This month, Bond Fund Intelligence featured the profile article, "`Pros & Cons of Ultra-Short BFs by Crane, Pope & Olsen." We wrote in our July issue about our June Money Fund Symposium conference in Atlanta, which featured the ultra-short bond session with our Peter Crane, along with Fidelity's Kerry Pope and Northern Trust's Morten Olsen. The three discussed the growing use of ultra-short bond funds by institutional cash investors. We quote from this session below. (Note: This "profile" is reprinted from the July issue of BFI. Contact us if you'd like to see the full issue or if you'd like to see our new Bond Fund Portfolio Holdings "beta" product, which ships to subscribers Monday.)
Crane explained, "Ultra-short bond funds have been one of the great hopes [in the near 'cash' space].... The good news about the space is that after several years of a lot of launches and a lot of pushing from providers, there is a [now] awareness. Big corporate investors who've been targeted now know about ultra-short bond funds [as an] alternative to prime money funds, and as an alternative to get more yield. The other good news is, they're starting to gain critical mass."
Pope tells us, "We had the benefits of the 2007-2008 enhanced cash product [experience and problems] when we were creating these new ultra-short products. They're different for a couple of reasons. One is that we're focused on ... volatility, and [not] simply providing a higher rate return rather than a money market fund. They're not holding a tremendous amount of structured product [or] mortgage securities in these types of products."
He continues, “The client base that we’re selling to is: 1) a more stable client base, primarily because we’ve explained to people the use of this type of a product is not for operating cash, it’s for strategic liquidity, liquidity that has some level of dormancy around it. As opposed to back in the day, when they were selling enhanced cash products, those products were designed to compete directly with money market funds."
Pope adds, "They were sold as operating cash equivalents. They were highly rated [but] most of the product ... was structured product.... We all know what happens in times of stress with structured products, there's no liquidity.... [Before they were] certainly mis-marketed, mis-sold and poorly managed."
He continues, "So part of the lessons learned is that what we're now selling are basically products that you used to buy as money market products. These are basically the old 2a-7 money market products, but because of rate reform, money market funds have become shorter in duration and more conservative. We used to manage to a $1.00 NAV very protectively back when we had 90 day weighted average maturities or 120 day weighted average maturities in the money market space. What we're really looking to recreate is that conservative profile."
Pope explains, "There's been a tremendous number of forces that have reshaped the liquidity space. We've had 2a-7 rate reform, where money market funds have become more and more conservative, and now prime [potentially have] fees associated with [them and] 4 decimal places. We have banks that now have different regulatory requirements that encourage the lengthening of their liabilities, and then, of course, we have now rates moving higher. So all of these come together to create an environment [in which] it's appropriate to step back and look at how cash is being managed and what the credit methodology is. Corporations should be thinking about managing the liquidity that they have."
Pope says of Fidelity's Conservative Income Fund, "When we did the analysis, we were concerned initially about bumping up against some of the regulatory forces. We wanted to circle that with what the SEC was looking to do. So we knew we didn't want to replicate a current 2a-7 kind of structure. Initially, we wanted to position this product differently ... to those clients that have strategic liquidity [needs, giving them] additional value by creating a little bit of a different structure."
Olsen says of Northern's offerings, "One of the big differences is we can buy the full investment grade spectrum and that means that [other very short] ultra-short funds are mostly in financial securities.... With money fund reform [about] 70-80% of [fund holdings are in] financial issues.... That's much lower than our ultra-short fund; it's closer to 40%.... We buy Treasuries, we always have roughly 15% relating to Treasuries and agencies. So our ultra-short funds is a very well diversified investment vehicle.... We don't buy any derivatives; we don't buy cross-currency, because everything is dollar denominated.... We take a bit of duration risk; we take a bit of credit risk. We feel like it's well controlled, and we focus on the two things we need to do that, which is the yield curve and credit."
We ask Pope, "How do we know funds are 'conservative' ultra-shorts?" He answers, "There are differences in all of the various ultra-shorts, even the conservatives are different. So you really have to look at the prospectus. From our perspective, we can get investment grade and [a] higher percentage of A-rated debt. That too is extremely important... We want a short duration, so we target 4.5 months. But during this time of rising interest rates we've shortened that to about 2 [months]. It's at 0.2 year at this point in terms of duration."
He says, "Then in terms of weighted average maturity, we are 3/4 of a year or shorter, and we think that's appropriate to help us [dampen] volatility.... [T]o launch this type of product, we went back to the 2008 crisis to understand the type of volatility and its potential in the product. Certainly in times of stress, there will be some volatility, especially as credit spreads move. But generally speaking ... we're looking at providing a product that, if your holding period [is] 2 months or longer, you will have a positive experience versus over in the prime money fund."
Pope adds, "Ours has been up and running for over 6 years. It took 3 years to get a decent track record.... Once you get past the 3-year mark, people are much more comfortable in understanding how the performance works with NAV volatility.... One of the other things that is difficult: Morningstar evaluates the whole Ultra-Short category, and they don't specify the conservatives. So we're competing in that ultra-short category with funds that have double-B, single-B types of credit. So for us to get a 3-star rating on Morningstar is saying a lot, given that we're not taking nearly the level of credit risk of interest rate risk."
Finally, he tells us, "We've had great success [with this product]. [This is mainly] a function of our salespeople, [who] really jumped on this bandwagon early and recognized the opportunity ... and how many of our clients continue to carry structural liquidity.... This product was really appropriate for that.... They recognized that money market funds are going to need to be more conservative and subject to liquidity gates and fees. They did a very good job marketing it, so much so that in many cases we had clients that would come to us looking to jump in [with] several hundred million dollars.... We had to limit that flow of investor enthusiasm to something more appropriate."
