Money in Motion: It’s Not about Return on Principal, but Return OF Principal

kevin-temp2
Head of Fixed Income Strategy
Follow Kevin Flanagan
03/25/2020

In this challenging financial market and investment landscape, I wanted to start a series of “Money in Motion” blogs, to offer up insights for fixed income positioning. The first in the series reflects where we are at the present. In other words, it’s not about return on principal, but return OF principal.

Given what has transpired in the money and bond markets over the last two weeks, the aforementioned age-old adage should not come as much of a surprise. The declines in a whole host of fixed income markets, and signs of growing dislocations in the funding arena, have left investors in a state of fear, the likes of which we haven’t seen since the financial crisis. The good news is that the Federal Reserve (Fed) has been proactive in its policy approach. But, as I’ve written on numerous occasions over the last few weeks, monetary policy can’t turn the economic and financial tide all on its own. Meaningful fiscal policy responses need to be implemented as well.

The widening in credit spreads and general risk-off trade has not been the most surprising turn of events of late. However, fixed income investments that were thought to be safe-haven plays—namely, ultra-short and short duration strategies—were not all created equal. These strategies offer two distinct options. The first focuses exclusively on the U.S. Treasury (UST) market, and comes in two forms: fixed rate or floating rate. The other option includes credit, and more often than not, a heavy concentration in the Financials sector.

Unfortunately, investors discovered last week that the approach involving credit can behave in an unexpected manner. In highly charged risk-off periods, this approach can be overtaken by the negative dynamics concerning credit, overwhelming the rate aspect of the instrument. This is exactly the result investors were trying to avoid. The UST option, backed by the full faith and credit of the U.S. government, typically may lag the credit approach in terms of yield. But as we witnessed, this is obviously for a reason. However, keep in mind the fixed-rate aspect can still contain an element of interest rate risk while the floating rate aspect does not.

So, what are fixed income investors to do? The current money and bond market environment has afforded investors the opportunity to review their fixed income asset allocations. Once the dust does settle, our base case looks for interest rates to begin retracing their recent declines. If the recent volatility is any indication, it could happen rather quickly. The UST floating rate strategy eliminates the potential for further credit risk while also mitigating the potential for rate risk. In our view, this strategy provides investors with a solution for not only the near-term outlook, but for the horizon as well.

 

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About the Contributor
kevin-temp2
Head of Fixed Income Strategy
Follow Kevin Flanagan
As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.