February 2021 – Monthly Commentary

February 2021

The bond market has struggled mightily of late with one unexpected “fire” flaring up after another, and despite demanding attention, the Federal Reserve has failed to act.   Of concern has been the downward trend in Treasury Bill yields over the last few weeks.  No one wants to see the yield for T-Bills go negative, but with the Treasury reducing supply temporarily to stay under the debt cap, the Fed buying in the secondary market and money market funds now effectively all government Bill funds, the yield has nowhere to go but down.

Contrary to what was happening in the Bill market, longer maturity Treasuries have been under selling pressure as investors are starting to worry that the Fed is letting the economy run too hot.  From that, signs have emerged that inflation may flare up.  When Chairman Powell testified before Congress in late February, he only served to worsen that fear.  On both days of testimony, the S&P 500 reversed big intraday drops on his dovish comments.  The street was whispering that he may suggest the possibility of curve flattening but instead his message was that the Fed will look past any transient inflation and continue to buy bonds for the foreseeable future.  As a reminder, the Fed is buying $1.44 trillion in the secondary market annually. 

He also failed to address issues in the money market.  The whisper prior to his testimony was that the Fed would raise the Interest on Overnight Excess Reserves (IOER) left at the Fed but they would communicate that it was technical and not a rate hike.  Unfortunately, he missed the opportunity and the upward trajectory of long end interest rates continued.

Against that backdrop, the most recent 7-year auction was an unmitigated disaster.  The auction cleared more than 4 basis point above where it was trading at the 1:00 auction time.  When auctioning Treasury debt, the Treasury allows the soon to be issued debt to trade several days before the actual auction in what’s known as the “when issued” market.  Dealers and investors can buy and sell the issues without paying for it until the official settlement date, which is the day after the auction.  This trading allows buyers and sellers to come in to balance so that at auction time there is no surprise.  Usually, the auction yield is nearly identical to that at which it’s trading at auction time.  When the auction clears at a higher yield than it was at auction time, it’s referred to as a tail.  At the last 7-year auction, the tail was one of the largest on record – 4 basis points.  On the news, the entire Treasury market when through a mini flash crash, as the long bond initially fell four points in price before recovering to retrace about one half of that move.

That’s an unheard of occurrence and should be a wake-up call to Congress and the Treasury department.  The U.S. has been running annual budget deficits on the order of about $1 trillion and will do so again this year.  Moreover, with the COVID stimulus bill being passed into law, that’s another $1.9 trillion that’s going to need to be financed through bond sales.  With investors showing indigestion from the deficits already financed, one wonders how they are going to finance future sales.

Separately, the financial press seized on the 10-year note repo trading as low as -4.00% during the first week of March.  Such a situation exists when the short sellers aren’t able to borrow the bond to make delivery.  It’s a situation that’s not unlike what happened to Game Stop last month, except for one big difference.  The Treasury will reopen $38 billion of the same 10-year note in the coming days, so investors shouldn’t expect any significant short covering rally. 

Lastly, Minneapolis Fed President Kashkari was quoted as saying that if real rates spike it may warrant more easing from the Fed, which is a little perplexing.  Real rates rise when the economy is accelerating and the Fed is either raising rates or is poised to do so.  Easing in such a circumstance would likely cause real rates to rise further.

Copyright 2021, Halyard Asset Management, LLC. All rights reserved.

January 2021 – Monthly Commentary

February 2021

Risk/Reward valuation of the Bond Market

The Bloomberg U.S. Aggregate Bond index (Formerly the Barclays Aggregate Bond Index), the widely followed benchmark measure for the broad U.S. bond market, generated a total return of 7.51% last year.  That performance was primarily due to the Federal Reserve buying all manner of fixed income instruments.  The Fed has promised that their monetary manipulation will continue into the foreseeable future, but some members have raised the topic of tapering the purchases. 

With that, should investors expect similar returns in the coming 12 months?  Alternatively, if interest rates rise, what is the magnitude of loss that an investor should expect?  With interest rates hovering near decade’s low levels, we believe that now is the time for fixed income investors to understand the potential risk and reward of their bond portfolio.  This paper seeks to generally quantify the current value and risk inherent in the Treasury bond and the corporate bond markets.

In its simplest form, valuation is the expected purchasing power (also known as the real rate of return) of a dollar invested in a bond at the end of a holding period, given the current interest rate and anticipated rate of inflation.  The starting point for this exercise is the U.S. Treasury note, also known as the “risk-free” rate.  Note that “risk-free” refers to credit-worthiness, not interest rate sensitivity.  As Figure 1 illustrates, the risk-free Treasury rate can be described as a combination of the inflation rate and the real rate. 

Figure 1.

As a valuation benchmark, I compare metrics to those witnessed in 2005, a time when the economy, inflation and Fed policy was arguably in equilibrium.   At that time, the 7-year Treasury note yielded 4.43%, but 3.40% of that yield was compensation for expected inflation, as measured by the University of Michigan 12-month Inflation Expectations index.  From that, the investor expected to be rewarded with 1.03% more purchasing power at the end of the one year holding period.  The “rule of thumb” among bond investors is that a real rate of 1.0% is approximately fair value for a risk-free Treasury note.  At the end of 2005, one could conclude that the 7-year note in question was fairly valued.   The circumstances today are much less favorable.  With the 7-year note yielding 0.83% and inflation expected to register 2.50% in the coming 12 months (also based upon the University of Michigan Index), an investor holding the note for one year would realize 1.77% less purchasing power at the end the holding period.  Using the 1% real return “rule of thumb,” the current 7-year note would need to rise to 3.50% to be considered fairly valued.  Inputting that interest rate differential into a bond calculator delivers the astonishing conclusion that the price of the 7-year note is16.75% overvalued.

Turning to the corporate bond market we employ a similar valuation technique to determine fair value.  In this exercise, we use the Barclays Capital U.S. Credit Index as a proxy for the corporate bond market.  The index has interest rate sensitivity similar to the 7-year Treasury note.  To assess value, we subtract the yield-to-maturity of the 7-year Treasury note just discussed from the yield-to-maturity of the index.  The difference is defined as the credit risk premium, or the incremental return investor’s demand for assuming credit risk over and above the risk-free Treasury note.  In 2005, subtracting the 4.43% risk-free rate from the 5.30% yield-to-maturity of the index indicated that the credit risk premium was 0.87%.  Again, using rule of thumb, fixed income investors would consider a risk premium of 0.87% to be a close approximation of fair value.  Refocusing on the yield-to-maturity of the index on January 15, 2021, the credit risk premium has shrunken to a less attractive 0.40%.  Returning to the bond calculator, we find that an investor would most likely collect the 1.23% Yield to maturity of the Aggregate index and nothing more. 

Figure 2.

Considering the two measures of valuation, the astute investor is likely to conclude that assuming the risk of an 16.75% loss to achieve a 1.23% gain doesn’t make a lot of sense.  Especially, given that the market and the economy are a long way from what one would consider equilibrium. 

Additionally, we believe it’s quite possible that as the Federal Reserve begins to raise interest rates, the credit risk premium could widen.  That premium has a high correlation with the stock market and given the heightened volatility witnessed in that market lately, such a widening seems plausible.  To revisit the question “Can an investor expect 2021-like performance from the bond market”?  Our answer is “Quite possibly, but investors should consider the downside and not be seduced by recent performance.”

References to specific investments or strategies are for illustrative purposes only and should not be relied upon as a recommendation to purchase or sell such investments or to engage in any particular strategy.    Opinions expressed herein are based on current market conditions and based on certain assumptions and may change without notice.   Recipients are advised not to infer or assume that any investments, companies, sectors, strategies or markets described will be profitable or that losses will not occur.  Actual events are difficult to predict and are beyond our control.   Actual events may be different, perhaps materially, from those assumed.   This report is not to be considered an offer to sell or solicitation of an offer to buy the investments or to engage in a strategy similar to the one discussed herein.   Assumptions are based on information available as of the date hereof and we assume no responsibility to update this report based on a change in underlying assumptions or market conditions.  There is no assurance that the results discussed herein can be realized or that actual returns or results will not be materially different than those presented.  Past performance is no guarantee of futures results.   

Copyright 2021, Halyard Asset Management, LLC. All rights reserved.

December 2020 – Monthly Commentary

December 2020

The Halyard Asset Management Reserve Cash Management (RCM) strategy generated 1.23% after fees and expenses for the year.  That compares favorably to the 0.32% total return of the iMoneyNet Money Fund average.  As of January 1, 2021, the RCM strategy has a duration of less than 5 months and a weighted average yield to maturity of approximately 0.37%.  In comparison, the benchmark has a yield-to-maturity of 0.00% due to the high management fees associated with those funds and the current low interest rate environment.  Aside from Treasury Bills, the top 5 RCM holdings are Toyota Motor Credit, Allstate Corporation, Lowe’s, Ralph Lauren, and Oracle.  The composite is overweight floating-rate notes, a structure that typically performs well when interest rates rise.  While we don’t anticipate an interest rate hike anytime soon, floaters are attractive relative to fixed rate paper.

Last year was a fabulous period for holders of risky assets.  The total return including dividends for the S&P 500 was 16.26%, the yield-to-maturity of the 10-year Treasury note fell more than 100 basis points and Comex Gold rallied more than 25%.  Similarly, the Pound Sterling appreciated 3.05%, the Japanese Yen by 5.16%, while the Euro rose 8.93%, all three versus the U.S. Dollar. 

That risky assets could rise in tandem despite an absolutely awful operating environment is entirely attributable to Federal Reserve and their easy money policies.  Given the above mentioned performance we ask the question how much did it cost to generate?  To approximate that number, we look to the Federal Reserve System’s Open Market Account (SOMA), which is published biweekly on the Central Bank’s website.  As of December 30th 2020, the Fed held $6.687 trillion in Treasury notes, bonds, Agency securities, and Agency Mortgage Backed bonds.  That is $2.97 trillion more than they held at the end of 2019, an eye-popping 80% increase in holdings.  The Fed’s job has historically been to act as an “invisible hand” when intervening in the financial system.  In that, the Fed should not destabilize or distort valuation as they endeavor to keep the system operating smoothly.  In buying nearly $3 trillion of notes and bonds in the secondary market, their operation is more like a punch in the face than an invisible hand. 

Of course, last year there were special circumstances, and they needed to act deliberately to ensure the entire system didn’t collapse, and are unlikely to repeat that this year, right?  Partly yes and partly no.  They are unlikely to increase their holdings by 80% year-on-year, but at their current pace of buying, which they have explicitly told us they would continue for the foreseeable future, they are on pace to add another $1.44 trillion to their holdings in 2021. 

The logical question is that if they are going to only do about half of what they did in 2020 can we expect similar capital market performance in 2021?  In bonds, probably not.  We sensed some real selling pressure at the end of last year, with the Japanese and Chinese both reducing their holdings of Treasuries.  Should the health authorities contain the coronavirus and economic activity bounce back we wouldn’t be surprised to see the yield-to-maturity of the 10-year note rise to 1.50%.  However, we do not think the Fed would be happy with such a move and could envision the Central Bank skewing their secondary market buying to longer maturities.  In this environment, where we see the potential for negative total return longer maturity fixed income, we believe that the RCM is an attractive alternative to cash, money market funds and longer term fixed income holdings.

Copyright 2021, Halyard Asset Management, LLC. All rights reserved.

November 2020 – Monthly Commentary

November 2020

It’s a paradox that as we wind down this very difficult year in which the pandemic ravaged so much of our day-to-day lives that the capital markets should close out the year on such a quiet note.  The bond market continues to benefit from the Federal Reserve’s open market buying and we have no expectation that the Fed will reduce their purchases anytime soon.  That’s especially the case given the upward pressure investors have put on 10-year Treasury note yields since early December.  The Fed continues to espouse the no inflation rhetoric citing government measures that show inflation continues to run below 2% in aggregate.  But we don’t subscribe to that view given the upwardly biased pricing we see in everyday goods and services.  Their desire to keep monetary policy excessively loose continues to benefit riskier assets as witnessed in equity prices and credit spreads. 

At the time of this writing medical professionals are administering the covid-19 vaccine to the first eligible patients and the expectation is that a third of the population will have received the vaccine by spring.  That would go a long way to returning life back to normal around the world.  But before that happens it appears we are on the precipice of another worsening outbreak.  Holiday vacations are being canceled, while politicians are mandating stay-at-home orders.  It’s hard not to be reminded of the adage ”don’t let a good crisis go to waste” as New York Governor Cuomo and New York City Mayor DeBlasio threaten ever more restrictive behavior to control the spread.  The repercussions have been sad.  The hustle and bustle of the holidays in New York are non-existent.  On a recent Sunday visit to midtown the sidewalks of Fifth Avenue were sparsely populated, an about face from the typical holiday weekend in New York where it is usually so crowded that passage becomes nearly impossible.  To compound that misery, restaurants in the city are now closed to all indoor dining.  The economic effect is once again likely to be terrible for the region.  We expect that fourth quarter Gross Domestic Product, when it’s released next month is likely to suffer another big downdraft versus the second quarter.  There is hope that Congress, after months of haggling, will finally pass a relief bill to support the millions of workers who are again being thrown into unemployment.  However once that aid is flowing it will need to be funded by even more government debt.  That additional debt which will need to be sold to investors that have shown signs of balance sheet indigestion.  To avoid an unwanted spike in yield the Federal Reserve will need to further expand their balance sheet to absorb the additional issuance.

This year has been trying on all of us and especially on those that were not able to survive the virus.  But the hope is that the vaccine is successful in eliminating the virus and the worldwide economy will return to its normal upward trajectory.  Then it will be the Federal Reserve’s mission to return the Central Bank back to a state of normalcy.  How they achieve that is anyone’s guess.

Copyright 2020, Halyard Asset Management, LLC. All rights reserved.

October 2020 – Monthly Commentary

October 2020

Since our last monthly update we have seen the Presidential election mostly come and go, have seen the coronavirus cases spike, and have learned of two successful vaccines.  The country is split in terms of satisfaction with the outcome of the election, but investors are looking past the surge in the virus to the potential endgame the vaccines present.  That optimism is reflected in the performance of the S&P 500 index.  Year-to-date the Index has generated a total return of 13.5% at the time of this writing.  It seems investors are anticipating that the economy will return to the growth it was experiencing this time last year, before anyone was locked down and working from home.  Surely there is pent up demand for travel and leisure activities.  However, there is still an outsized number of people out of work and with the recent uptick in cases we can likely expect that number to climb further. 

The Federal Reserve continues to verbally assure the public that they will keep monetary policy and interest rates at ultra-stimulative levels even after growth returns.  However, in doing so, they stimulate merger and acquisition demand which is supportive of equities.  Similarly, the ultra-low rate environment does not deter corporations from the practice of selling debt to buy back shares in their outstanding stock, as they’ve done since the Fed first cut rates in 2008.  However, it seems to us that in addition to the institutional stock purchaser driving prices higher, so too are retail investors.  Never before has equity trading offered such a level playing field.  The traditional stock brokerages have driven the cost of buying and selling shares close to zero.  In addition, newcomer Robinhood Financial, charges zero commission and offers tutorials to novice traders.  These novices trade stocks based on concepts and rumors, turning a blind eye to valuation.  Examples abound of stock prices trading at absurd Price/Earnings multiples simply based on a hope.

One that comes to mind is Tesla.  Tesla, as everyone knows, was the first mover in the now booming electric vehicle market.  They sell an attractive vehicle that owners seem to love.  However, Tesla trades at 183 times expected 2020 earnings and the carmaker is just barely profitable.  The Tesla shareholders point to the growth potential should everyone ultimately move to an electronic vehicle, which is a valid point.  But Tesla is no longer the sole occupant of the electric vehicle space.  In fact, every major auto manufacturer has an electric vehicle in their product offering.  Even General Motors plans on rolling out an electric Hummer in the near future.  But with CEO Elon Musk holding an outsized position in the stock, it’s difficult to short as short sellers have come to realize time and again.

The “Robinhooders” have applied the Tesla story to the Chinese car manufacturer NIO.  NIO traded at $4.02 a share at the start of the year, but its price has skyrocketed this year, recently trading as high as $50 a share.  The investment thesis is that NIO will become the Tesla of China and with it will come a similar valuation.  That’s despite losing well in excess of $1 billion a quarter since they began operation in 2017 and expect to incur losses for the foreseeable future.

The point is not to pick on Tesla, NIO or even the Robinhood traders; it’s to point to just a small sampling of what has become a large bubble in stock prices.  When stock prices are rising, it’s easy for the retail traders to believe that they will rise forever.  However, when prices correct, and enter a bear market, it’ll no longer be fun for retail traders to participate.  The Fed should take note of the retail stock trading and start to plan for an exit from ultra-stimulative monetary policy.

Copyright 2020, Halyard Asset Management, LLC. All rights reserved.

September 2020 – Monthly Commentary

September 2020

The bond market was little changed in September as investors grappled with continued virus uncertainty and traders with school-aged children tried to figure out the logistics of educating their young.  The latter issue made for uneven liquidity during the month which may have factored into the performance of the stock market.  For the month, the S&P 500 was down -3.91% breaking the string of consecutive positive months that extend back to April.  The performance of the bond market for the month was lackluster with the 10-year Treasury Note falling 1.5 basis points for the month.   

The end of summer has done nothing to clarify the uncertainty surrounding future earnings, as the contentious Presidential contest drags on.  Current polling has Joe Biden leading President Trump, but such an outcome is not a certainty.  Should Biden be elected President, it’s not clear who he would appoint to his economic team.  Senator Elizabeth Warren and Fed Governor Lael Brainerd have been floated as the potential Treasury Secretary.  The former is viewed by the consensus as being decidedly anti-business, while the latter would be viewed as a more balanced policy maker.  The ultimate choice will be tasked with continuing to support the economy despite the enormous challenge the virus poses.

That challenge has driven the Federal Reserve to become dovish in a manner never before witnessed.  Chairman Powell has abandoned any hint of being apolitical, having jointly testified before Congress with Treasury Secretary Steve Mnuchin, with the message that the lawmakers need to approve additional stimulus to avoid a continued economic downturn.  Granted, given the outsized unemployment rate and a near closure of the travel, entertainment, and hospitality industries, supplemental stimulus is warranted.  But there is no mention of how much money has already been spent.  The Fed’s balance sheet has ballooned to over $6 trillion as they continue to buy Treasury notes and bonds in the secondary market, with no end in sight.  Moreover, the various Fed Governors along with the Chairman have pledged to continue to do so for the foreseeable future.  Long gone are the days when Alan Greenspan said “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant.”  Back then, the Fed was staffed with monetary hard and soft liners that, by today’s standards, differed in policy thought in only a nuanced way.  Today, to the last one, members of the Fed are decidedly dovish and are not shy about vocally professing their panic over economic growth.

The excessive dovishness is reflected in the value of the U.S. Dollar which has been in a down trend since March.  That market, like the S&P 500 is being influenced by the Fed’s ultra-loose monetary policy.  From a fundamental perspective one would think that the dollar would maintain a stable value versus our major trading partners, especially given the worsening virus outbreak in Europe and the unresolved “Brexit” issue.  Also benefitting from the easy money policy is gold.  After correcting from its March low, gold has renewed its upward moment and looks likely to challenge the $2,075 high hit last summer.  Regardless of the outcome of the Presidential election, easy money is unlikely to end any time soon.

Copyright 2020, Halyard Asset Management, LLC. All rights reserved.

August 2020 – Monthly Commentary

August 2020

As we close out summer and the final month of the third quarter, the bond market has been relatively stable compared to the bipolar volatility of the stock market.  Earlier this month, stocks suffered an unexpected downdraft after rising steadily from the March low.  Speculation is that a sizeable Asian-based hedge fund had bought call options on a number of the largest tech equities.  To hedge the sale, the counterparties bought the underlying stocks and inadvertently created a virtuous circle of buying.  Once the hedging was complete, sellers stepped in to take advantage of the unexpectedly attractive prices.  While difficult to quantify the size of the trading, judging by the run up in stock prices and measures of option value, there seems to some inkling of truth to the theory. 

What’s certain is that the bond market has been relatively range bound.  The yield-to-maturity on the 10-year note has traded between 0.80% and 0.50%, while the 30-year bond has fluctuated between 1.50% and 1.25%.  We get the sense that traders would like to see interest rate move higher, but the Fed bond buying program is keeping that from happening.  The Fed continues to plow $80 billion per month into the secondary market for Treasury bills, notes, and bonds.  In addition, they have also been buying corporate notes both directly and through Exchange Traded Funds.  However, they’ve been buying the latter at a much smaller pace, and over the last month they haven’t bought at all.  While they may have paused the program, we suspect that they will put it back to work when the stock market suffers from the next meaningful swoon.  As in the most recent episode, by supporting corporate bonds, the Fed is able to avoid having panic spread through the capital markets.  Although, as with most Fed programs, the action artificially suppresses interest rates on most corporate borrowing including those companies with large cash balances.

Corporate Management is loving the ultra-low interest rates and have been issuing new debt at ridiculously low levels.  There are many reasons why the artificially low interest rates are bad policy but one of the most glaring is Apple Inc.  In August Apple issued $5.5 Billion in four tranches with maturities ranging from three years to forty years at an average cost of capital of 1.57%.  The yield-to-maturity on the three year notes was 0.55%.  Apple disclosed that the purpose of the debt was to buy back shares, a common practice among major corporations over the last decade.  What’s perplexing is that at the end of the second quarter the cash held on Apple’s balance sheet totaled $193 billion.  It’s as though they view the term structure of interest rates as a financial gift that they just can’t refuse. 

But Apple is not an isolated instance.  Year-to-date, corporate bond issuance totaled more than $1.9 trillion, more than last year’s total issuance, with much of that coming over the summer.  We expect that issuance will continue as the quarter comes to an end and into earnings season.  However, there really is no rush to issue debt as the members of the Open Market Committee have all but explicitly said that they intend to keep the overnight rate at the current level for years and have threatened to impose yield curve controls should long maturity interest rates rise.

Copyright 2020, Halyard Asset Management, LLC. All rights reserved.

July 2020 – Monthly Commentary

July 2020

This month, as previously announced, Fidelity will close their Prime money market fund after the fund suffered during the illiquidity of the Corona virus-inspired volatility experienced in March of this year.  We speculated that the decision was a business one made out of the preponderance of risk to reputation had the company been forced to support the fund.  However, we viewed the action as a one-off decision, and not one that would impact the entire industry.  It turns out that the risk posed by Prime money market funds has been on the radar of the Federal Reserve for some time.  The Fed is concerned that the Prime mutual fund structure represents a shadow bank.  The term shadow bank refers to an unregulated structure that has similarities to a bank.  The Federal Reserve tightly regulates the banking system and if they deem the money markets as a shadow bank, they are de facto indicating that they can’t control it.

Before digging too far into the implications, it may be useful to understand the evolution of Prime money market funds since the 2008 financial panic.  During the crisis there were numerous instances in which money market funds came under valuation stress as panicky investors pulled their investments and went to cash.  In the most extreme instance the largest Prime money fund, The Reserve Fund, was forced to suspend liquidations until they were able to determine which investors were owed what amount.  An obvious failure of what was considered a low risk sector of the fixed income market. The then SEC chair, Mary Jo White, implemented a new framework in which an event like that which befell The Reserve Fund would not happen again.  In doing so, they implemented a series of rules that would allow Prime money market funds to suspend redemptions under certain circumstances, for a specified period of time and under extreme circumstances impose an exit fee on existing investors.

When put in place we were immediately skeptical of the plan and believed that if investors were threatened with a suspended fund or forced to pay an exit fee they would have an even greater reason to panic under times of market stress.  It turns out we were right as witnessed in March.

What’s confounding is the Federal Reserve’s policy of ultra-low interest rates is directly responsible for the proliferation of investments in Prime funds.  In pushing interest rates to nearly zero, banks responded by paying little or no interest on bank deposits.  Historically, investors depended on a nominal rate of interest to grow their savings and deemed bank deposits as a safe way of doing that.  To be clear, when we refer to savers, we’re not just speaking of “Mom and Pop” growing their nest egg.  Savers include multi-billion dollar corporations growing their accumulated earnings.  If the bank is not going to reward savers with any interest, it’s only sensible that the savers will look to an alternative, and prime money market funds represented an attractive alternative.  The funds have varying degrees of risk based on their stated mandate, but in the simplest form the investment manager buys short maturity fixed income instruments and collects the interest.  As money flows into the funds, the manager buys securities and as investors redeem the manager sells those securities back to one of the brokers from whom they originally bought them.  The Fed has no control over the management of those portfolios, and in March when investors redeemed, fund managers such as Fidelity struggled to raise the needed cash to meet those redemptions. 

That begs the question, is the Fed correct in their assumption that money market funds are actually shadow banks and they should be regulated?  The answer is not so simple.  We’d argue that the flaw in Prime money market funds is that so many of the funds are poorly managed.  In an attempt to generate top performance in their category the fund managers are motivated to invest in the highest yielding notes they can buy.  Since the financial panic of 2008, the highest yielding investment grade paper has been issued by European and Asian banks.  The credit risk for those entities is arguably greater than U.S. banks.  During times of heightened volatility, the demand to buy that bank paper falls as does the price a counterparty is willing to pay to assume the risk.  Exacerbating the problem was the fact that the Prime funds held large undiversified holdings of the European bank paper.

One cannot be faulted for agreeing with the Fed that some control or elimination of the prime market is the obvious solution, but we disagree with that conclusion.  The Reserve Cash Management (RCM) strategy that we manage is a direct competitor with Prime money funds.  The big difference is that we build the portfolios to be broadly diversified and with high quality credits and view short term performance as a secondary mandate.  We’ve been through several panics and in each case the RCM has performed quite well because of that management style.

Finally, the Fed’s wish that Prime money market funds would go away isn’t entirely motivated by a need to reduce risk.  Especially considering that the ever growing, deficit-induced government bond market needs to be financed.  The more than $1 trillion invested in prime money market funds assets would go a long way to financing that amount.

Copyright 2020, Halyard Asset Management, LLC. All rights reserved.

June 2020 – Monthly Commentary

June 2020

In the decades that the Halyard team has been managing the Reserve Cash Management (RCM) strategy we’ve explained that the goal of the RCM is to outperform the money market universe while avoiding the downside risk the universe has demonstrated on occasion.  We endeavor to accomplish that through security selection, believing the mistake of so many investment advisors have made has been to focus investment in the highest yielding securities, turning a “blind eye” to the underlying credit quality of the issuer.  That job has become especially challenging since the financial crisis of 2008.  As of late we’ve seen two views of risk.  The first is the sudden, unforeseen risk like that which occurred in mid-March.  The second is the slow deterioration of corporate credit quality that has occurred in recent years as companies sold debt and used the proceeds to buy their stock in the secondary market.

The first risk appeared in mid-March as the global population came to terms with the Covid-19 virus and the economic impact of sheltering in place.  As with other instances of short term panic, investors dumped risky assets in favor of U.S. government debt.  The Halyard RCM portfolios suffered a minimal mark-to-market loss which was quickly reversed in April.  Other firms did not do nearly as well and were forced into the embarrassing situation of having to borrow dollars from the Federal Reserve to meet the redemption needs of panicky investors.  The Fed, realizing that the secondary market for lesser quality credits had become impaired, implemented programs to rectify the illiquidity, which it did.  But not before the damage was done.  The most noteworthy victim of the risk off trade is mutual fund giant Fidelity.  Fidelity said last month that they intended to close two Institutional Prime money market funds effective August 14.  We’ve been especially critical of the largest prime money market funds given their penchant for holding lesser quality securities to boost the current yield of their funds.  Specifically, their allocation to European and Asian banks.  A sector that we categorically avoid and continue to do so.  The European and Asian banks have a riskier profile than their U.S. counterparts and offer a higher yield to compensate for that fact.  With the portfolio manager assuming that no such risk exists, will likely conclude that he will be able to best their competition by that incremental yield year in and year out.

However, during times of financial stress, when portfolio managers want to offload that exposure, they often find that no counterparty wants to take on risk during a crisis.  In that instance, the out-performance goes out the window when the manager is forced to sell out of favor issues at a Draconian discount to the market.  It seems that this is the logic of the funds closing their prime money market funds.  While they have not said so directly, one could easily deduce that management came close to having to gate their prime funds, which would have been a huge reputational “black eye” for the giant.  Following on with the deduction, after the Fed stabilized the market and the risk of gating had passed, it’s likely that management concluded they would never again face such an outcome by terminating the funds and returning the capital to investors.

The second risk discussed is the deterioration in credit quality of the broad market through balance sheet arbitrage, the practice of borrowing in the bond market and using the proceeds to buy back stock.  With interest rates so low, the cost of the arbitrage was manageable and if management was successful in driving their stock price higher, they would enjoy the double edged reward of the company stock price appreciating (directly benefiting their stock options), and the ability to justify their outsized pay packages.  The risk to the strategy is that the company finds itself in the situation where their debt has become unmanageable and the ratings agency have dropped their credit quality to just above junk. 

At Halyard, we take credit analysis as our first and foremost building block of portfolio construction and are willing to forgo a few basis points as we seek to build a portfolio.  We believe that philosophy can compete and outperform other similarly styled investments but still have the confidence to weather the next storm. 

Copyright 2020, Halyard Asset Management, LLC. All rights reserved.

May 2020 – Monthly Commentary

May 2020

The Reserve Cash Management composite continued to enjoy the benefit of spread tightening in May, generating a total return net of fees of 0.36%.  The characteristics of the composite changed little from the prior month and the average credit rate is A+.

The Federal Reserve executed their lender of last resort function brilliantly.  That is until the June 10th post-FOMC press briefing.  Prior to the meeting, the Fed had successfully engineered a comeback in stock prices, much to the dismay of institutional investors and hedge funds, that missed the rally.  We previously outlined the steps the Fed has taken to date, with the most recent policy change coming to the Main Street Lending Facility announced just days ago.

What spooked the market on June 10th was the Summary of Economic Projections (SEP), also known as the dot plot.  The forecast presented a unanimous view that the Fed would not need to raise the overnight interest rate until at least 2022, with several members believing that the current Fed Funds rate will remain in place well into 2022.  For better or for worse, market participants believe the Fed has superior information in terms of what’s going to happen in the market.  The logic flowed that if the Fed sees interest rates unchanged for the next two years, then the state of the economy must be worse than had been feared.  The rally in the stock market over the last six weeks has been premised on the United States being close to ending the shelter-in-place policy and a corresponding rebound in economic activity.  With that belief, analysts were upgrading their earnings forecasts and the hope that higher stock prices were justified.

To compound the unwelcome forecast, Chairman Powell did little to calm investors as he addressed the media.  Unlike his predecessors, Chairman Bernanke and Chair Yellen, Powell has developed a reputation as a commanding, inspiring speaker.  However, that man didn’t show up for the press conference.  He waffled on how long interest rates would stay at current levels and what in the economy would prompt the committee to change their mind.  Granted, asking an economist to answer questions on a Covid-19 virus is not entirely fair.  Moreover, the zoom-like social distancing format for the press conference likely caused him some unease.  The format, like the last, had journalists calling in from remote locations resulting in some difficult to understand audio and caricature-like broadcast of the participants.

Also concerning to us, but seemingly lost on the general market, is the Fed’s consideration of yield curve control.  The concern is that the as the economy normalized, interest rates would rise and that could impair any nascent economic revival.  Investors suffered through a similar occurrence in May 2013, in what has been dubbed the “taper tantrum.”  To avoid a recurrence, the Fed is considering establishing a predetermined level at which it would step in to suppress rising interest rates.  As with so many of the Fed ideas for managing the economy, they seemed to be contrived without adequate thought as to what will happen when they need to be reversed.  Recall, the Fed has the dual mandate of full employment and stable inflation.  By definition, yield curve management by capping interest rates further limits the Fed’s ability to tackle inflation should it arise quickly. 

Initially, stocks reversed from their high of the day, but after sleeping on the news, investors decided their pre-meeting assumption that activity would bounce back was wrong.  On the day after the meeting, the S&P 500 plunged more than 4%, with the Bank and Finance sector falling nearly 10%.  It will be interesting if equity investors again climb the wall of worry emboldened by the belief that the Fed will bail them out if economic circumstances disappoint.

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