The character Norm on the popular TV show Cheers spent his days atop his reliable bar stool, wryly contemplating the world while imbibing with his friends. Few would point to Norm as a standard-bearer of forward thinking. But there is something to be said for his perch.
That sturdy stool represents a unique vantage point for surveying any situation: everyday life, a sporting event or, yes, even the money markets. At PIMCO, the view from a metaphorical three-legged stool (sans the suds) is key to the day-to-day operations on our short-term desk. These three legs intersect to form the foundation of the short-term marketplace: excess cash investing, funding requirements and short-term portfolio management. We developed this approach because we are not only investing cash for specific portfolio mandates, we also are simultaneously helping manage liquidity for portfolios across the firm, allowing us to continually price and capture liquidity premiums.
Excess Cash Investing "“ Excess cash represents first tier (immediate) liquidity for all portfolios and thus needs to be strictly safeguarded. Our early morning evaluations begin at 4:00 a.m. Pacific time, before the fixed income markets are widely engaged: Checking the initial offering levels for repurchases (repos), Treasury bills and agency discount notes provides PIMCO a window on the market sentiments toward liquidity and risk. Moreover, this allows our portfolio managers to quickly identify any signs of stress (e.g., a flight to quality), as well as potential dealer- or investor-specific issues, and expedite those issues.
It is also as important as ever to monitor developments in monetary and regulatory policy. The new, more restrictive 2a-7 money market regulations are likely to compress money market yields further than ever before vs. other short duration strategies. This is likely to provide great opportunities to invest just outside of the money market space (e.g., 15-month or 18-month maturities rather than 13-month maturities). We were able to capture some of these opportunities as money market funds sold securities in order to comply with the new regulations. We believe this will be a structural opportunity that will continue even when the Federal Reserve eventually increases rates.
Funding and Collateral Trading "“ In addition to investing, PIMCO's short-term desk manages the funding and collateral requirements for portfolios around the firm. We have never thought of funding as a back-office responsibility: It takes dedicated and experienced trading professionals to manage the relationships and liquidity for these portfolios. With financial institutions' balance sheets becoming an increasingly scarce resource, funding is turning into a means to gauge dealer appetite for risk and liquidity both in short-term (i.e., overnight) and long-term commitments, so experienced and deep resources are critical.
Deep resources are also key in raising liquidity for portfolios: Depending on market conditions, reverse repos, short-term maturities, lending securities or just liquidating securities may offer the most efficient liquidity at the best relative value. Along with identifying the instruments likely to provide the most liquidity for the lowest funding cost, we also consider the term of the funding commitment relative to the cost. Additionally, we are especially mindful of managing the second-derivative exposures to counterparties, such as margin collateral posted and received. We believe it is critical to individually manage both liquidity and credit as contributors to performance in the short-end. As a result, we utilize PIMCO's extensive credit team of more than 30 credit analysts globally when evaluating both counterparty risk and credit opportunities within our portfolios.
Short-Term Portfolio Management "“ Similar to other portfolio strategies at PIMCO, short-term strategies "“ i.e., dedicated portfolios that are not needed for immediate liquidity "“ incorporate top-down macroeconomic philosophy with bottom-up specialist expertise. This is where it may be possible to take advantage of structural yield premiums outside money market space to target high-quality alpha. With money market yields continuing to remain low, many investors are thinking about tiering liquidity and stepping beyond money market investing while properly managing credit exposures.
Over the past few years, investors have come to realize there are risks of varying degrees in all asset classes "“ money markets and short duration strategies are no different. Just because interest rate risk is potentially lower in short duration strategies when compared with intermediate duration total return strategies, it does not mean that other uncalculated risks can be ignored. Similarly, investors can no longer hesitate to make portfolio decisions because they assume low-cost liquidity will always be available. The assumption of these unknown risks in a portfolio can be costly, in relative and absolute performance and in liquidity.
This is where our view from this three-legged stool is so critical: It allows the portfolio management team to continually monitor the health of the liquidity market. In times of stress, this view helps give us the ability to be one of the first movers when we need to take preventive measures to preserve liquidity and, in extremely adverse situations, capital.
The unique vantage point of the three-legged stool also helps us target opportunities and dislocations in the market. We strongly believe that the new 2a-7 regulatory changes will have a damping effect on money market yields and that the demand for true liquidity will be very costly in terms of yield performance. Having several points of integration to highly interconnected markets helps PIMCO's short-term desk anticipate liquidity events and respond in a highly efficient, cost-effective manner across our complex of portfolios.
It is important to accurately identify liquidity needs in short duration portfolios, so that investors are paying the painfully high cost of true liquidity in the form of lower yields only when absolutely required. The corollary is just as important: 2a-7 and other potential regulatory reforms may create new structural opportunities to generate alpha in short duration strategies that are not needed for daily liquidity.
The ability to capture liquidity premiums is likely to prove immensely valuable for many strategies, but particularly those with an eye on the short end of the maturity spectrum. We believe our three-legged short-end stool provides a great perspective for identifying higher-yielding options that may offer higher degrees of liquidity at more attractive yields. We have seen many investors seek short-term and low duration strategies that have the potential to fill this niche quite effectively, not only now with rates near zero, but even as rates begin to increase in the future.
Maybe Norm had it right all along.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
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