Money market funds were the big winners of 2023, garnering more inflows in the past 12 months than during the previous eight years combined, according to Calastone’s Fund Flow Index.
The £6.6bn Royal London Short Term Money Market fund raked in £4.5bn of new inflows last year by offering yields of 5.5% and was one of the most popular funds on interactive investor’s platform.
But with rate cuts on the horizon this year, FE fundinfo Alpha Manager Craig Inches, head of rates and cash at Royal London Asset Management (RLAM), and senior fund manager Tony Cole expect investors to pivot towards the £4bn Royal London Short Term Fixed Income fund.
It received £700m in inflows last year but was overtaken as RLAM’s most popular liquidity fund. A couple of years ago, when rates were lower and money market funds looked less appealing, it had the edge.
Inches and Cole compared their fund range to Goldilocks and the three bears’ porridge. “Short Term Money Market is probably on the cool side, Short Term Fixed Income is just right and Short Term Fixed Income Enhanced can be a bit hot at times,” Inches explained.
What is your view on interest rates?
Inches: I think rates will decline over the medium term as the recent rate hiking cycle will eventually take its toll on the economy. However, currently the market is far too optimistic on how many cuts will take place in 2024. To justify this speed of cuts we would need to see a sharp recession and a collapse in inflation, however that is not the central case scenario of many economists, including our own.
If there’s a massive recession then you will get a big rally from bond markets, but if there isn’t, the market probably has too many cuts priced in. We feel the market has pushed yields too low, so we are investing in shorter-dated assets and attractive covered bonds.
Our Short Term Fixed Income fund is yielding 5.25-5.5% with very little credit risk and the credit risk it does have is senior secured, so what’s not to like? Government bonds, by contrast, are yielding 4% so you’re dropping 1.5% of yield for a product that will only give you a return if rates fall.
How would rate cuts affect the yield from your funds?
Cole: Short Term Money Market tracks the base rate so it will move quickly if central banks cut rates because it has a short duration.
Inches: The yield from Short Term Fixed Income will be a bit slower to fall. Floating rate covered bonds give you a spread of 0.5-0.75% above the bank rate, so that fund has a bit more ballast. When people start searching for a bit of yield again, I expect flows into Short Term Fixed Income to pick up.
What is your investment process?
Inches: Short Term Fixed Income focuses on two asset classes, short-dated money market instruments and floating rate covered bonds.
The money market instruments are a combination of bank deposits, certificates of deposit and UK Treasury bills with a final maturity of less than 365 days.
The floating rate covered bonds are issued by highly-rated global financial institutions and are secured against prime residential mortgages. The floating rate aspect of these instruments means they have very limited interest rate risk and the secured aspect is tightly regulated, resulting in an asset that is generally AAA rated, extremely liquid and exempt from bail-in in the event of a financial default.
Our £1.4bn Short Term Fixed Income Enhanced fund invests in money market instruments, covered bonds and short-dated corporate bonds from AAA to BBB. It can buy mortgage-backed securities as well. It’s like splicing together the Short Term Fixed Income fund with a short-term credit fund.
Why should investors choose your funds?
Inches: Short Term Money Market was yielding 5.5% in 2023 with very high liquidity, good environmental, social and governance (ESG) credentials and solid portfolio construction. People were saying ‘I don’t need to push for the extra 10, 20, 30 basis points of yield, I’m happy to take 5.5%’.
It is an onshore sterling fund with two-day settlement, so it suits the needs of UK financial advisors and private investors.
The Short Term Fixed Income fund’s portfolio construction, focusing on secured assets and financial institutions with a strong ESG ethos, has resulted in robust medium-term returns for clients whilst navigating numerous economic crises during its lifetime.
What were your best calls over the past year?
Inches: The Short Term Fixed Income portfolio increased its exposure to floating rate covered bonds and we were buying these assets at spreads of SONIA +0.5% to SONIA +0.7%. These are perfect assets for a fund that has an annual target of SONIA +0.5%.
We expect to see a lot more issuance of floating rate covered bonds in 2024 because banks need to replace cheap government borrowing. Tony has just bought a floating rate note with three years to maturity yielding SONIA plus 67 basis points and it is exempt from bail-ins.
We also increased the duration of the fund last year via one-year fixed deposits. We probably started extending duration slightly earlier than we could’ve done. Tony and I were both bearish on bonds for most of last year but when we saw yields of 6%, we got excited. We were still buying certificates of deposit all the way up to 6.8% at the peak.
On average we bought one-year assets at a yield well above 6%. The fund benefitted strongly from these calls and outperformed the bank rate or SONIA by over 0.7% this year. We knew yields above 6% were unlikely to be sustained and if you can lock that in, it made perfect sense for cash investors.
How do you incorporate ESG?
Cole: We run a quantitative model that scores the amount of ESG risk in the fund. We’ve been considering ESG for a long time, but in 2020 we started graphing our quant ESG scores. Since then, our charts have been on a downward trend showing lower ESG risk and volatility, which suggests that transparency does have an impact on your behaviour. Most of our funds are now in the green zone with an AAA MSCI ESG score.
We buy longer-dated instruments from issuers with a good ESG score and only lend on a very short-term basis to issuers with a lower ESG score, so we mitigate the ESG volatility and risk through portfolio construction.
Inches: If we have an asset in the fund with a poor ESG score that is hit by negative headlines while we own it, that name becomes completely illiquid. No one wants to buy it. The number one concern for a cash fund is liquidity.
We can still lend to lower quality ESG institutions but we keep it short and we engage with them to explain why we are only lending at a very short duration.
A lot of issues can be avoided through ESG analysis rather than credit analysis. Credit Suisse had a strong balance sheet but their governance couldn’t keep that institution going.
What do you do outside of fund management?
Inches: I’ve got the entire family into golf so now we live at the golf course.
Cole: We’re a family of musicians so we do duets and trios. I play the piano and I used to play trumpet in a band.