Paul McCulley

PIMCO

Footing the next grocery bill is the most immediate cash concern for many retail investors these days. But once the refrigerator has been stocked with fruits, veggies and other goodies keeping leftover cash on the sidelines may actually be detrimental to their health.

Paul McCulley, managing director at PIMCO, says that the current climate is rife with opportunities to put cash to work and that investors may want to begin shifting toward securities that assume more risk as government-sponsored relief efforts take hold.

“For your longer dated cash needs there’s never been a more propitious time to pick up some yield in total return,” McCulley says. “Investors are well positioned to take advantage of wide spreads in corporates and the opportunity in the mortgage space.”

He notes that the market is flush with liquidity (there is up to $800 billion in excess reserves in the banking system) but exceedingly risk averse. This is due to the uncertainty surrounding the solvency of the banks. “What’s freezing risk appetite is the fact that we don’t know who will be left standing,” McCulley says. Additionally, “this is the nastiest recession in the post-World War II period.”

Indeed, the current financial crisis has spurred widespread anxiety among many households prompting investors to seek shelter in money market funds or even stuff wads of cash under their mattresses. This flight to safety in money market strategies may seem like the logical play in a volatile and seemingly unforgiving market. However, now is not the time to panic, McCulley says. “Despite concerns over the solvency of the mega banks, we should not let it freeze us from action.”

He points out that monetary policy makers have endeavored to make it more palatable for investors to return to the equity and fixed income markets by ratcheting down interest rates to historic lows. “Money markets [almost] always trade at par but they don’t yield very much,” McCulley said. “This is exactly what the Federal Reserve sought to achieve when it lowered the Fed fund rates to zero. The Fed explicitly wanted to make holding cash painful.”

The shortfall on the balance sheets of troubled banks and Wall Street firms is being substituted by government subsidies in the form of the Troubled Asset Relief Program (TARP), the Term Asset-Backed Securities Loan Facility (TALF) and aggressive monetary policy decisions.

The TALF, designed to boost credit availability by propping up the market for car, small business and student loans, will start distributing funds March 25 and will likely accept securities backed by vehicle-fleet and equipment leases beginning in April, the Fed said earlier this month. The Fed also lowered so-called collateral haircuts for loans pegged to asset-backed securities with guarantees by the Small Business Administration or to government-backed student loans.

These and other fiscal stimulus efforts are likely to encourage investors to be less conservative and create opportunities in asset classes such as commercial mortgage-backed securities. “Our government – the Fed, Federal Deposit Insurance Corporation and the Treasury – does not want securities trading at pawn shop level,” McCulley says. “The Fed is trying to bring intrinsic value pricing back to the marketplace making high-quality short-term securities attractive.”

So rather than letting that cash that you don’t need for your grocery bill remain idle, investors may earn a higher yield by putting it into investment-grade bonds with a duration of less than one year, effectively moving from “pure cash” in money markets to “near cash,” McCulley says.

“It’s a prudent step to move from a money market strategy to a short-term strategy,” McCulley says. “It’s a great opportunity to buy on the cheap, to get good solid running yield as well as the upside of tightening spreads, as the full force of the balance sheet of Uncle Sam comes into play.”