Is it possible to generate useful returns in the short-term markets while remaining low-risk? Neil Hutchison, Lead Portfolio Manager for Managed Reserves, Europe, J.P. Morgan Asset Management believes so.

The dash for yield

Expectations for lower interest rates across the globe has sparked a grab for yield. At the same time, strong technicals in credit markets are supporting spreads despite the late cycle risks that are increasingly prevalent in the market. Even in Europe, where rates are already in negative territory, further easing is expected. In this environment, the yield drag for staying in cash is only likely to increase.

For many cash investors, maintaining an attractive yield means having to increase credit exposure at a time when market risk is greater than it has been in a long time. The question investors must ask themselves is how aggressively they wish to pursue their step-out strategy. In Europe, for example, a strategy designed to achieve a positive yield would require a portfolio that is 100% invested in credit with an average BBB rating out to five years.

But an average BBB rated portfolio obviously contains more risk than a AAA rated portfolio. Therefore, a blind focus on yield, as opposed to total return, could give some investors a wrong steer – particularly with credit risks increasing.

Put cash in its place

Overstretching for yield in the current market environment could present serious hazards. Among the current known market risks – not all of which have been priced in – are ongoing trade disputes, Brexit uncertainty, falling interest rates, changing regulations, and an ageing credit cycle (to name but a few). To this list may be added the threat of one or more key markets slipping into recession in the next 24 months.

At the same time, credit risks are rising. Leverage in investment grade markets, for example, is higher than ever (particularly in the industrials sector). While falling interest rates may help these companies eke out cheaper refinancing, what happens if the major economies do go into recession? Furthermore, while investors would expect a higher yield for investing in BBB rated securities, greater demand for BBB assets is actually causing spreads to tighten.

Find the sweet spot

For investors in the ultra-short space who seek yield in this volatile economic environment, there is a strategy that could help them. Segmenting cash and leveraging solutions across the full ultra-short spectrum can help investors target the cash sweet spot by maximising yields and helping them to prepare for lower rates, without taking on too much risk.

This strategy involves stepping out of the AAA “dead zone” just enough to boost yield, but with a laser-sharp focus on the credit fundamentals of every suitable asset, rather than relying for guidance on today’s market pricing, which is dangerously influenced by technical factors (where demand is outstripping supply) instead of a focus on fundamental value. Undertaking the right level of credit research helps to strip out unacceptable volatility and ensure that credit risks are managed in the portfolio.

For most treasurers – those without credit research resources – implementing a cash segmentation strategy that is backed by fundamental credit analysis will mean engaging with a specialist adviser. In today’s challenging environment, access to such specialised credit analysis is crucial, allowing investors to account for the kind of “known unknowns” being created by Brexit, for example, and helping them to get on the right side of any market fall-out.

A proven track record

J.P. Morgan Asset Management’s active, liquid and diversified Managed Reserve investment model has a decade-plus track record that eschews a dangerous fixation with yield and instead looks to total return, with a deliberately low risk approach to BBB credit.

The focus is on short-term positions, and then only in names that are good enough to make it onto a well-researched buy list built for liquidity-style investors. The result is a credit selection process that is appropriately conservative for treasurers seeking yield in these uncertain times.

To quantify outcomes, J.P. Morgan Asset Management’s Sterling Managed Reserves strategy, for example, aims to outperform a typical cash proxy (such as a money market fund) by 20 to 40 basis points (bps).

In a late cycle environment, where fundamentals are deteriorating, spreads are tightening and technical are driving the market, picking up 20 to 40 basis points in yield looks attractive – particularly when the new normal is for zero or negative rates.

For yield seekers aiming for principal preservation, hitting that ultra-short sweet spot is still possible with the right advice. It’s therefore time to put cash in its place.

To find out more, please visit www.jpmgloballiquidity.com or contact us at jpm_global_liquidity@jpmorgan.com