.
“The European Central Bank [ECB] is clearly unsure of what to do. The U.S. Federal Reserve is unsure what to do. There are important decisions to be made in Japan and elsewhere that will not be easy, and so I think we can agree that global banks in general are very far from moving in anything like a coordinate way that would promote normalization in rates,” he continues.
Giving some advice directly to retirement plan investors, Rhoderick says “we all have had to accept a new global yield environment, where U.S. rates and government securities widely are limited in their prospects for the short and mid-term.” There are, simply put, limits on what can be accomplished with a traditional approach to fixed-income investing for the foreseeable future.
“It’s going to be very hard to have a strong sense of conviction about how to generate safe and steady return in these troubled markets,” he feels. “Just given all the conflicting influences and the reduction in importance of the traditional drivers of the marketplace, new challenges and opportunities are going to continue to emerge. In that respect awareness and nimbleness will be important.”
Venturing into the territory of specific investment ideas, Rhoderick suggests as an example that investments with sensitivity to the Libor rate “could be a powerful tool given everything going on at the U.S. Fed and at the ECB.”
“From a longer-term, 20-year perspective, the two-year U.S. Treasury rate and the three-month Libor rate tend to move in a similar fashion,” he observes. “It is not uncommon for the yield on the three-month Libor to exceed the yield on the two-year Treasury, in fact.”
NEXT: Distorted patterns
This pattern of outperformance has historically emerged and persisted more in periods of financial stress, Rhoderick explains, but the uncoordinated movements at the Fed and ECB and elsewhere have offered a boost.
“While still somewhat modest, this relative spread presents unique opportunities,” Rhoderick says. “There are several ways to invest in securities with yields that move in relation to Libor. Examples include floating-rate notes specifically benchmarked to the one-month/one-month Libor, as well as short-term instruments such as commercial paper and certificates of deposit.”
Rhoderick concludes by observing that the long-awaited deadline for money-market fund reform, approaching on October 14, is yet another source of distortion for the traditional supply and demand dynamic of capital preservation investing. “As of that date, institutional prime money-market funds will be required to float their net asset value, based on the market value of the underlying investments,” he warns. “By contrast, government money-market funds will be generally permitted to maintain a stable NAV.”
As a result, assets in institutional prime money-market funds have fallen roughly 35% over the course of the year to approximately $600 billion.
“The drop in prime money-market fund balances is a reflection of both forced conversions to government money-market funds and to a lesser degree investor redemptions. There is considerable uncertainty regarding what the timing and amount of additional prime-fund withdrawals will be, but most estimates range from $200 to $400 billion,” Rhoderick concludes. “Given the need for money-market fund managers to ensure sufficient liquidity in an uncertain environment, we expect these imbalances to persist well into the fall ... This will further strain traditional supply and demand dynamics for bond securities.”
A recent white paper penned by Rhoderick tackling some of these topics is available for download here.