The October issue of our Bond Fund Intelligence newsletter features an interview with Rich Mejzak, Managing Director & Portfolio Manager at BlackRock, who manages the company's Short Obligations Fund and some other short duration strategies and separate accounts. Mejzak tells us that while many conservative ultrashort portfolios may have underperformed their more aggressive peers the last few years, they are poised to outperform in a rising rate environment. He says, "We believe we are approaching market conditions that will make this fund more attractive on a comparable basis." Here is a reprint of the interview, which was originally published Oct. 14. (E-mail us at info@cranedata.com to see the full most recent issue of BFI.)
BFI: How long has BlackRock been running short-term bond funds? Mejzak: BlackRock has been involved in short term bond funds for a long period of time. However, our approach to short term bond funds focusing more on preservation of principal and liquidity came to fruition in late 2012 when we officially launched our Short Obligations Fund. We recognized that the short term bond space is very broad, and that the differences in prospectuses, guidelines and yields can vary greatly. Our goal is not to compete necessarily on a yield level, but more on stable NAV, preservation of principal, and liquidity.
We view the Short Obligations Fund more as the next step out from money funds. It is managed on the same desk that we manage our money market business and our separate accounts that have similar strategies. Although the underlying securities and some of the parameters of the fund themselves are very similar -- whether it be average duration, spread duration or even the tenor of the assets that we're buying -- the design of the investment strategy overall is to be the next step out from money funds, and not necessarily a high yielding, total return bond fund.
BFI: What is your background? Mejzak: I joined BlackRock in 2006, following the merger with Merrill Lynch [funds]. At Merrill, I was in a similar role and have been focusing on everything 'non-2a-7' cash at BlackRock. Since joining, I have been co-portfolio manager of Short Obligations Fund since its inception in 2012. In addition, I have been co-manager of our ETF, ICSH. I also manage the team that services and invests on behalf of our separate account clients, whose highly customized cash investment needs require dedicated resources.
BFI: How has the growth been in the separate accounts business? Mejzak: We have a fairly large presence in the liquidity separate account space, as well as in the short duration/enhanced cash separate account world and are seeing increasing levels of interest. That investor base is most concerned about using [these] as a liquidity vehicle. Once you get out to 1-year average duration, we think the audience is much broader, and is often seeking a variety of different outcomes. We believe there are two ways to approach it: 1) more NAV stability and preservation of principal; and, 2) more from a total return perspective. So we have a team in New York that concentrates on short duration, but with a higher degree of total return focus, and our team here in Philadelphia manages in a more conservative fashion, focusing on stability or principal.
One of the main distinctions is the assets that we're buying. We invest with the assumption that everything must be made or could be made liquid in one day's time. As such, even though the investment guidelines might be very broad, the assets we actually invest in are, most times, much more restrictive. As an example, guidelines will normally just allow triple-A ABS with an expected maturity of inside of 3 years. However, we normally limit our ABS exposure to only what we believe to be the most highly liquid -- credit cards, prime auto loans, and, occasionally, equipment.
The advantage is that a separate account doesn't need to hold 10% overnight and 30% one-week liquidity like a 2a-7 MMF. Assuming in today's interest rate environment that yield will be close to zero, that's an immediate 5-7 basis point pickup with identical guidelines. Then all you need to do is broaden the investment parameters just a little by adding some A-2, P-2s or expanding the average duration to 90 days and, in most cases, you're able to deliver 15 to 20 basis points more in incremental yield.
BFI: What are some other "sweet spots"? Mejzak: Supply has been one of the key market drivers in the front end over the last couple of years. Clearly, as the supply of most money market asset classes has shrunk over that time period, one area that has actually grown is the Tier-2 Commercial Paper sector. That is certainly one of the opportunities that we've been looking to capitalize on in this type of strategy. These [names] also allow for greater diversification away from financials, as many of those A-2, P-2 issuers are normally industrials.
Also, a byproduct of money fund reform has been that the credit curve has moved in. As money fund investors ready for [reform] implementation in October 2016, we're discovering that most fund providers, including ourselves, are repurposing funds well ahead of that date. The bid for credit for money funds which used to go out to 13 months, has shortened significantly -- in most cases to 6 months, and sometimes to even as short as three. We believe that these products -- whether it is a separate account or short term bond fund -- in today's marketplace, can deliver meaningfully more yield with only taking much smaller increments of increased risk vs. a comparable money fund. Generally speaking, our goal is to provide excess return over money funds with limited additional risk.
BFI: Do investors use these in tandem with money funds? Mejzak: While some investors will use this as their liquidity vehicle, we believe that going forward the concept of bucketing cash will become even more critical. These products, we believe, solve the bucket of cash not necessarily for daily operating cash, but more the bucket of cash where there would be either weekly or monthly cash withdrawals. We think investors recognize that as prime institutional money market funds adopt floating NAVs as part of reform a new paradigm emerges. If they are going to consider a product that has a floating NAV, it is perhaps most advantageous to take the next step into one of these products that will offer them: 1) more yield, and, 2) no liquidity fees and gates.
BFI: What is your investment strategy? Mejzak: The short term bond fund universe is very broad, and our offering falls on the more conservative side of that. Over the last 2-4 years, with interest rates extraordinarily low and credit spreads so tight, most of those more aggressive products have outperformed. Most 'riskier' asset classes have outperformed the safer ones. It is our expectation that going forward, as interest rates begin to rise and credit spreads become more volatile, at some point the products in the short term bond universe with riskier parameters will experience more volatility. The short obligations products invest in no high yield, no currency, no non-dollar securities, and with a 185-day WAM and a 1-year WAL, we don't have the ability to own too many 3-year securities.
BFI: Does the product fill a gap? Mejzak: There were several motivations for launching the product in 2012. One, in anticipation of zero rates for a long period of time, we thought there was a gap in product offerings and we needed something to offer more yield than money funds. Second, we recognized that money fund reform was imminent and would likely involve, to some degree, floating NAV. So we thought that in the longer term, this offering would be sustainable going forward as a complement to money funds. Lastly, we wanted to be able to establish a track record of providing a stable NAV. At this point we believe that we have achieved all of these. However, the strong performance of more aggressive funds in this space has challenged the attractiveness of this product. But we believe we are approaching market conditions that will make this fund more attractive on a comparable basis.
BFI: Have investors been bucketing their cash in preparation for reforms? Mejzak: Our experience has been that most investors are not being proactive in bucketing cash or moving money away from prime money funds. Most providers are repurposing funds well in front of that date. [But] we believe this will be a first and second quarter 2016 event where the assets that are expected to be in motion will be in motion. While many potential clients have explored the idea of either separately managed accounts, Short Obligations, or similar products, we believe that the impetus for them to actually move will occur well ahead of October 2016.
BFI: What is your outlook for rates? Mejzak: We believe that higher rates will bring higher volatility, and with that there is the opportunity to deliver more yield. The positioning of this type of product will be most important to strike the balance between incurring enough risk, yet not too much risk, to endure the market volatility that we anticipate. That is why we have chosen to approach this product the way that we have, which has been very conservative since its inception. It has underperformed most of its peers on a yield basis since then, but I think that limiting curve exposure and limiting exposure to asset classes that we would expect to be most volatile is going to be critical in a period of rising rates. While we expect that trajectory of higher rates to be slow, we do think that the two to three year part of the curve could become vulnerable.
BFI: What are your expectations for the future of this ultrashort space? Mejzak: The space is so broad that there will be winners and there will be losers, depending upon positioning and what that investment environment brings. Providers are trying to provide many different solutions, but selecting the right strategy and, most importantly, executing the right way is going to be most important. Depending upon how a product is managed, there will be ones that have a huge degree of success and ones that will not have any success at all. We think it's important to commit to one strategy, the strategy that you think will be most successful going forward and most appropriate for the interest rate cycle. This is the product and the strategy that we believe will perform best in the environment that we anticipate.
