With the Federal Reserve pushing short-term rates to near zero in their bid to prop up markets and the broader economy, high-quality “cash-like” investments have seen dramatic drops in yields. While 3-month T-Bills were trading around 2.5% yield in mid 2019, they are currently yielding just 0.10% – a drop of 96%. In this article we take a look at a number of options to risk-free short-term investments at investor disposal. These options are not risk-free but they also do not require sizable risk outlays.
Why Being In Cash Is Particularly Unattractive
To get our bearings, let’s take a look at the popular ultrashort fund iShares Short Maturity Bond ETF (NEAR), which we use as the benchmark for the Ultrashort sector in our Sector Framework. The fund has seen a 66% drop in distributions from its 2019 peak level – a figure that far exceeds anything across other fixed-income sectors. Its distributions are back to pre-2016 levels when short-term rates were nailed down to a near-zero level.
Source: Systematic Income
Apart from the absolute level of short-term rates, there are two other indicators that show why the opportunity cost of being in short-term risk-free rates is particularly high.
First, the difference between high-yield bond and T-Bill yields is at elevated levels relative to the last 5 years. Investors are giving up over 5% in yield by moving into cash. Prior to the drawdown that figure was closer to 4% – indicating a lower opportunity cost.
Source: Systematic Income
Secondly, there is a dislocation between short-term rates and the level of inflation. Inflation expectations have recovered after collapsing earlier in the year and are trading around 1.5% above short-term rates. This means that by virtue of being in cash, not only are investors earning close to zero but they are also losing around 1.5% in real terms because cash rates are, arguably artificially, anchored around zero.
Source: Systematic Income
Both of these trends make it increasingly painful to remain in risk-free short-term rates.
In the sections below we take a look at ways that investors can generate higher yields without taking on sizable risk.
Take Some Corporate Credit Risk
The larger and more popular ultra short-term funds generate additional yield above the risk-free rate by moving out the credit curve into investment-grade corporate and securitized credit.
For example, the popular PIMCO Enhanced Short Maturity Active ETF (MINT) holds a barbell portfolio with a third of the portfolio in secuities rated AA and higher and 20% of the portfolio in securities rated BBB. The iShares Short Maturity Bond ETF (NEAR) follows a similar strategy. The JPMorgan Ultra-Short Income ETF (JPST) takes a bit more credit and duration risk while staying within the investment-grade space. The SEC yields of these funds is broadly similar at around 0.5-0.75%.
These funds have seen drawdowns of around 3-10% this year and have positive year-on-year returns of 1-2%. JPST looks relatively attractive based on its 1.1% current yield, the smallest drawdown of the three funds, the lowest fee and the highest year-on-year return.
Take AAA CLO Risk
The AAF First Priority CLO Bond ETF (AAA) allocates to AAA-rated USD denominated CLO tranches with a 25bp fee and is the first ETF of its kind. The fund has only recently started to make distributions and the first distribution reflects a partial accrual period.
According to Palmer Square, the yield of AAA-rated CLOs as of September month end was 1.48%. The fund’s SEC yield of 1.21% ties out well against this figure and its fee. This is about twice the figure we see from the diversified ultrashort ETFs above, despite a higher rated portfolio.
One advantage of debt CLO tranches is that they don’t carry duration risk though they do have credit spread duration which add a bit of volatility to the product.
AAA CLOs saw a drawdown of about 4% in March, going by Palmer Square month end figures though intra-month the picture is likely to be worse. We know that around $2bn of AAA CLOs traded at 90 cents on the dollar at the worst of the crisis and some tranches likely traded down to mid 80s.
Source: Systematic Income
This doesn’t compare all that well to the diversified ultra-short credit funds, however, this speaks to the lower liquidity and transparency of these products rather than their fundamental resilience.
Historically, rated CLO tranches have performed quite well. Keep in mind this does not incorporate equity tranches, as they are unrated. The default rate in investment-grade CLO tranches has been miniscule and as far as AAA tranches no US or European tranche has ever defaulted, according to S&P.
Source: S&P
Take Short Maturity Muni Risk
Investors who are not comfortable with either linear or structured corporate credit risk may find target maturity muni ETFs attractive. Invesco and BlackRock both offer ETFs with bonds maturing around a given year across a number of different credit sectors. Muni ETFs are shown as orange dots in the following chart with the near-maturity ETFs highlighted in red. The yields on the y-axis are the SEC-equivalent yields calculated as portfolio yield-to-worst less the fund fee. Though yields of less than 1% may not look attractive, keep in mind that the tax-equivalent yields would be quite a bit higher.
Source: Systematic Income
For example, the Invesco BulletShares 2025 Municipal Bond ETF (BSMP) has a yield-to-worst net of fund fee of 0.73%. Because the yield-to-maturity is well above the yield-to-worst at 2.14%, it is entirely possible that the final yield will end up being a bit higher if issuers fail to refinance in the most efficient manner. The fund does have some duration risk, which may not look appealing in an environment of growing deficits, however, this is less of an issue if the fund is held to termination. About 83% of the portfolio is investment-grade rated with the rest not rated. Historically, investment-grade munis have had an annual default rate of 0.10%.
Take Equity Tail Risk
A number of CEFs have issued preferred shares as a way to source leverage. The Investment Company Act of 1940 requires CEFs to maintain at least twice as many total assets as the preferred stock liquidation preference in order to carry on business-as-usual. However, some funds maintain very high asset coverage ratios making it extremely unlikely that the level of their assets will drop below the preferred share outstanding amount, even in a serious drawdown.
The Gabelli Dividend & Income Trust, 5.375% Series H (GDV.PH) has a 3.17% yield-to-worst and 5% stripped yield with 734% asset coverage, requiring a drop of more than 86% in order to have fewer total assets than the liquidation preference of the preferreds. GDV had a NAV drawdown of 43% this year – quite a bit higher than the S&P 500.
Ellsworth Growth and Income Fund (ECF.PA) has a 1.83% yield-to-worst and 4.99% stripped yield with 679% asset coverage which requires a drop of more than 85% in order to have fewer total assets than the liquidation preference of the preferreds. The fund had a slightly lower NAV drawdown than the S&P 500 this year.
To put these required drawdowns in perspective, since 1872 the S&P 500 had only 2 drawdowns above 50% – 85% ending in 1932 and 51% in the financial crisis. These are gross or total return drawdowns, so relative to funds that continue to make distributions these are slightly understated by comparison but they paint a pretty clear picture that principal loss of these preferreds is minimal, particularly with the Fed that has grown only more active with time in supporting financial assets through drawdowns.
High asset coverage is not the only defense mechanism of preferred shareholders. What we have seen time and time again, whether it’s equity CEFs during the financial crisis or MLP CEFs during the 2015 Oil crash or CLO equity CEFs this year is that CEF managers will do whatever it takes in order to defend preferred asset coverage. CEF managers have repeatedly reduced leverage, issued additional common shares and bought back or redeemed their preferreds. We have covered some of this ground in an earlier article.
Take NAV Risk In Deleveraging Term CEFs
Another strategy that may be slightly unusual but that can deliver a significantly higher return is to allocate to term CEFs that have already partially deleveraged. For example, the Nuveen Corporate Income November 2021 Target Term Fund (JHB) has begun to deleverage in expectation of termination and is about 15% in cash equivalents. The fund repaid all of its borrowings in June and has begun to convert its assets into cash.
Source: Systematic Income
Conceptually it makes sense to split the fund into a 85% short-term high-yield bond allocation and a 15% cash allocation. The 85% high-yield bond allocation receives the fund’s earnings yield of about 4% and its pull-to-NAV yield of about 3.55% (3.7% discount annualized from now to termination date). The 15% cash allocation receives only the pull-to-NAV yield of 3.55%.
While taking NAV risk with a “cash allocation” in a high-yield CEF may seem like the last thing anyone would want to do, the NAV volatility of the fund is actually relatively muted. The fund’s NAV volatility is mitigated by two things. First, the fund holds very short-dated bonds with maturities not much longer than its termination date of late 2021. And secondly, the fund’s current 85% allocation to bonds further mutes its volatility.
The fund had a much smaller NAV drawdown than the benchmark high-yield ETFs and that was when it was running at a significant leverage. A similar market shock would now likely result in a mid-single digit drawdown for the fund.
Source: Systematic Income
This strategy carries an additional risk. First, is that the fund’s board has a right to extend the term of the fund by six months without a shareholder vote. In our view, this is more of a risk management measure to manage any potential market illiquidity, particularly for a target term CEF (rather than a plain-old term CEF), rather than a plan to squeeze out additional fund fees.
Nuveen can also attempt to turn the fund into a perpetual CEF which would require a shareholder vote. This is certainly possible and we have seen this done by other managers such as Western Asset and BlackStone, however Nuveen has a strong track record of terminating its term CEFs. For example, it has already terminated the High Income December 2018 Target Term Fund (JHA), the High Income December 2019 Target Term Fund (JHD) and appears to be in the process of terminating the High Income 2020 Target Term Fund (JHY).
Views and Takeaways
The Fed has crushed yields on cash-like investment products. Investors who want to maintain a degree of safety without completely forgoing income can take measured risk across a number of dimensions such as corporate and securitized credit risk, short-duration muni risk, equity tail risk or low-volatility NAV risk in term CEFs. Our own approach across the Income Portfolios has been to hold both low-volatility term CEFs as well as CEF preferreds, with yields of 2-4% while offering a greater degree of safety and dry powder, which may turn out particularly useful as we head into year-end.
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