Markets & Economy

Fixed Income

Short-Term Bonds: A New Take on Cash Management

May 24, 2017
Joe Lynagh, the T. Rowe Price Ultra Short-Term Bond Fund’s portfolio manager, discusses higher-yielding cash management solutions.

Key Points

  • Even after several rate hikes, the hunt for higher yield and income continues as investors create new demand for high-quality short-dated investment alternatives.
  • The 2016 money market fund reforms not only changed the overall composition of the money fund industry, they also permanently transformed the cash management industry from a “one-size-fits-all” money market fund industry into a more dynamic cash investment solution industry.
  • As a result of investors’ search for high yields and money fund reform, investment strategies like T. Rowe Price’s Ultra Short-Term Bond Fund have grown in popularity as they can offer investors a way of increasing yield and income while sacrificing only a bit of price stability.
  • T. Rowe Price’s Ultra Short-Term Bond Fund seeks to provide more income than a money market fund by taking on slightly more risk.

Investors often spend significant time thinking about which stocks and bonds to invest in, but they may spend little time considering how they might invest their cash used for short-term funding needs or how they would allocate it to their portfolio. Cash returns have gained more attention following the recent rise in interest rates and last year’s money market fund reforms, which not only separated retail and institutional investors, but also imposed redemption gate and liquidity fee rules that can restrict access to cash in periods of economic and market stress.

Traditionally, retail investors have kept the bulk of their cash savings in prime money market funds, which can invest in potentially higher-yielding nongovernment obligations, such as commercial paper. In the wake of reforms, these investors have been moving aggressively into government funds—which invest almost exclusively in U.S. Treasuries and other U.S. government money market securities (see Figure 1). Government funds have been gaining popularity because, unlike nongovernment funds, they are not required to charge liquidity fees or restrict access during periods of heavy redemptions from what has traditionally been the most liquid part of a portfolio.  

The migration to government money funds, however, has made the search for yield even more difficult for retail investors. Higher demand has kept the yield on government money funds below yields on traditional prime and tax-free money funds. As of March 31, 2017, the spread, or yield difference, between the two types of money funds was 27 basis points, or 0.27%.  

The Reforms

The Securities and Exchange Commission’s (SEC) money fund reforms, enacted in October 2016, are intended to prevent a run on money market funds, like the one that occurred during the 2008 financial crisis. The SEC categorizes money funds as government, retail, and institutional. Distinctions also exist between government and nongovernment funds. Under the new rules, institutional nongovernment money funds must allow their net asset value (NAV) to fluctuate daily above and below $1.00 to reflect current market prices of underlying holdings. Institutional investors are not allowed to invest in nongovernment money funds designed for individual investors. Money funds sold to individual investors can continue to be managed to keep their NAV at $1.00. The rules require all nongovernment money market funds to have the ability to temporarily prevent investors from making withdrawals or to impose liquidity fees for investors who redeem shares during times of stress in the money market. Government money funds are not required to have the ability to impose liquidity fees or restrict redemptions.

Cash management no longer a “one-size-fits-all” solution

While money market funds have been favored by investors seeking to protect account balances from market fluctuations and to manage cash flows and liquidity, we believe the reforms have been changing that preference, transforming the cash management industry from a “one-size-fits-all” money market fund industry into a broad and more dynamic cash investment solution industry. Since the reforms, the size of the overall money market universe has been shrinking. As of March 31, 2017, assets in money market funds totaled about $2.65 trillion compared with $2.77 trillion in February 2016, according to the Investment Company Institute.

The combination of regulatory changes and low yields has pushed investors to reevaluate how they manage their cash. In other words, they are looking for higher-yielding places to put the cash they use for their short-term investment needs. We believe other low-duration options can play a role in generating additional yield, especially if investors are willing to increase risk in their quest for yield.

For instance, in looking at cash management solutions, investors might substitute or pair an ultra short-term bond fund with a money market fund in an effort to more accurately achieve their risk and return objectives while optimizing the total income produced by their cash investments. This is an example of what is known as a cash, or liquidity, tiering solution, which has been gaining ground in the wake of the reforms.

Tiering fixed income investments can help investors address short-, intermediate-, and longer-term cash needs while putting their assets to work. Using this technique, investors would divide cash and other fixed income assets into buckets to meet short-term cash needs, ongoing funding needs, spending needs a year or more into the future, and longer-term needs, which could be funded through riskier investments. Using an ultra short-term bond fund to address short-term funding needs could expose an investor to greater income opportunities through Treasury and agency-backed securities, as well as corporate bonds and notes with only slightly more credit risk than money market funds. Investments in the Ultra Short Term Bond Fund could also be subject to interest rate risk. An investor could lose money, if rates rise and bond prices fall.

The T. Rowe Price Ultra Short-Term Bond Fund, for instance, can invest in the entire investment-grade universe with maturities of three years or less, including short-term investment-grade and government securities, asset-backed securities, and bank obligations. As of March 31, 2017, about 90% of the fund comprised corporate bonds rated BBB or higher, while the remainder consisted of U.S. Treasuries and other government bonds. While ultra short-term bond funds are by definition more risky than money funds, they are much less so than other bond funds. Investors can also write checks on the Ultra Short Term Bond Fund, a feature found in money market funds.

When deciding whether to make this move into an ultra short-term bond fund, investors should be aware of how the portfolio compares with a government money market fund. The money market investment universe is heavily regulated by the SEC. As a general rule, money market funds can invest only in securities with the highest credit quality (AA credit ratings or higher) and relatively short maturities (397 days or less). By comparison, short-term bond funds, such as The T. Rowe Price Ultra Short-Term Bond Fund, typically can invest further down the credit quality spectrum into securities that are rated BBB- and better.

Also, the Ultra Short-Term Bond Fund features daily liquidity but not necessarily NAV stability. However, as seen in the chart below, the NAV of the T. Rowe Price Ultra Short-Term Bond Fund has fluctuated only modestly since its inception in December 2012. Its NAV, while floating, has been relatively stable because of the relatively short maturities of the fund’s underlying assets.

We believe that an investor in the T. Rowe Price Ultra Short-Term Bond Fund still benefits from the safety found in very short-term securities, but the pickup in yield from taking on incrementally more credit risk can be meaningful.

By segmenting cash into different liquidity tiers, investors can more efficiently deploy capital across the risk/return spectrum and gain access to higher-yielding opportunities.

Important Information

Call 1-800-225-5132 to request a prospectus, which includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.

Retail Funds: You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. Beginning October 14, 2016, the Fund may impose a fee upon the sale of your shares or may temporarily suspend your ability to sell shares if the Fund's liquidity falls below required minimums because of market conditions or other factors. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund's sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.

Government Funds: You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund's sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.

Institutional Funds: You could lose money by investing in the Fund. Because the share price of the Fund will fluctuate, when you sell your shares they may be worth more or less than what you originally paid for them. Beginning October 14, 2016, the Fund may impose a fee upon the sale of your shares or may temporarily suspend your ability to sell shares if the Fund's liquidity falls below required minimums because of market conditions or other factors. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund's sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at anytime.

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the author as of May 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

The T. Rowe Price Ultra Short-Term Bond Fund is not a money fund. Its share price will fluctuate daily, which means you could lose money by investing in it.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments involve risk. All charts and tables are shown for illustrative purposes only.

T. Rowe Price Investment Services, Inc., Distributor.

 

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