4 min read 30 Mar 22
In an environment of higher inflation and expected future interest rate rises, investors have begun to see the real value of their cash holdings being eroded and experienced a lack of protection from the income generated by fixed rate government and corporate bonds – as well as mark-to-market capital losses from these positions.
Given the duration risks many core fixed income portfolios now face, investors are re-evaluating their defensive allocations and seeking potential diversification, while also trying to minimise cash drag on overall portfolio returns.
In our view, floating rate senior AAA European ABS are an often overlooked potential protective measure that can complement cash and other defensive assets. Among their attributes are low duration; high levels of structural resilience through credit enhancement; large, liquid trading volumes; and typically a significant yield premium over many other defensive assets.
To determine the extent to which they can provide effective diversification, we must first identify the roles of cash in an investment portfolio.
In our view, investors typically hold cash for three key reasons – usually in the following order of priority:
Ultimately, cash should be safe and liquid. This is why many investors hold large cash deposits in custodian accounts, despite their deeply negative real yields. However, not all cash deposits require immediate access.
As such, any decision to reallocate excess cash holdings are likely to involve considering how this cash may be needed in future to meet specific objectives across the safety-liquidity-yield spectrum.
While cash deposits are needed for immediate cashflow needs, and cash equivalents can offer a small yield pick-up for other short-term horizons, there may be potential opportunities to reallocate excess cash for intended holding periods of 6-12 months or longer into higher-yielding liquid assets.
In our view, floating rate senior AAA European ABS fare well in meeting the safety, liquidity and yield criteria for such circumstances, with a view to complementing, rather than replacing other defensive assets as part of a holistic approach to cash management.
1. Safety. Senior ABS sit at the top of the capital structure, which means they benefit from robust structural protection and credit enhancement. They are therefore well-protected from potential losses in the collateral pool by the tranches below them, which has been successfully demonstrated in extreme market conditions.
2. Liquidity. AAA ABS represent the largest part of the public securitisation market, with secondary market volumes offering potential liquidity for daily trading, even in stressed conditions such as those experienced in 2020, as evidenced by M&G’s traded volumes of ABS shown below. European AAA ABS are listed on regulated exchanges and have a minimum of two ratings – often three.
3. Yield. Senior AAA European ABS typically offer a significant yield premium over cash and money market funds, without facing the same duration risks as government and corporate bonds thanks to their floating rate coupons.
In an environment where investors face geopolitical uncertainty and risks from inflation and interest rate rises, we believe a tiered approach to cash allocation, including strategic reallocation of cash to defensive alternatives, could help to reduce the drag of cash on investment returns, while helping investors retain access to liquidity and safety.
In our view, European senior AAA floating rate ABS have offered several potential advantages over traditional short-dated government and corporate bonds to achieve this. As such, we believe they could be considered a useful potential diversifier in the period ahead.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.