Liquidity lowdown: Security in an environment where the economic landscape may be deteriorating

The current economic landscape in the UK is fraught with increasing risks from escalating tensions in the Middle East and an upcoming budget which is keeping markets firmly on edge.

With the Chancellor of the Exchequer’s eagerly awaited fiscal statement on Wednesday (31st October), the downbeat narrative from Rachel Reeves has only added to decreasing consumer confidence, despite an economy which has been surprisingly strong. There has been a lot of speculation about how the apparent £22m billion fiscal hole left by the former government will be filled, with the Chancellor keen to encourage growth and investment whilst ensuring any potential tax rises do not end up having a contrary effect. With increased government borrowing a likely scenario, investors will naturally be cautious of the weeks ahead. In times of uncertainty and potential volatility, security of investments begins to become more important than ever in portfolio construction and utilising the yield of short-dated liquidity solutions may once again look very appealing.

Money Market Funds (MMFs) tend to focus on assets with short maturities and keep a large proportion of the portfolio in overnight assets to meet daily liquidity requirements set out by the regulators. Reverse repurchase agreements are commonly used by MMFs because of their ability to provide a degree of security – as cash being lent out is backed by high quality collateral (typically UK government debt). So if the financial institution which is being lent money gets into difficulty, the agreement is secured on underlying assets which MMFs can access. All things being equal, this is preferable to lending cash on an unsecured basis (typically overnight), especially when investors are not being sufficiently compensated for taking on unsecured risk. Yields on reverse repurchase agreements have currently been higher than those achieved on unsecured overnight deposits, an unexpected dynamic which has been seen ever since the Bank of England began their quantitative tightening programme, which increased the supply of government bonds in the market.

As you move into longer duration liquidity solutions, like the Royal London Short Term Fixed Income Fund and Royal London Short Term Fixed Income Enhanced Fund it is important to understand the additional risks. The former uses standard money market instruments, but also aims to hold up to 50% in AAA rated covered bonds which are highly regulated by the home regulator for each geographical region. These bonds are exempt from bail-in, meaning they will not be brought into any winding-up process if the issuing bank defaults. These security characteristics typically become more in demand when economic uncertainty increases or economies begin to slow. Building in an increasing amount of security and diversification into portfolios becomes key given the most significant risk a MMF or short bond fund must manage is default risk, and we believe that managing that risk by using secure assets exempt from bail in is an important element in creating a portfolio that remains highly liquid in all scenarios without compromising on the yield.

The Royal London Short Term Fixed Income Enhanced Fund can invest additionally in mortgage backed securities – off balance sheet securitised products backed by mortgages and are mainly AAA rated – and ultra short dated investment grade corporate bonds. When moving into longer duration or higher risk bonds we believe it is sensible to seek an increased exposure to secured assets where possible, or aim to diversify into non-financial corporates that are also exempt from bail in. Liquidity strategies have been changing ever since the trajectory of interest rates shifted in late 2021. We still believe that investors can benefit from using a combination of MMFs and longer duration solutions to balance various liquidity requirements whilst maintaining security of capital  - especially in times of economic uncertainty. We continue to expect increased market volatility in the months ahead but think that MMFs can continue to help investors calmly navigate through these uncertain times.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.