Stretch Too Far And Things Can Snap!

At the age of 55 I am getting to that point (regrettably) that it is becoming more and more difficult to do the things that I did as a younger man. However, this article’s title isn’t referring to my inability to touch my toes without straining most muscles in my body. No, I am referring to the stretch for yield by institutional investors that just my strain, tear, rip, and snap their portfolio’s fixed income exposure.

The holy grail for most public fund and Taft Hartley plan sponsors remains the ROA (return on assets assumption). As such, as interest rates continued to fall in the US, plan sponsors either exited fixed income or they sought higher yielding, less liquid fixed income alternatives in an attempt to generate a return that approximated their ROA. We’ve already discussed on many occasions the negative impact on the asset / liability relationship from reducing fixed income within a plan’s portfolio. There are short duration liabilities that can be immunized with lower yielding fixed income instruments that don’t need to have a return anywhere near the ROA.

In the second instance, the reach for yield has created crowded trades that may be difficult to unwind, potentially exacerbating any loss. We are beginning to see the higher yielding segments of the US credit markets twitch. In the week ended Wednesday, August 6th, EPFR reported that mutual fund flows from high yield funds was -$7 billion, which is the largest withdrawal since 2010, and the largest as a % of AUM ever. Furthermore, the flight to quality that has pushed the yield on 10-year Treasuries to a 52 week low of 2.39% (as of this morning), has also seen it’s yield spread to high quality credits expand beyond 100 bps for the first time since June.

Don’t be shocked if higher yielding credits in ETFs and mutual funds continue to see outflows. The fear of Federal Reserve tapering, geopolitical uncertainty (Ukraine / Russia and Iraq), and Europe’s inability to generate sustained economic growth are creating angst among the investing community. If you want to alleviate this uncertainty, KCS has developed an investment approach to convert your alpha assets (ROA-driven) into beta assets (liability focused) that will help stabilize your funded ratio, potentially reduce contribution costs, and use your fixed income exposure more wisely. Why risk injury trying to exit the credit markets with everyone else.

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