Money market funds can play an important role in helping investors manage capital and liquidity during stressed market conditions, but their potential to provide yield should not be overlooked.
During times of crisis, such as the current pandemic, money market funds (MMFs) have become an asset class of choice, as cash equivalents can offer an effective solution for managing capital and liquidity requirements. When selecting MMF investments, there are several important factors to consider such as security of capital, diversification, level of liquidity and yield. Although yield was once an afterthought in MMF selection, it is now of greater importance to investors—particularly in this prolonged low interest rate environment.
In a time when every basis point counts, meeting target returns is equally important as preserving capital and diversification. And while cash is often overlooked as a potential source of excess return, MMFs can in fact be actively managed to try to enhance yield without sacrificing a portfolio’s creditworthiness.
Euro Liquidity Fund (ELF) performance
The Aviva Investors Euro Liquidity Fund (ELF) is an example of how active MMF management can result in better performance than the benchmark, as shown below. ELF’s relative performance has been particularly strong since the onset of the pandemic crisis in March, demonstrating the importance of active management during times of market stress.
Figure 1: Euro Liquidity Fund net performance versus 7D EUR LIBID
ELF’s outperformance over the past two years can be attributed to actively seeking opportunities to enhance yield. The first example of this was in summer 2019, when geopolitical tensions combined with a deteriorating European growth and inflation outlook led market participants to anticipate European Central Bank (ECB) intervention. At the time, the market was pricing in a deposit rate cut of 20 basis points (bps) in advance of the September 2019 ECB meeting. This was evidenced by a drop in commercial paper and certificate of deposit (CD) fixed rates and an inverted EONIA swap curve.
The decision to not take additional duration risk and to invest in EONIA floating CDs boosted fund performance
In early summer, we extended the duration of ELF’s portfolio to protect against this anticipated rate cut. However, as summer progressed, we noted volatile levels in fixed-term paper and opted for the more stable spreads of EONIA floating-rate CDs, accessed through our relationships with French counterparties.
This decision not only resulted in a yield pick-up of three bps, but also positioned the portfolio for a rate cut that was lower than anticipated. When the ECB ultimately announced a cut of just 10 bps, the money market yield curve repriced higher in September and October, especially in the six months to one-year maturities. Thus, the decision to not take additional duration risk and to invest in EONIA floating CDs boosted fund performance.
The COVID test
Strategic portfolio positioning and the active pursuit of yield opportunities throughout the COVID-19 crisis have also been behind strong ELF performance. In the first two months of 2020, the virus outbreak resulted in EUR short-term market volatility, and the market was pricing a deposit rate cut until mid-March. Concurrently, liquidity pressures were building as many MMFs saw outflows amidst dwindling secondary market activity and a growing reluctance among banks to buy back paper.
Going into the crisis, the ELF portfolio was positioned with shorter duration and strong liquidity buffers
Going into the crisis, the ELF portfolio was positioned with shorter duration and strong liquidity buffers. This positioning, coupled with high visibility into MMF flows, enabled us to take advantage of several opportunities. Firstly, the scarcity of short-term funding led to issuers offering attractive levels, and we were able to use our risk budget to invest in high quality financial institutions, effectively locking in higher returns.
In addition, a favourable EUR-USD basis move presented an opportunity to buy highly rated Canadian and Swiss banks at positive EUR levels. The likes of RBC and TorDom are rare issuers in euros, but swap moves at the time had them issuing at positive EUR yields of 0.45 and 0.50 per cent for six months. Our portfolio positioning allowed us to take the opportunity to add such high quality names after ensuring we were comfortable with the issuer fundamentals over the period of the trades.
Our ability to enhance yield over the past two years has also been made possible by strong counterparty relationships. We have developed excellent long-standing relationships with highly rated counterparties. In addition to accommodating overnight and weekly liquidity solutions, these counterparties have provided more flexibility and diversification for short-term liquidity, helping us comply with AAA-rated standards and MMFR requirements.
ELF: Looking ahead
We expect the ECB to maintain its accommodative policy stance, and believe additional intervention is likely for several reasons. First, economic recovery in the euro zone remains fragile, as COVID-19 cases have recently seen a resurgence and resulting new restrictions will stall activity. Headline inflation is another consideration, as the ECB expects it to remain in negative territory until early 2021. Additionally, euro strength relative to the USD also calls for accommodative policy, as it could have a negative impact on exports and inflation.
In recent months, the ECB’s Governing Council (GC) members have looked to calm markets, repeatedly stating they stand ready to act and to use all available tools. As expected, the ECB left policy unchanged at its October meeting, and highlighted the GC will recalibrate all available instruments. This process will consider the new round of staff macroeconomic projections in December, as well as “incoming information, including the dynamics of the pandemic, prospects for a rollout of vaccines, and developments in the exchange rate”.
There are a number of possibilities for additional stimulus measures. Increasing the size of the Pandemic Emergency Purchase Programme (PEPP), extending its duration or expanding it to include more asset classes could all be effective in supporting the recovery. Other options for stimulus measures could include modifying the conditions for the asset purchase programme, changing the collateral rules and conditions of targeted longer-term financing operations (TLTROs), or adjusting the tiering multiplier for deposits.
ECB members have expressed that expanding the PEPP is the most appropriate option for the current crisis
To date, ECB members have expressed that expanding the PEPP is the most appropriate option for the current crisis. During the press conference, the ECB’s president Christine Lagarde clarified the bank is looking at a combination of measures in pursuit of the best outcome to support financing conditions.
While euro zone interest rates are already in deeply negative territory, ECB officials have signalled even further policy rate cuts could be part of the stimulus toolkit. At the time of writing, the EONIA swap curve is pricing a 10 bps rate cut for September/October.
In the euro short-term space, the collapse in credit and term premia has been ongoing since early summer. This has been supported by expectations for further ECB easing, together with issuers’ lack of appetite for short-term funding. We continue to focus on names with strong fundamentals, looking to diversify the ELF portfolio, and adding longer maturities when we feel adequately compensated for the duration risk.
Sterling Liquidity Fund (SLF)
Over the past two years, the Aviva Investors Sterling Liquidity Fund (SLF) has also been successful in seeking yield enhancing opportunities. As shown below, since the outbreak of the pandemic, the fund consistently outperformed the benchmark.
Figure 2: Sterling Liquidity Fund net performance versus 7D LIBID
SLF: Actively pursuing yield opportunities
Much like the ELF portfolio, the SLF benefited from the active pursuit of yield opportunities. One such opportunity presented itself in September 2018, when Aviva Investors became the first existing provider to adopt the new market standard of Low Volatility Net Asset Value (LVNAV) funds. The SLF converted from Variable Net Asset Value funds (VNAV) to LVNAV funds, targeting a £1 share price. In light of the macro picture at this time we did not anticipate interest rates rising, and thus we targeted longer weighted average maturity (WAM) when converting the portfolio to lock in higher yields.
We also sought yield opportunities around the December 2019 UK general election. We had shortened the duration of the SLF portfolio to neutral in advance of the election, given the uncertain outcome and direction of interest rates. After the landslide election—when the “Boris Bounce” pushed rates higher—we took advantage of the steepening yield curve and added duration to lock in higher yields.
In early 2020, the market was pricing in a Bank of England (BOE) rate cut, as we saw the yield curve flatten and even invert in some cases. In our view, a rate cut was not imminent, as policy was already easy and economic fundamentals were strong. As such, we fanned down SLF portfolio duration and kept investments short.
The SLF performance against the benchmark has been particularly pronounced since the onset of the COVID-19 crisis
However, as the COVID-19 crisis unfolded, the BOE cut rates to 25 bps and then to 10 bps, but market rates shot up to over one per cent as banks struggled to attract liquidity. We took advantage of the surge by increasing SLF’s portfolio duration. And, as the central banks ultimately announced sizeable liquidity programmes and rates normalised, this decision effectively locked in the rates at their previously elevated levels.
The SLF performance against the benchmark has been particularly pronounced since the onset of the COVID-19 crisis. We believe this demonstrates the importance of active management during times of market stress, and how liquidity funds can have the potential to perform well not only during market rallies, but also during sell-offs.
SLF: Looking ahead
In response to the second wave of COVID-19, the government has announced a second national lockdown and an extension to the various support schemes to minimise the economic impact. The Bank of England Monetary Policy Committee (MPC) expects this second lockdown to have a further negative effect on growth and productivity. As a result, it has again eased monetary conditions by increasing the amount of quantitative easing by another £150 billion—bringing it to £875 billion in total.
We expect fiscal policy to continue to be geared toward government spending to support the recovery. We do not anticipate any fiscal tightening until the economy is on stronger footing.
COVID-19 crisis remains the dominant theme but Brexit is not to be overlooked
While the COVID-19 crisis remains the dominant theme, Brexit is not to be overlooked. The fragile state of the economy cannot afford a hard Brexit that results in increasing costs and reduced trade. As such, a satisfactory EU trade agreement before the end of the year is essential.
The BOE is currently exploring the efficacy and practicality of negative policy rates, weighing the impact the policy would have on building societies that rely on net interest margins for their profits. This study is likely to take several months; if it concludes the system can cope with negative rates, we anticipate the May MPC meeting as the earliest time the policy would be introduced. At this time, the committee will have a clearer picture of the impacts of Brexit and COVID-19 restrictions.
Against this macroeconomic backdrop, we are targeting a long WAM for the SLF portfolio so that we can keep rates locked in at positive levels for as long as possible.
Actively managing cash can make a difference
The global macroeconomic picture has shifted considerably over the past two years, most notably since early 2020 when the COVID-19 crisis roiled markets and economies. Government policy has looked to address the economic impact of the crisis, in effect further prolonging the low interest rate environment. As such, while liquidity, diversification and security of capital are all important considerations when selecting a MMF, yield has become a greater priority for investors.
As demonstrated by our ELF and SLF performance, actively managing liquidity funds through both calm and turbulent market conditions can make a difference in performance. We believe these funds can not only be a source of liquidity for investors struggling to meet target returns, but also a source of yield.
