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This blog post was initially published on 18 April 2024. It has been edited to include market index data.
The 2-year Treasury yield shot up 23 basis points on 10 April after another higher-than-expected inflation print. An increase of that magnitude has only happened 13 times since the year 2000—a period of nearly 9,000 days. The Fed’s forward path is hardly certain, but for now, the market has ratcheted down and pushed out rate cut expectations. We think it is an opportune time to consider cash flow generating strategies that can capitalize on the currently higher yield levels to address near-term liquidity needs.
Nobody wants to be a forced seller
A cash flow generating portfolio can look very similar to a traditional fixed income strategy. The primary difference is that a cash flow generating strategy endeavors to choose bonds whose anticipated cash flows align with upcoming liquidity needs (e.g., pension benefit payments, expenses, spending needs). Certain investors—from corporate, public and Taft-Hartley plan sponsors to endowments and foundations and prepaid tuition plans—know it is difficult to adjust near-term benefit payments or spending needs in the face of a challenging market. For example, a pension plan needs to pay monthly benefits regardless of the environment, and endowments and foundations are often committed to long-term spending plans. Incorporating a cash flow generating structure can help investors looking to establish a reliable source of incoming cash flows without needing to be a forced seller and transact when bid-ask spreads may be unfavorable.
Furthermore, as institutions continue to increase allocations to illiquid private investments, we believe it is especially critical for investors to remain vigilant about near-term cash outflows. For example, in a market selloff, the “denominator effect” can cause illiquid investments to become a larger portion of assets, shrinking the portion that can be used to meet cash needs.[1] A cash flow match strategy is designed to allow improved flexibility in terms of the liquidity burden.
Potential cost-benefit
Perhaps most critically, we believe the “opportunity cost” of investing in short-term fixed income is currently low. As the chart below indicates, current yields for short-term US Treasury indices were at levels approaching or above 5% as of 10 April 2024. Market indices of short-term high quality corporate bonds show approximately 55-65 basis points of additional yield, which, in our view, offers an attractive tradeoff versus potential risks (primarily default risk in a typical cash flow generating structure). We also believe these market yields illustrate how a short-term fixed income portfolio could be competitive with a public equity portfolio (based on publicly available industry-wide capital market assumptions[2]) with significantly less assumed volatility. If and when the Fed begins cutting, this phenomenon may fade.
Toeing into cash flow strategies
Cash flow generating strategies do not have to be an all-or-nothing proposition. We stress that a cash flow strategy does not necessarily need to satisfy 100% of expected payments over a specified period. Investors who want to seize on higher yields may choose to establish a modest cash flow generating strategy initially as a way to gain comfort with the mechanics and structure. Over time, when the yield environment is perceived as favorable, they can add capital and replenish cash flow matching accounts. In our view, it’s an approach worth considering while the window of opportunity remains open.
[1] The denominator effect refers to when a portfolio allocation, designed to meet certain cash flow needs, goes out of balance. In such an instance, a market selloff reduces the value of the portfolio’s publicly traded securities while the valuation of its private investments remains unchanged. As a result, the target allocation intended to meet cash flow needs is disrupted.
[2] Sources: https://am.jpmorgan.com/us/en/asset-management/institutional/insights/portfolioinsights/ltcma/ltcma/
https://www.blackrock.com/institutions/en-us/insights/charts/capital-market-assumptions
https://www.verusinvestments.com/wp-content/uploads/2023/12/2024-Capital-Market Assumptions.pdf
https://www.capitalmarketassumptions.com/
Market conditions are extremely fluid and change frequently.
Past market experience is no guarantee of future results.
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This blog post is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Information, including that obtained from outside sources, is believed to be correct, but Loomis Sayles cannot guarantee its accuracy. This material cannot be copied, reproduced or redistributed without authorization. This information is subject to change at any time without notice. Market conditions are extremely fluid and change frequently.
