Following years of sustained economic growth, investors did not reevaluate what had been winning investment strategies, but the extent of the global financial crisis has helped them recognize the importance of defensive investing. The markets also show signs of defensive approaches, as firms deleverage and outstanding commercial paper diminishes. Policymakers, regulators and rating agencies are planning and implementing more conservative programs and methods. In this environment, cash investors can find many opportunities to play defense as a winning strategy.

Success Can Lead to Overconfidence

For almost a decade, the global economy was fortunate to have the tailwinds of growth and low inflation assisting investors toward attractive nominal and real return opportunities. These phenomena raised expectations to lofty levels for the better part of a generation. As we have seen, such a track record of relative outperformance can unfortunately lead to misallocation of resources within capital and personal investment portfolios.

Investors became complacent in their investment styles and, more importantly, their performance expectations were often based on unrealistic assumptions that were backward looking. Smug with the spoils of victory, investors became fans of the market, not arbiters of the market. As many fans of the late-1990s New York Yankees (or the Los Angeles Lakers or Manchester United) have learned, successive victorious seasons can lead to blind loyalty and unrealistic expectations for future performance. Obviously, this fanatic mindset can be harmful, or at least disappointing over time.

Many lessons that athletes learn on the field can apply for all investors and portfolio managers too. The keenest lesson is that when the calls are not going your way or your best sluggers are sluggish, sometimes swinging for the fences is not the right approach. Especially in an uncertain investment environment, your best offense might, in fact, be defense.

Why Play Defense?

Defensive play allows you a little extra time to survey the field for the best opportunities. Sure, you still need to score to win the game, but a good defense will always position you for victory. Defensive specialists can be big “playmakers” too: Ozzie Smith, “the Wizard of Oz,” made so many great defensive plays as shortstop for the St. Louis Cardinals that he probably saved at least one run every game. And Bobby Murcer, a renowned Yankee (from Oklahoma – a nod to Jerome’s roots), was both a strong hitter and a defensive powerhouse in the outfield.

On the investment field of play, the rules of the game have obviously changed over the past two years. And while some of the most renowned economic and financial minds have posited where the world is going on a secular basis, there is less consensus about the cyclical near term and how to invest in it. With such uncertainty in the game, playing defense may be the best strategy in the near future.

How Did the Markets Play Defense?

When the financial crisis was at its peak, the global economy was forced to play defense in order to create liquidity for the cash and credit markets, and the markets are still playing defense in a variety of ways. Investment banks are retrenching their appetites for riskier mortgage assets and structured products and regulatory authorities around the world are contemplating and implementing central clearing entities for derivatives, repo funding transactions and collateral.

Central banks played an extremely important defensive role during the crisis to unlock liquidity, and this continues to be necessary. The European Central Bank is offering term repo at fixed rates of 1% to member institutions, and the Federal Reserve extended well into next year the terms of the liquidity programs it created last fall: the Commercial Paper Funding Facility (CPFF), the Term Securities Lending Facility (TSLF) and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF). These programs were vital in providing a defensive liquidity backstop for the markets, but the Fed is also beginning to gradually, cautiously and defensively unwind them. Assets in the CPFF are declining (see Chart 1), a clear indication that liquidity is returning to the short-term markets and that sometime in the foreseeable future this defensive program will no longer be needed.

Assets in the CPFF and the AMLF

Source: Federal Reserve

Chart 1

The recent decline in outstanding commercial paper (CP), both traditional corporate CP issuance and asset-backed CP (ABCP) – see Chart 2 – represents a defensive measure by the market to rid itself of potentially less liquid securities. Many ABCP issuers were from levered structured investment vehicles (SIVs) and structured product entities, which are unlikely to ever regain the significant market share they had during the boom. Other ABCP issuers include consumer-oriented receivables programs, which are now in decline as the economy slows and consumer credit abates. The lack of transparency in the underlying collateral has the potential to make ABCP securities less liquid in more turbulent markets. As investor demand for ABCP declines, then the cost of funding increases until it becomes prohibitively expensive and the issuer must cease operations – adding impetus to the recent decline in CP outstanding.

U.S. Commercial Paper Outstanding

Source: Federal Reserve

Chart 2

Deleveraging – another defensive strategy – is not only apparent at investment and commercial banks, but also within the real economy. Many corporate issuers are electing to take a conservative approach by issuing longer-term liabilities at a higher cost in an effort to avoid the liquidity risk associated with continuing to rollover the cheaper, shorter maturity CP that had been previously outstanding. The increased corporate issuance further out the maturity curve was met with a huge appetite from investors hungry for yields, especially after spreads had been recalibrated at wider “normals” due to the financial crisis. However, spreads have tightened quickly over the past few months as investors found their risk appetites again after a long winter hibernating. Also, because they are electing to term out their debt, fewer corporations are issuing CP into the money markets (included in the Unsecured CP figures in Chart 2). As a result, CP spreads have tightened in sympathy with longer-dated corporate spreads, but for a different reason: diminishing supply. Investments in shorter-dated assets appear more attractive as they limit downside risk should spreads widen again (a defensive approach) while potentially providing excess return relative to sovereign benchmarks.

The dynamics of economic conditions are not the only factors influencing portfolio performance and allocation decisions; investors should also watch for changes in rating agency mandates and methodologies, as well as alterations in accounting and bank regulatory frameworks. Following the turmoil of the global financial crisis, investors should expect regulators and rating agencies to be more restrictive and conservative in the future, which would provide an additional line of defense in the marketplace. The Basel II regulations were a step in the right direction toward evaluating bank credit and market risk. But Basel II is only the beginning of the changes we may see as inter-regional and international regulators – the market’s umpire crew – review the “film” of the errors made and infractions overlooked during the past season of financial upheaval.

How Can Investors Play Defense?

With so many factors in flux that may impact portfolio performance, the timing may be right for a strategy that manages interest rate exposure while allowing for some downside protection. While credit products were cheap a few months ago, the recent rally has investors asking whether a credit-focused strategy is ideal for the long term. Investors have defense in mind, given their concerns that the green shoots of recovery might wilt in the summer sun if corporate earnings over the next one or two quarters are weaker than expected. This is precisely the time for investors to consider how to conservatively manage the interest rate, credit, and most importantly, liquidity risks in their portfolios.

Recently, due to significant market volatility, the greatest needs for cash investors have been preservation of principal and liquidity. The ultimate defense is investing in Treasury bills, but these investors face the possibility that the nominal rate of return could often fall below the real rate of return. The price of a Treasury can fluctuate, so although they are very liquid, the return can be negative if they are sold at the wrong time. Thus, owning only T-bills can be a losing proposition in the long run. To counteract this, investors might consider supplementing their potential returns by taking some duration and credit risk, via commercial paper or short-dated investment grade corporate debt with an average duration under one year.

While money market strategies are often reserved for managing cash, they can also be a simple way to play defense for investors who normally have an orientation toward offense. They are designed to provide preservation of principal and daily liquidity. However, with so many market participants playing defense in this environment, money market yields have been driven to very low levels. This can be somewhat painful for investors, but if liquidity and principal preservation are the key objectives, then playing defensively by investing in money markets may be the appropriate strategy. The key to managing cash is maximizing liquidity while not overpaying for it, but in these times that can be a challenge. Still, we believe a money market strategy successfully embodies this concept.

In our June Viewpoints: “The CFO’s Cash Dilemma,” we discussed strategies that have the potential to provide liquidity and a competitive return over money markets. In the current environment, short duration strategies may provide a more attractive return profile than money market strategies while still investing in defensive areas of the market. A portfolio that targets select corporate issues and mortgage and agency exposures with durations of approximately one year may offer a cushion against market uncertainty for the next few quarters, and also may offer a modest return on capital. Although spreads have tightened over the first half of 2009, investments in strong credits that have limited duration exposure remain highly attractive compared to long duration sovereign and credit securities, which have tightened more over the same timeframe.

Even with these opportunities in the current environment, there should be no need to take material risk. Over the past two years, we have all seen the potential damage that overconfidence or unrealistic expectations can inflict on a portfolio when an investor tries to stretch a single into a double when the outfielder already has the ball. Although we believe that the Fed will remain on hold for some time, and that other central banks will likely continue (though not expand) their quantitative easing programs, it is not time to take an aggressive home-run swing at the investment ball. Play to win by playing defensively: Hit a single and advance the runner to the next base.

It is important to manage portfolios defensively, emphasizing liquidity and capital preservation in short-term strategies rather than stretching for returns at the expense of incurring downside risk. Rigorous market and credit risk management will help investors avoid many of the sectors and securities that could be negatively impacted if the slowing economy continues, and will help keep investors in the game over the long term.

About the authors:

Paul Reisz, CFA, is a senior vice president in the Newport Beach office and a product manager covering the spectrum of money market, enhanced cash, stable value and income strategies. Prior to joining PIMCO in 2000, he was with Transamerica Asset Management for more than 10 years, responsible for business development, client servicing and product development. He has 25 years of investment experience and holds an MBA from the Marshall School of Business at the University of Southern California. He received an undergraduate degree from the University of California, Berkeley. He is also a certified public accountant.

Jerome Schneider is an executive vice president in the Newport Beach office and deputy head of the money market and funding desk. Prior to joining PIMCO in 2008, Mr. Schneider was a senior managing director with Bear Stearns. He specialized in credit- and mortgage-related funding transactions and was instrumental in the development of one of the first “repo” financing companies. He has 14 years of investment experience and holds an MBA from the Stern School of Business at New York University. He received an undergraduate degree from the University of Pennsylvania.