How has the Covid-19 crisis impacted different money market assets?
It has definitely been a rollercoaster ride over the past three months. The good news is that given their short-term nature and high quality, money markets in general tend to perform better than most other asset classes in such conditions. Inevitably, there were going to be some assets that saw their spreads widen and their prices fall because of the panic selling, which at times rivalled the 2008 global financial crisis. At the height of the panic, even the spreads on fiveyear gilts widened by 60 basis points (bps) over the course of just a few days as everyone ran for cash. As we got to the height of the gilt sell off, that was the time for the Bank of England (BoE) and other global central banks to step in. In the UK the BoE lowered the base rate to its lowest ever on record, while introducing unprecedented packages of support in the form of quantitative easing. This brought some stability and confidence back to capital markets. For example, as markets and asset holders began to see the effects of the BoE’s actions and the government step in with furlough packages, yields began to move back down to where we would expect them to be, albeit still elevated. One thing that was clear throughout the crisis, was that although gilts and other Sovereign, Supranational and Agency (SSA) assets did suffer in the initial panic, they far outperformed other parts of the market.
How was the fund positioned going into the crisis?
When the pandemic first struck, we had substantial overnight and one week liquidity to meet the fund’s needs. Another reason the fund held its own during the crisis was that we had 12% of the portfolio in SSA assets, in addition to covered bonds, overnight deposits and a weekly ladder of very short maturities, to meet any liquidity requirements. To clarify, this is not a short-term money market fund, the aim is to provide a high degree of liquidity, while looking for some extra yield for investors without impacting the fund’s conservative risk/ return profile. This leads us to adopt a cautious approach that concentrates on counterparties with strong fundamentals that are able to contribute to our investment objectives. Has the crisis given rise to some attractive investment opportunities? The excess liquidity in the fund enabled us to pick up some very high quality, attractive credits, some of which hit once in a lifetime spreads. The market had panicked to such an extent that, within reason, you could name your price for some of the assets, even high quality ones, that banks were desperate to get rid of. This is where the fund benefits from working hand-in-hand with the credit analysts at Canada Life Investments, as well as the wider fixed income fund management team. Although social distancing means we are no longer in meeting rooms and these conversations take place via conference calls and videos, they have been vital in our current asset selection and counterparty risk monitoring. The approach we take is that we are not going to invest short-term in a counterparty that Canada Life Investments is not prepared to invest in long-term for the annuity funds. We look at companies and banks that we are very comfortable with, the emphasis very much on quality. One asset we had been eyeing closely and stood out in terms of value for risk, was the ING April 2021 Bond. Going into the crisis the spread on this bond, which we rate A+, was 50-60bps over gilts. We bought it in late March after it had cheapened to 165bps, securing a 1.9% yield for one year in an A+ senior preferred bond, which has already had a positive impact on the fund. We also saw opportunities within the SSA space. For example we bought a one year European Investment Bank (EIB) bond, which is a AAA-rated, high quality, supranational bank that has deep pockets and support through the European nations. Where in normal markets, EIB trades at 3 month libor -5bps, we purchased a one year floating rate note (FRN) with a spread of 11bps over 3-Months Libor, locking in an attractive return for the coming 12 months.
Can these investment opportunities be accessed without forsaking quality?
When we set up the fund in June 2017, I was asked how I wanted to create the portfolio. The first thing I said it needed to provide was liquidity, which is achieved through overnight deposits. Today we have 11% (around, £70m) of the portfolio in overnight deposits, versus the regulatory requirement of 7.5%. We then look for quality by adding covered bonds and government and SSA assets. Thirdly we look for stability in pricing in relation to potential interest rate movements, that is when the FRNs come in. So over the past 12-18 months, where we have seen the potential for rate hikes, we have selectively been buying FRNs where we felt their long-term benefits would outweigh fixed income bonds. The key is being flexible and working with whatever tools are most effective for the fund at any one time. Previously we had been taking advantage of the UK treasury bill (T-bills) and gilt market, which met the fund’s requirements of liquidity, yield, quality, stability and regular maturities. However, with T-bills now yielding less than 10bps in the secondary market, we have been eyeing suitable alternatives, increasing our positions in SSA assets. In addition to EIB, Germany’s KfW and Canada’s EDC can be bought at yields in line with bank bonds, but also with AAA ratings. Because of the higher degrees of stability in SSA assets, we feel confident holding such longer-dated assets to maximise returns.
Do you see any impending risks?
That is a tough one to call. You’d think that whatever comes now won’t be as much of a shock as the first wave of the virus, and that the central banks are ready to deal with anything that comes through. However, at the same time, there is the fear of a second wave coming through and shutting down economies again. That could have a more profound impact on people, businesses and economies than it did the first time, because those that thought that they had made it through the first wave could find themselves, this time, made permanently redundant rather than being furloughed. The way I see the Bank of England right now is that they are testing the waters for negative interest rates. With concerns around Brexit set to start again, even without a second wave, there are some logical arguments coming through for such a move, albeit further down the line. Under these circumstances we need to make sure the fund is structured to cope with any scenario. The recent spike in spreads reminds everyone that all assets are liquid, at a certain price, but the only truly liquid assets are the ones people want to buy in a crisis. These are the assets I look to buy.
How has the fund performed so far this year and can this continue going forward?
The last three months have shown why you need liquidity funds in your overall portfolio. When you see stock markets slump by 25-50% because of the panic going on in markets, you need a stable allocation within your portfolio that also gives you the liquidity to be able to add to more distressed asset classes when you see an opportunity. Peak-to-trough, the fund fell by just 0.13% during the crisis, all of which was recovered within a month. With a return profile (in the current low interest rate environment) of 50-100bps a year, this is not an asset class that is going to make you rich. However, it is designed to offer liquidity and capital stability at times when other assets can’t, as well as ensuring your cash deposits are also generating a return. While we continue to seek yield, for the time being, as the pandemic evolves, liquidity, quality and stability remain the watchwords.
For more information on the LF Canlife Sterling Liquidity Fund please visit here
