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.
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