Finding yield in cash markets


Craig Inches, Head of Short Rates and Cash

30 November 2016

Low interest rates, economic uncertainty, decreasing liquidity and a limited pool of available counterparties have been thorns in the side of cash markets during 2016. Nevertheless, the requirements for income, security and liquidity remain as strong as ever. Despite the pick-up in global inflation and policymakers placing more emphasis on fiscal rather than monetary policy, interest rates, and consequently cash yields, remain at very low levels. The fall in yields over 2016 has generated phenomenal returns for investors in longer dated bonds, but has posed a problem for investors looking for low volatility income generation. 
Historically, a standard method for increasing the yield on a portfolio has been to increase the duration (sensitivity to interest rates) by investing in paper with longer maturities, but at a time when we expect interest rates to rise, we think this is a risky strategy. Our preferred strategy for increasing yield is to increase credit risk incrementally – investing in selected securities that enable us to raise the yield in a controlled and efficient manner. One of our favoured asset classes for such investment is covered bonds, which have a number of protective features. First, they are protected by ‘double recourse’, i.e. recourse not only to the issuer but also to the underlying pool of assets, in the event of default. Secondly, these assets are highly regulated and have never defaulted in a 200-year history, and therefore receive very high credit ratings.  Finally, covered bonds are excluded from the ‘bail in’ process should the underlying bank default, allowing the investor access to their capital. These characteristics mean that we can enhance yield efficiently without increasing duration risk.
The political events of 2016 will have implications for markets that carry through to 2017 and beyond. The first steps for leaving the EU have not yet been taken, nor has Trump yet been inaugurated as president. The potential for bond volatility remains high, we feel that there is very little yield protection in longer dated assets and we believe that focusing on short duration strategies that provide diversification and liquidity will prove beneficial in an environment of gradually rising interest rates.

Low interest rates, economic uncertainty, decreasing liquidity and a limited pool of available counterparties have been thorns in the side of cash markets during 2016. Nevertheless, the requirements for income, security and liquidity remain as strong as ever. Despite the pick-up in global inflation and policymakers placing more emphasis on fiscal rather than monetary policy, interest rates, and consequently cash yields, remain at very low levels. The fall in yields over 2016 has generated phenomenal returns for investors in longer dated bonds, but has posed a problem for investors looking for low volatility income generation. 

Historically, a standard method for increasing the yield on a portfolio has been to increase the duration (sensitivity to interest rates) by investing in paper with longer maturities, but at a time when we expect interest rates to rise, we think this is a risky strategy. Our preferred strategy for increasing yield is to increase credit risk incrementally – investing in selected securities that enable us to raise the yield in a controlled and efficient manner. One of our favoured asset classes for such investment is covered bonds, which have a number of protective features. First, they are protected by ‘double recourse’, i.e. recourse not only to the issuer but also to the underlying pool of assets, in the event of default. Secondly, these assets are highly regulated and have never defaulted in a 200-year history, and therefore receive very high credit ratings.  Finally, covered bonds are excluded from the ‘bail in’ process should the underlying bank default, allowing the investor access to their capital. These characteristics mean that we can enhance yield efficiently without increasing duration risk.

The political events of 2016 will have implications for markets that carry through to 2017 and beyond. The first steps for leaving the EU have not yet been taken, nor has Trump yet been inaugurated as president. The potential for bond volatility remains high, we feel that there is very little yield protection in longer dated assets and we believe that focusing on short duration strategies that provide diversification and liquidity will prove beneficial in an environment of gradually rising interest rates.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.