Payden & Rygel: The benefits of a low duration investment strategy

Oct 21, 2024

 

What exactly are low duration or ultra short investment strategies, and how do they differ from traditional money market funds?

Low duration strategies, also known as short duration, enhanced cash, or enhanced income strategies, offer investors the potential to earn more than traditional money market funds or cash deposits. These strategies broaden the investable universe in two key ways.

First, low duration strategies can invest in bonds with maturities as long as five years, compared to the 397-day maturity limit on money market funds. This gives them the potential to take advantage of price appreciation as interest rates fall—something money market funds cannot do as effectively.

Second, low duration strategies can invest across the fixed income universe, from riskless assets to corporate and structured credit. This diversification allows for greater return potential while still maintaining liquidity.

Can you explain the risks associated with low duration compared to money market funds?

While low duration strategies offer higher return potential than money market funds, they come with slightly more volatility due to longer maturities and the inclusion of credit. However, the investments remain short-term enough to limit risk, especially as bonds quickly approach maturity and their prices 'pull to par' helping to stabilize returns.

By its nature, a low duration strategy must be liquid. However not every security holding needs to be available to function as liquidity. Though money market securities have less price risk and lower trade costs than corporate bonds, both can be sold to generate liquidity. Active management ensures that portfolios are structured to maintain liquidity while seeking opportunities for higher returns.

Payden offers several low duration strategies. What differentiates them?

Payden & Rygel’s Low Duration Strategy team is generally thought of as encompassing two strategy solutions: Enhanced Cash and Low Duration. Both aim to outperform passive cash strategies, but they differ in their benchmarks and duration profiles:

Enhanced cash is the first step beyond money market funds, with a duration typically under 0.75 years and spread duration under 1.25 years. As a result, volatility is low and liquidity is exceptional.

Low duration is the next step out. Duration is typically between 1.50 to 2.50 years and spread duration is between 1.25 to 2.50 years. Volatility is higher than in an enhanced cash strategy but remains low relative to a Core bond strategy. And again, active management looks to minimize the volatility over time.

Many clients employ a mix of both enhanced cash and low duration strategies, as they look to put longer term reserve cash to work in a low duration strategy. Within the strategy, we offer unique and customized approaches to fulfil our clients’ investment objectives.

How does a low duration strategy differ from other fixed income strategies?

Low duration strategies are for investors who want a balance of liquidity and moderate returns with lower risk, while Core bond strategies are for those seeking higher returns over the long-term but are willing to take on more volatility.

Low duration strategies are positioned between the safer world of money market funds and the more volatile space of Core bond or credit-only strategies. While they carry more risk than money market funds, they have much lower volatility and duration risk compared to Core bond strategies.

With interest rates trending lower, what key factors should investors consider when seeking higher yields?

The Fed is cutting its Federal Funds rate to return interest rates to a neutral level, but this affects very short-term securities first. You will see the greatest impact on securities with zero to three-year maturities.

This means that money market fund yields will fall rapidly as the Fed lowers rates. However, low duration yields will not decrease as quickly. By investing a portion of their cash in longer-duration bonds, investors can lock in higher yields further out on the yield curve.

Clients can customize the amount of duration or spread risk they wish to tolerate through guidelines. The broader these investment guidelines, the more opportunity they have to earn higher long-term returns (along with some additional volatility) than a money market fund.

What are the main sources of returns for your strategy?

Returns in a low duration strategy are primarily driven by sector allocations. Investment grade corporates and structured credit are integral parts of the portfolio. We invest in debt ranging from zero to five years in maturity, with both fixed rate and floating rate coupons. Diversification guidelines limit our exposure to any single issue (except in government bonds). We actively manage credit exposure, selling securities when changes in their valuations or fundamentals make
it necessary.

This multi-sector approach seeks to provide multiple sources of return and allows us to improve risk-adjusted performance across a variety of market environments.

What trends do you foresee in the low-duration investment space as interest rates continue to trend lower?

Currently, over $6 trillion is sitting in money market funds—an increase of $1.5 trillion since the start of the pandemic. We expect that as the Fed continues cutting rates, between $1 and $2 trillion of this cash could move into higher-yielding investments like low duration strategies, as investors seek better returns.

Recent regulatory reform governing institutional prime money market funds will make it more challenging for prime funds to outperform government funds. Some of the largest institutional prime funds have already either converted to government only or closed the fund entirely. For investors looking for returns beyond government yields, low duration strategies provide opportunities.

Why partner with Payden & Rygel for a low duration strategy?

Payden & Rygel has specialized in customized cash management solutions for over four decades. Although we have expanded to many other fixed income strategies as well as equities, cash management remains a core part of Payden’s business. Over 50% of the firm’s assets under management are invested in low duration strategies.

Our deep experience in this area allows us to create customized cash solutions tailored to our clients’ liquidity and investment objectives. Moreover, our long-term relationships with brokers enable better access to liquidity in challenging markets.