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Jerome Schneider, Head of Short-term Portfolio Management: Given the broader market volatility we’re seeing, investors focused on capital preservation should be focusing on two tenets of portfolio management: volatility mitigation and liquidity management. Liquidity obviously is very important, thinking about it not just as a defensive mechanism but also as an offensive mechanism when we get into these periods of uncertainty. 

And having enough liquidity in the portfolio is fundamental to making sure that you’re able to withstand these bouts of volatility within your portfolio construction.

As we've seen over the past few days, certain indicators of financial stress have actually become more prolific in the marketplace. Back in 2008, many investors looked to many indicators to see signs of stress in the marketplace. 

One of those was the FRA-OIS spread or the LIBOR-OIS spread indicating the difference between risk free rates and credit sensitive rates.

Chart: The line graph depicts the spread of the LIBOR 3-month vs. the OIS 3-month from 2007 to 2020. The line starts low, sharply spikes in 2009 and then moderates to low again with slight peaks and troughs to the current period, which is rising.

Back in 2008, that reached a pinnacle of over 350 basis points differential. Today, that's elevated, but is only about 50 basis points, and it's elevated for very different reasons at this point in time. 

Predominantly, back in 2008, the concerns were financial risk, insolvency potentially in the financial markets, and systemic breakage that we were terrified of. 

Today, it’s quantified by fear of credit risk, uncertainty on global growth, and predominately uncertainty within the energy sector and corporate credit. And as a result, we've seen credit spreads widen.

Simultaneous to that, we've seen the OIS component, or the risk free rate, fall to two near term lows really driven by a duopoly of one, the financial intermediaries and the benchmark rates moving to lower rates—the Fed effectively adapting to more aggressive monetary policy—and the second aspect to that is the Fed's open market operations, which were utilized to alleviate funding pressures back in 2019, are now driving front-end rates lower and specifically T-bill rates lower as they continue to buy T-bill purchases on the open market. That differential has grown, but what it's done this time is it's not necessarily an indication of a systemic breakage, but rather an indication of a credit sensitivity and a widening. 

High quality assets are still out there. Liquidity is obviously more of a concern at this point in time, and as long as investors take an active and an adaptive approach to liquidity management, what we will find is a tiering structure, as we've discussed many times before, is still a compelling argument to tier between immediate cash needs and intermediate cash needs. 

With this in mind, we urge investors to manage capital just like we would ourselves: be defensive, be diversified, and be nimble.

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Disclosure

The "risk-free" rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return. All investments contain risk and may lose value.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

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