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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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