Vanguard released a new white paper entitled, "Post–money market reform: Considering trade-offs between short bond funds and institutional prime money market funds," which examines the risks and rewards of money market funds vs. ultra-short term bond funds. Authors Kevin DiCiurcio and Lucy Momjian with Vanguard Research write, "U.S. institutional investors are increasingly considering the trade-offs between money market funds and short-term bond vehicles for the management of their liquidity reserves.... This paper evaluates these trade-offs by integrating both a historical return analysis and forward-looking simulations using the Vanguard Capital Markets Model."
It finds, "Although noting both the historical outperformance and the forecast higher expected returns of ultra-short- and short-term bond funds versus money market funds, our analysis suggests that investors who accept the additional interest rate and credit risk materially increase their probability of loss of principal. We furthermore observe that moving from a money market fund to an actively managed ultra-short- or short-term bond fund increases manager uncertainty due to the broader opportunity set of investments."
The paper explains, "U.S. Securities and Exchange Commission rulings set to take effect in October 2016 will require floating net asset values (NAVs) on institutional prime money market funds, in addition to potential fees and other restrictions on investors to help ensure the funds' liquidity. Investors in institutional prime money market funds who desire a certain level of principal protection because of short-term spending needs or liability obligations have a range of short-maturity, pooled fixed income options to consider. They can remain in their current investment vehicles; they can switch to government money market funds, which will not be subject to floating NAVs or potential fees and restrictions; or they can invest in either ultra-short- or short-term bond funds or securities as substitutes for their liquidity needs. Choosing among these options is nuanced and requires consideration of trade-offs among risks to preservation of capital, liquidity, and yield."
It continues, "Given the prospect of higher yields that short-term bond funds might offer and their potentially increased flexibility, the small increase in fund duration may seem worth the risk. Based on both customized and industry indexes used for this study's analysis, we observed 60 and 140 basis points in respective yield advantages on average historically, for ultra-short and short-term credit investments relative to prime money market options. However, moving from a tightly regulated money market fund to a short-term bond fund that is often actively managed presents key risk-return trade-offs that should be evaluated. This paper aims to help investors better understand these trade-offs, so that they can determine whether ultra-short- and short-term bonds may be appropriate for their liquidity pool of assets."
Vanguard explains, "Fixed income investors are compensated for bearing three primary types of risks -- duration or term risk, credit risk, and risk from negative convexity. More specifically: Term premium is the compensation required for bearing the risk that interest rates do not evolve as expected; credit bonds are issued at a positive yield spread over comparable-maturity U.S. Treasury bonds to compensate investors for possible default; and callable bonds and those with prepayment risk are characterized as having a negatively convex price and yield relationship (i.e., duration may extend [or shorten] as interest rates rise [or fall], causing underperformance) for which investors also require compensation. Although investors can expect to earn additional yield for bearing these risks, exposure to them also creates additional return volatility in the portfolio. Money market funds and conservative ultrashort- and short-term bond portfolios are generally exposed to interest rate and credit risk."
Furthermore, they write, "When reviewing return behavior with respect to interest rate exposure since the financial crisis, returns of both the prime money market index and the ultra-short index have been anchored near zero. The tight performance is due partly to the fact that the U.S. Federal Reserve has kept the target federal funds rate at extremely low levels since late 2008, and only began the move to "normalize" interest rate policy in mid-December 2015. [T]he federal funds rate level has explained 75% of the variation in money market duration-matched Treasury bond returns. By comparison, the federal funds rate level has explained 60% of the variation in ultra-short bond duration-matched Treasury returns and only 19% of the variation in short-term credit returns. The Fed's move to begin policy normalization from the zero lower- bound level will likely mean that the behavior of the ultra-short-term bond index return as a result of interest rate exposure will revert to its pre-global financial crisis volatility."
Vanguard's paper continues, "In addition to differences in market risk that may result from moving to ultra-short-term or short-term bond funds from money market funds, implementation risk may also increase in the form of manager uncertainty. Although money market funds will remain tightly regulated by the SEC, and have a much more limited investment opportunity set than other investment options discussed here, the U.S. ultra-short and short-term bond fund opportunity set is derived from the more heterogeneous capital markets, spanning longer terms and crossing various credit sectors."
It says, "As such, managers have much more discretion in terms of yield curve positioning and credit risk-taking, and may also consider the negative-convexity risk premium, which is typically obtained through purchases of U.S. agency and non-agency residential mortgage-backed securities. Although most ultra-short-term bond funds have durations of about 1 year, and the duration of most short-term funds is between 2 and 3 years, variation in portfolio positioning relative to the yield curve and credit risk may be obscured by looking at the "duration" metric alone. As a result ... there is wider dispersion of returns among the cross-section of managers, which suggests greater manager uncertainty when selecting an active manager."
Finally, Vanguard concludes, "The possible liquidity and accounting implications of expected money market reform have led investors to evaluate ultra-short-term and short-term bond funds as substitutes for their cash management needs. As this paper has demonstrated, the decision to extend investment duration in this manner requires an understanding of the risk-return trade-offs. Although history suggests higher expected returns as investors add duration and credit risk to a bond portfolio -- a contention that is also supported by forward-looking simulations from the Vanguard Capital Markets Model -- we see the additional risk as two-fold: first, greater risk to principal protection from the longer duration interest rate and credit exposure and, second, risk from manager uncertainty. Given the ongoing low interest rate environment, we would expect a material increase in the probability for principal loss, while investor selection of active management in longer-term capital markets could lead to wider dispersion in return outcomes compared with those of money market managers."
